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WFTRA’s Individual Income Tax Provisions Generally, the Working Families Tax Relief Act of 2004 (WFTRA) affects individuals by accelerating the effective dates of prior legislative changes, creating a uniform definition of a “child” and temporarily extending alternative minimum tax relief. This article analyzes the effect of these and other WFTRA provisions. Ellen D. Cook, MS, CPA Nathan Oestreich, Ph.D. Editor’s note: Profs. Cook and Oestreich are members of the AICPA Tax Division’s Individual Taxation Technical Resource Panel. For
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The Working Families Tax Relief Act of 2004 (WFTRA),1 signed into law on Oct. 4, 2004, prevents estimated tax increases of $146 billion for some 94 million taxpayers ($132 billion for individuals; $14 billion for businesses). It also accelerates the effective dates of many of the tax reduction provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). However, a sunset remains in effect; thus, barring future Congressional action, all of the EGTRRA provisions expire for tax years beginning after 2010. Even though the title refers only to working families, the WFTRA also includes benefits and technical corrections affecting other individuals and businesses. This article details the significant changes for individuals; see Exhibit 1 for a summary of the provisions. The WFTRA represents a number of election-year compromises between members of Congress wanting to make the EGTRRA tax cuts permanent and those who preferred fiscal constraint. The compromise and the margins by which the bill passed (339–65 in the House; 92–3 in the Senate) provide some insight as to the legislative climate and the potential for future changes, which have been altered somewhat after the Presidential election. Uniform Definition of a “Child” According to Treasury Secretary Snow, the new law’s uniform definition of a child helps realize President Bush’s overall goal of simplifying the Code, by creating one definition for purposes of the dependency exemption, head-of-household (HOH) filing status, the earned income credit (EIC), the child credit and the child and dependent care credit. For the most part, the WFTRA did not modify any other requirements of those respective provisions. The discussion below applies to tax years beginning after 2004, and, thus, does not affect 2004 tax liabilities. Three Tests Under the uniform definition of a child, a child is a “qualifying child” of the taxpayer if he or she satisfies three tests, as follows, under WFTRA Section 201: 1. The child has the same principal place of abode as the taxpayer for more than half the tax year (Sec. 152(c)(1)(B)). As under pre-WFTRA law, temporary absences due to special circumstances, such as education, illness, business, vacation or military service, are not treated as absences. 2. The child has a specified relationship to the taxpayer (Sec. 152(c)(2)). The child must be the taxpayer’s child (natural child, step-child, adopted child or eligible foster child); a descendant of the taxpayer’s child; the taxpayer’s sibling (including half-brother and half-sister) or step-sibling; or a descendant of the taxpayer’s sibling or step-sibling. An eligible foster child includes one placed with the taxpayer by an authorized placement agency or by judgment, decree or other order of any court of competent jurisdiction. An adopted child is one lawfully placed with the taxpayer for legal adoption. Noteworthy is the elimination of the pre-WFTRA rule requiring a taxpayer to care for a sibling or step-sibling (or a descendant of such individual) “as if the child were the taxpayer’s own child.” 3. The child has not yet attained a specified age (Sec. 152(c)(1)(C)). The age varies according to the benefit. For the dependency exemption, HOH status and the EIC, the child must be under age 19, or under age 24 if a full-time student for any part of five months during the tax year. For purposes of the child credit, the child must be under age 17, according to Sec. 24(a); for purposes of the child and dependent care credit, the child must be under age 13, according to Sec. 21(b)(1)(A). Except in the case of the child credit, no age limit apples to individuals totally and permanently disabled (within the meaning of Sec. 22(e)(3)) at any time during the year. Further, except for EIC purposes, a child who provides more than one-half of his or her own support would not be a qualifying child, under Sec. 152(c)(1)(D). Tiebreaker Rules When a person could be treated as a qualifying child on more than one return, WFTRA Section 201 provides tiebreaker rules in amended Sec. 152(c)(4). Ties are broken as follows:
