In today’s guest post, Carl Smith discusses how the EITC can put the IRS in the unusual position of arguing that the taxpayer overstated her taxable income and was required to take deductions.
We have written a number of posts discussing the somewhat unusual fit of the EITC and tax procedure and tax administration, looking at for example the EITC’s special due diligence rules and the separate EITC civil penalty regime. The post and case raise some interesting issues and unanswered questions, including what role if any a preparer played in the taxpayer’s decision to pinpoint the income needed to maximize the EITC and whether incentives under the ACA to overstate income may lead the IRS to more aggressively pursue taxpayers who fail to claim eligible deductions. Les
Litigation over the earned income tax credit (EITC) is a perennial of low-income taxpayer clinics. For those readers who were never clinicians, but who want to help pro se individuals showing up at Tax Court calendar calls, I thought it might be useful to discuss a recent bench opinion out of the Tax Court that illustrates how the EITC can reverse litigation roles when the IRS tries to disallow the credit — with the IRS being in the unusual position of denying the taxpayer’s receipt of reported gross income and occasionally even asserting the taxpayer’s entitlement to unclaimed deductions. This income-related litigation is probably the second-most-common issue litigated in EITC cases — with the top issue being where each child who the taxpayer claims as a “qualifying child” lived for purposes of increasing the amount of credit. This post will only discuss the income issue that was involved in the bench opinion, Kalokoh v. Commissioner, Docket No. 29859-13 (order dated March 18, 2015). Pro bono lawyers need to be aware of why the IRS takes this topsy-turvy position in order to effectively represent EITC taxpayers.read more...
There are four kinds of taxpayers who can claim the EITC — ones with no dependents, ones with one qualifying child, ones with two qualifying children, and ones with three qualifying children. The more qualifying children a taxpayer has, the bigger the potential EITC. There are three filing statuses that can claim the EITC: single, head of household, and married filing jointly. Married filing separately taxpayers cannot claim the EITC. Section 32(d). Single and head of household filers with the same “earned income” get the same amount of EITC. So, basically, there are two types of filers who can get the credit and four amounts of credits (varying on how many qualifying children, if any, the taxpayer has). That means that the EITC tables have eight columns of figures for EITCs at various levels of “earned income”.
A review of the EITC tables in the Form 1040 instructions for 2014 (at pages 61-69) shows that for each of these eight possibilities, the EITC amount rises as earned income rises, and then for a several thousand dollar range of earned income, the EITC stops rising. It reaches a maximum and stays there. Finally, once the range is exceeded, the EITC falls as earned income rises further until the EITC finally disappears. The area of earned income where the maximum EITC is received looks like a plateau on a graph. Using a different metaphor, clinicians often call this plateau the “sweet spot.”
As an example of the amounts we are talking about, for a taxpayer who is head of household (as, I assume that Ms. Kalokoh was, though the bench opinion does not say) and looking at the EITC tables for 2012 (the taxable year involved in Kalokoh), the credit keeps rising as earned income rises, then reaches the following maximum amounts in the following earned income ranges: one child (maximum EITC of $3,169 at any earned income of between $9,300 and $17,100), two children (maximum EITC of $5,236 at any earned income of between $13,050 and $17,100), and three children (maximum EITC of $5,891 at any earned income of between $13,050 and $17,010). (Note that the maximum EITCs are the same for married filing jointly filers, but the sweet spots of earned income are at higher levels.) It beats me what the policy reason is for the EITC to start falling after $17,100 of earned income, no matter how many children one has. Don’t extra children add extra living expenses? And it also beats me what the policy reason is for the sweet spot to begin and end at the same amounts of earned income whether one has two qualifying children or three. Part of this may have to do with Congressional compromises when the third child credit was added during the recent recession. For our head of household filer in 2012, the credits would gradually descend from the sweet spot amounts to reach zero at earned income figures as follows: no children ($13,980), one child ($36,920), two children ($41,950), and three children ($45,060).
The IRS doesn’t challenge reported income that is supported by third-party Forms W-2 and 1099. However, there are a lot of people in the low-income community who get paid in cash (by multiple customers) for whom there will never be a Form W-2 or 1099 issued. In my experience, the two most common professions in low-income communities where there is no third-party form generated supporting income are daycare or “babysitting” services and hair cutting services. Although to cut hair, one has to have a license in many states, having such a license doesn’t prove that one actually engaged in the activity or how much money was made in the activity. Unfortunately, very few low-income taxpayers in these professions write down how much they receive each day in cash income and keep receipts as to their expenses.
