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B. Earned Income Credit (Sec. 111 of the Act and secs. 32 and
3507 of the Code) 8
An eligible individual who maintains a home for one or more children is allowed a refundable income tax credit based on the individual's earned income up to a specified dollar amount. The credit is available to married individuals filing a joint return who are entitled to a dependency exemption for a child, a head of household, and a surviving spouse."
Under prior law, the earned income credit generally equalled 11 percent of the first $5,000 of earned income, for a maximum credit of $550 (Code sec. 32). The amount of the credit was reduced if the individual's adjusted gross income (AGI) or, if greater, earned income, exceeded $6,500; no credit was available for individuals with AGI or earned income of $11,000 or more.
To relieve eligible individuals of the burden of computing the amount of credit to be claimed on their returns, the Internal Revenue Service publishes tables for determining the credit amount. Eligible individuals may receive the benefit of the credit in their paychecks throughout the year by electing to receive advance payments.
Reasons for Change
The earned income credit is intended to provide tax relief to lowincome working individuals with children and to improve incentives to work. Periodically since enactment of the credit in 1975, the Congress has increased the maximum amount and the phaseout levels of the credit to offset the effects of inflation and social security tax increases.
The Congress concluded that further increases in the maximum amount and phase-out level of the credit were necessary to offset past inflation and increases in the social security tax. In addition, the Congress believed that an automatic adjustment to the credit to reflect future inflation should be provided, just as it is provided for the personal exemption, the standard deduction, and rate brackets, in order to eliminate the reduction in the real value of the credit caused by inflation.
For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 111; H.Rep. 99-426, pp. 94-95; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 111; S.Rep. 99-313, pp. 43-44; Senate floor amendment, 132 Cong. Rec. S 7969 (June 19, 1986); and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 12-13 (Conference Report).
• For definitions of head of household and surviving spouse, see Title I., Part A., above.
Explanation of Provisions
The Act increases the rate and base of the earned income credit to 14 percent of the first $5,714 of an eligible individual's earned income. As a result, the maximum credit is increased to $800.
The income level at which the credit is completely phased out is raised to $13,500. Starting in taxable years that begin on or after January 1, 1988, the phase-out range is raised to $9,000/$17,000.
Under the Act, the credit is to be adjusted (beginning in 1987) for inflation. The adjustment factor for 1987 equals the increase in the consumer price index (CPI) from August 31, 1984, to August 31, 1986. (Thus, the maximum amount of earned income eligible for the credit beginning in 1987 equals $5,714 as adjusted for inflation between August 31, 1984 and August 31, 1986.) Subsequent annual increases are to adjust for the effects of additional annual changes in the CPI. These adjustments affect the amount of income to which the credit applies and the lower and upper limits of the phaseout range.
These inflation adjustments to the earned income credit are not subject to the $50 rounding-down rule otherwise applicable under the Act to inflation adjustments. Instead, as under the generally applicable inflation adjustment rule of prior law, any inflation adjustment relating to the credit that is not a multiple of $10 will be rounded to the nearest multiple of $10.
The Act also directs the Treasury Department to include in regulations a requirement that employers notify their employees whose wages are not subject to income tax withholding that they may be eligible for a refundable earned income credit. (The regulations are to prescribe the time and manner for such notification.) However, this notice does not have to be given to employees whose wages are exempt from withholding pursuant to Code section 3402(n). This exemption applies, for example, to many high school or college students who are employed for the summer.
The increases in the credit rate and base and the provisions relating to inflation adjustments are effective for taxable years beginning on or after January 1, 1987.
The increase in the beginning phase-out level to $9,000 is effective for taxable years beginning on or after January 1, 1988.
This provision is estimated to decrease fiscal year budget receipts by $14 million in 1987, $309 million in 1988, $723 million in 1989, $886 million in 1990, and $1,077 million in 1991, and to increase fiscal year budget outlays by $83 million in 1987, $1,731 million in 1988, $3,149 million in 1989, $3,481 million in 1990, and $3,848 million in 1991. (To the extent that the amount of earned income credit exceeds tax liability and thus is refundable, it is treated as an outlay under budget procedures.)