Dependency Exemption For tax years beginning after 2004, Sec. 152(a) allows taxpayers to claim both qualifying children and relatives as dependents. A qualifying child must meet the uniform definition, as well as the current joint-return and citizenship tests. Neither the gross-income test nor the support test applies, except that the child must not have provided more than one-half of his or her own support during the calendar year in which the taxpayer’s tax year begins. Under Sec. 152(d), qualifying relatives must meet the five current (pre-WFTRA) tests—the gross-income test, support test, relationship test, joint-return test and citizenship test. A qualifying child of any taxpayer cannot be claimed as a qualifying relative by another taxpayer (i.e., the rules for a qualifying child apply). The requirements are a blend of prior and current law. Exhibit 2 summarizes the updated requirements. The tiebreaking rules discussed above also apply. As a result, (1) an individual who is a qualifying child of any taxpayer cannot be a qualifying relative of another taxpayer; and (2) a qualifying child cannot be claimed on more than one return. For children of parents who (1) are divorced, (2) are separated under a written separation agreement or (3) did not live together during the year, current law gives the dependency exemption to the custodial parent. WFTRA Section 201 retains a revised rule that allows the custodial parent to release that exemption through a custodial waiver. This waiver can take the form of a written decree of divorce or separate maintenance, or a written separation agreement. Alternatively, under Sec. 152(e)(2), it can take the same form as under prior law—a signed declaration that the custodial parent will not claim the dependency exemption. The dependency exemption waiver also effectively waives the child credit. It does not, however, affect the EIC, the child and dependent care credit and HOH status.2 Child Credit Sec. 24(a), as amended by WFTRA Section 101, allows a $1,000 child tax credit per year for each of the taxpayer’s qualifying children under age 17. The credit, which was scheduled to decrease to $700 in 2005 under the EGTRRA, now remains at $1,000 through 2010. Without future Congressional action, the credit will revert to $500 after that. Under Sec. 24(b), the credit is phased out $50 for each $1,000 (or fraction thereof) of modified AGI in excess of $75,000 for single taxpayers ($110,000 for married filing jointly (MFJ) and $55,000 for married filing separately (MFS)). These amounts are not indexed for inflation. Although both the Senate and House versions of the bill accelerated the phaseout ranges, they were unchanged in the final bill. Under WFTRA Section 204 and Sec. 24(c), for tax years beginning after 2004, a qualifying child is an individual under age 17 (1) for whom a taxpayer can claim a dependency exemption; (2) who is a U.S. citizen or resident alien; and (3) who meets the uniform definition of a child.
J can claim the dependency exemption and child credit for O, but not K, who fails the gross-income test. K may not claim O as her dependent, because she did not provide over half of O’s support.
Because O meets the definition of a qualifying child for purposes of the dependency exemption (i.e., is a child of the taxpayer, under age 19 or a full-time student under age 24 and lives in K’s principal place of abode), K may claim O as her dependent. While O also qualifies as J’s dependent, under the tiebreaking rules, K, the parent, is entitled to claim the dependency exemption and child credit. For 2004–2010, the child credit is refundable to the extent of 15% (increased from 10%) of the taxpayer’s taxable earned income in excess of $10,750, indexed for inflation.3 Families with three or more children are allowed a refundable credit for the amount by which the taxpayer’s Social Security taxes exceed his or her EIC, if that amount exceeds the refundable credit computed under the 15% rule. HOH Status For tax years beginning after 2004, Sec. 2(b)(1)(A) is amended by WFTRA Section 202, to provide that a taxpayer is eligible for HOH status if he or she is unmarried and maintains a home that is the principal place of abode for more than half the year for either (1) a qualifying child, as defined in Sec. 152(c); or (2) an individual for whom the dependency exemption may be claimed. As under current rules, a married child must still be the taxpayer’s dependent and a dependent parent need not live in the taxpayer’s home, for the taxpayer to claim HOH status. Some taxpayers who qualified as HOH in 2004 may not under the new law.