The IRS is aware that there are totally unscrupulous people who never earned any income or got Forms 1099 and who claim the EITC from working as babysitters or hair cutters. These people tend to file returns with a Schedule C on which they report the gross income (often in a round number) and a few expenses (all fictitious). Any EITC that is generated offsets the self-employment taxes payable thereon. For income tax purposes, the claimed dependents, a personal exemption, and the standard deduction brings taxable income down to zero, so no income tax is due to be offset against the EITC. (We won’t discuss the refundable additional child tax credit in this post, but, for children under 17, that often is also generated by these returns, and that credit’s amount also depends on the amount of earned income.) Unscrupulous preparers in the low-income taxpayer community know to prepare such returns showing income in the sweet spot for the EITC — to generate the maximum check from the federal government. Though these returns are prepared by commercial preparers, the preparers hide their identities by writing “self-prepared” in the area for identifying the commercial preparer.
Not all babysitters and haircutters are phony, though. Often, they go to an unscrupulous preparer and admit that they did not keep good income records and have no Forms 1099. So, the preparer (knowing the sweet spots) may say something like: “Well, would you say you earned about $300 a week for 50 weeks?” That works out to $15,000 of gross income, which will put the taxpayer in the sweet spot even after having to subtract $1,060 (which is half the self-employment tax thereon required to be subtracted to reach “earned income”). The taxpayer will honestly respond, “That sounds about right.” So, the return will be prepared seeking the maximum EITC refund possible.
It is impossible for the IRS to know in advance whether a person filing an EITC sweet spot return who got no Forms 1099 is a fraudster or a person really entitled to roughly that amount of the EITC reported.
In my experience, about 90% of the people who came to me in my clinic with a notice of deficiency in which they were denied the EITC based on an alleged lack of income were people whose returns were filed seeking the sweet spot amount of EITC. So, I assume that IRS computers are programmed to do this funny computer matching looking for the absence of Forms 1099 or W-2 to support an EITC claimed in the sweet spot. Since a fraudster is unlikely to come to my clinic to complain when caught, I generally believed the taxpayer who came to my clinic that he or she had worked in the profession shown on the Schedule C, though I tried harder to pin down estimated income figures.
In EITC litigation where the taxpayer has children and is at or below the sweet spot, it is in the interest of the IRS to claim that the taxpayer earned less or, usually, no income or had additional unreported deductions. I actually have not seen the IRS argue before for unreported deductions. But, it probably does sometimes. It certainly did so in the Kalokoh case.
In Kalokoh, the taxpayer claimed to have run a haircutting business in an area consisting of about half of the lowest floor of a three-story house she rented. On her 2012 Schedule C, she reported gross income from the activity of $15,900 and took a deduction of $500 for “threads and gels.” Thus, regardless of how many children she claimed (which the opinion does not indicate), her return put her in the sweet spot for getting the maximum EITC refund. Lacking any Form 1099 to support the gross income, the IRS disallowed the EITC, in part claiming that she had no income in 2012. The taxpayer and the IRS stipulated that she was entitled to an unspecified (in the opinion) number of dependency exemptions. So, the sole issue in the case was what amount of net income, if any, she had earned from haircutting. Bucking the usual IRS position, here, to get the taxpayer below the sweet spot, the IRS argued for reducing gross income and increasing unreported deductions.
As to the income that she reported, Judge Gustafson found that “[m]ost of her customers paid in cash, and she often spent the cash without first depositing it in the bank, so her bank deposits do not reflect that total revenue.” Presumably, though, the fact that there were bank deposits generally corroborated that the taxpayer was in some income-earning activity in 2012. The judge also wrote that he was “convinced by her testimony, her records, and her corroborating witness that she did conduct the business and earn the revenue. Her records leave something to be desired, but they are not wildly out of keeping with the modest scale of this home-based business.”
It was smart of the pro se Ms. Kalokoh to bring a corroborating witness.
Unfortunately for Ms. Kalokoh, the IRS still got her knocked out of the sweet spot. Prior to the trial, it stipulated with her that she had spent an additional $1,074 in 2012 to purchase hair — which amount she had not deducted on her return. The IRS also stipulated with her the annual figures for rent ($20,400), water ($1,449), and gas ($1,523) paid by her for her house — a combined figure of $23,372 of expenses. Notably, the judge did not question how she could afford to pay all these amounts based on a reported net income of only about $15,400.
After finding that her gross income was as reported, though, the judge held that she used one-sixth of the house exclusively for business purposes, so was entitled to (and required to) deduct one-sixth of $23,372 (i.e., $3,895) in computing her earned income. The judge also held that she must deduct the additional $1,074 in expenses for purchasing hair. This effectively reduced her earned income by about a third and reduced the EITC. While it also reduced her self-employment income and self-employment tax, the reduction in self-employment tax would have been less than the reduction in the EITC that the IRS achieved.
So, bottom line, if a taxpayer at the calendar call presents a notice of deficiency to you that seeks to remove all income and disallow the EITC, be prepared to argue something you would never argue for a high-income taxpayer — that the taxpayer actually earned the reported income, even though no Form W-2 or 1099 shows it.