T does not qualify as A’s dependent, because he fails the gross-income test. However, for 2004, T will be considered a qualifying individual under the HOH provisions, because a taxpayer’s unmarried child does not have to qualify as the taxpayer’s dependent. Thus, A may file as HOH.
A may not file as HOH, because T neither meets the uniform definition of a child nor qualifies as A’s dependent. Child and Dependent Care Credit Under Sec. 21, taxpayers who pay qualifying expenses for the care of eligible individuals can claim a nonrefundable credit, so that they may work or seek work. Qualifying expenses include costs for both in-home care and daycare. Before the WFTRA, eligible individuals included: (1) a dependent or child under age 13; (2) a dependent (or someone who could be a dependent except for the gross-income test), physically or mentally incapable of self-care; and (3) a spouse of a taxpayer physically or mentally incapable of self-care. For divorced parents, the credit was available to the custodial parent. WFTRA Section 203 adopts the uniform definition of a child with regard to a qualifying individual, but (1) Sec. 21(a)(1) eliminates the requirement that a taxpayer must provide more than one-half of the cost of maintaining the household; and (2) Sec. 21(b)(1)(B) adds the requirement that an individual who is physically or mentally incapable of self-care must live with the taxpayer for more than half the tax year. EIC For purposes of the EIC for parents, the uniform definition of a child is adopted for years beginning after 2004. Several special variations are made to the uniform definition to achieve the EIC’s goals; these rules are summarized in Exhibit 3. Further, under Sec. 32(c)(1)(B), a qualifying child cannot claim an EIC on his or her own return. Combat Pay for Armed Forces Members The exclusion of sick pay for members of the armed forces, although intended to provide a tax benefit, can result in even larger reductions in other tax benefits. To avoid this for the child credit and EIC, the WFTRA includes two provisions, which provide nearly $200 million of assistance to families of military personnel in combat. 1. Child credit: WFTRA Section 104(a) amends Sec. 24(d)(1) by providing that combat pay otherwise excluded from gross income under Sec. 112 is treated as earned income only when calculating the refundable portion of the child credit. This change applies for tax years ending after 2003. 2. EIC: Armed forces members may treat excluded combat pay as earned income for EIC purposes under Sec. 32(c)(2)(B)(vi), as amended by WFTRA Section 104(b)(3). The taxpayer can elect this treatment if it increases the credit, or waive it if it reduces it. This election applies for any tax year ending after Oct. 4, 2004, and before 2006. Marriage Penalty Relief/Tax Rates The EGTRRA, as amended by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), provided temporary relief from the marriage penalty—the additional tax due on the combined income of a married couple filing jointly (as compared to that which would be imposed if each filed single returns). WFTRA Section 101(b) increases the Sec. 63(c) basic standard deduction for MFJ to twice the basic standard deduction for single returns for tax years 2005–2008, effectively extending this relief for MFJ taxpayers through 2010. WFTRA Section 101(a) and (d) extends two of the tax reduction provisions under the EGTRRA, as amended by the JGTRRA. These extensions, coupled with the child credit extension, will save taxpayers from a $109 billion tax increase through 2010. First, for tax years 2005–2010, the size of the 15% rate bracket for joint returns (otherwise scheduled to decrease in tax year 2005), remains at twice the corresponding rate bracket for single returns for tax years 2005–2007.4 This effectively eliminates the marriage penalty in the 15% bracket. However, the marriage penalty still exists above the 15% bracket (i.e., the “spread” in brackets for MFJ taxpayers is not twice that of single taxpayers). Second, the expanded 10% bracket for single and MFJ taxpayers through 2010 is also extended.5 In addition, although indexing was not scheduled to begin until after 2004, it is now allowed beginning after 2003.6 Without further Congressional action, the EGTRRA’s sunset provisions will apply. Exhibit 4 illustrates the effect of the changes in the child credit, marriage penalty relief and tax rate cuts by comparing the pre- and post-WFTRA tax liability of two families with two children each, filing joint returns—one with $30,000 income and one with $50,000 income. At the $30,000 income level, the WFTRA provides a $730 tax savings, which includes $130 ($1,300 x 0.10) from the increased standard deduction, and $600 ($300 x 2) from the increased child credit. The $925 tax savings for the family with $50,000 income consists of $130 from the increased standard deduction, $600 from the increased child credit, $130 (($14,600 $12,000) x (0.15 0.10)) from the expanded 10% bracket and $65 (($28,500 $27,200) x (0.15 0.10)) from the marriage penalty relief in the 15% bracket. This example does not consider the EIC. AMT Relief Without some relief, an IRS Taxpayer Advocate’s Report7 estimated that 12.4 million taxpayers would be subject to the AMT in 2005, up from 2.4 million in recent years. WFTRA Section 103(a) postpones this explosion until 2006, by temporarily increasing the AMT exemption for individuals. The temporary exemptions of $40,250 for singles and $58,000 for MFJ under Sec. 55(d)(1) applicable for tax years ending in 2003 and 2004 are extended to 2005. However, without further Congressional action, the exemption will drop in 2006 to the year 2000 amounts ($33,750 and $45,000, respectively), costing taxpayers an additional $23 billion over the next 10 years.
The 2005 AMT exemption under the WFTRA is $58,000 for MFJ. Using this exemption, the TMT is zero; J and E will pay the regular tax. They will also be able to claim the child credit, due to the extended personal tax credit relief. Personal Tax Credit Relief Sec. 26 generally limits nonrefundable credits to the excess of the regular tax over the TMT. With recent cuts to the regular tax rate and the granting of additional personal credits, this can limit benefits for many taxpayers—a possibility that has been postponed in recent years and again by the WFTRA. WFTRA Section 312(a) amends Sec. 26(a)(2), to permit all nonrefundable personal credits (e.g., the dependent care credit, the credit for the elderly and disabled, the adoption credit, part of the child credit, the credit for interest on certain home mortgages, the education credits, the savers’ credit and the District of Columbia homebuyer’s credit) to be used in full in calculating the regular tax and the AMT for tax years 2004 and 2005. Pre-WFTRA, only the adoption credit, child credit and IRA contributions credit were allowed in full against the regular tax and the AMT in 2004 and later years.
Under prior law, the $1,500 education credit would have reduced their regular tax liability to $5,000, which would have triggered AMT of $600 ($5,600 – $5,000). Their 2004 tax liability would have been $5,600. Under the new law, the education credit could offset both the regular tax liability and the AMT liability, reducing them to $5,000 and $4,100, respectively. Thus, their tax liability would be $5,000 for 2004. Teacher Deduction The Sec. 62(a)(2)(D) above-the-line deduction for eligible educators’ expense, scheduled to expire after tax year 2003, is extended by WFTRA Section 307 to tax years 2004 and 2005. Eligible educators (kindergarten–grade 12 teachers, instructors, counselors, principals or aides for at least 900 hours during the school year) may deduct up to $250 of unreimbursed classroom expenses incurred in connection with books, supplies (excluding those for health or physical education), computer equipment (including software, services and other equipment) and supplemental materials. As before, the maximum deduction is allowed only to the extent that the expenses exceed excludible U.S. educational savings bond interest, distributions from Sec. 529 qualified tuition plans and Coverdell education savings accounts. Archer MSAs Sec. 220, added by the Health Insurance Portability and Accountability Act of 1996, allows employees of small employers and self-employed individuals to establish Archer MSAs to help pay for medical expenses in conjunction with a high-deductible health plan. Originally established as a pilot project that allowed new Archer MSAs to be established through 2003, WFTRA Section 322 extends that through 2005. Business Provisions The WFTRA extends, without change, generally through tax year 2005, several business incentives originally scheduled to expire in tax years ending after 2003, including:
Conclusion The President has included tax simplification, the preservation of current tax cuts/incentives and small business tax relief as major components of his second-term agenda, while Senate Finance Chair Charles Grassley (R-IA) has pledged his committee’s support, indicating that taxpayers should see no lapse in tax relief. Tax advisers and taxpayers should continue to monitor expected tax-related activity in the 109th Congress. |