C. Exclusions from Income
1. Unemployment compensation benefits (sec. 121 of the Act and sec. 85 of the Code) 10
Prior law provided a limited exclusion from income for unemployment compensation benefits paid pursuant to a Federal or State program (Code sec. 85).
If the sum of the individual's unemployment compensation benefits and adjusted gross income (AGI) did not exceed a defined base amount, then no unemployment compensation benefits were included in gross income. The base amount was $18,000 in the case of married individuals filing a joint return; $12,000 in the case of an unmarried individual; and zero in the case of married individuals filing separate returns. If the sum of unemployment compensation benefits and AGI exceeded the base amount, the amount of the benefits included in gross income generally was limited to the lesser of (1) one-half the excess of the sum of such benefits plus AGI over the base amount, or (2) the amount of such benefits received.
Reasons for Change
While all cash wages and similar compensation (such as vacation pay and sick pay) received by an individual generally have been treated as fully includible in gross income under the tax law, unemployment compensation benefits were includible under prior law only if the taxpayer's AGI and benefits exceeded specified levels. The Congress concluded that unemployment compensation benefits, which essentially are wage replacement payments, should be treated for tax purposes in the same manner as wages or other wagetype payments. Thus, repeal of the prior-law partial exclusion contributes to more equal tax treatment of individuals with the same economic income. Also, if wage replacement payments are given more favorable tax treatment than wages, some individuals may be discouraged from returning to work.
Explanation of Provision
Under the Act, all unemployment compensation benefits (whether paid pursuant to a Federal or State law) received after 1986 are includible in gross income.
10 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 122; H.Rep. 99-426, pp. 98-99; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 121; S.Rep. 99-313, pp. 46-47; and H.Rep. 99-841, Vol. II (September 18, 1986), p. 14 (Conference Report).
The provision is effective for amounts received after December 31, 1986.
The provision is estimated to increase fiscal year budget receipts by $230 million in 1987, $764 million in 1988, $749 million in 1989, $723 million in 1990, and $701 million in 1991.
2. Prizes and awards (sec. 122 of the Act and secs. 74, 102, and 274 of the Code) 11
Under prior and present law, prizes and awards received by an individual (other than scholarships or fellowship grants to the extent excludable under sec. 117) generally are includible in gross income. Treasury regulations provide that such taxable prizes and awards include amounts received from giveaway shows, door prizes, awards in contests of all types, and awards from an employer to an employee in recognition of some achievement in connection with employment.
However, prior-law section 74(b) provided a special exclusion from income for certain prizes and awards that were received in recognition of charitable, religious, scientific, educational, artistic, literary, or civic achievement ("charitable achievement awards"). This exclusion applied only if the recipient (1) had not specifically applied for the prize or award (for example, by entering a contest), and (2) was not required to render substantial services as a condition of receiving it. Treasury regulations stated that the section 74(b) exclusion did not apply to prizes or awards from an employer to an employee in recognition of some achievement in connection with employment. 12
While section 74 determines the includibility in gross income of prizes and awards, the treatment of other items provided by an employer to an employee could be affected by section 61, defining gross income, and prior-law section 102, under which gifts may be excluded from gross income. Section 61 provides in part that "gross income means all income from whatever source derived," including compensation for services whether in the form of cash, fringe benefits, or similar items. However, under prior law, an item transferred from an employer to an employee, other than a prize or award that was includible under section 74, might be excludable from gross income if it qualified as a gift under section 102.
11 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 123(b); H.Rep. 99-426, pp. 103-07; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 122; S.Rep. 99-313, pp. 47-54; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 17-19 (Conference Report).
12 Treas. Reg. sec. 1.74-1(b). But see Jones v. Comm'r, 743 F.2d 1429 (9th Cir. 1984), holding that an award from an employer to an employee could qualify for the prior-law section 74(b) exclusion under extraordinary circumstances. The court held that the exclusion applied in the case of a prominent scientist who was rewarded by the National Aeronautics and Space Administration (NASA) for lifetime scientific achievement, only part of which was accomplished while the scientist was employed by NASA. No inference is intended under the Act as to whether the decision in this case was a correct interpretation of section 74(b) as in effect prior to the Act.
The U.S. Supreme Court, in a 1960 case involving payments made "in a context with business overtones," defined excludable gifts as payments made out of "detached and disinterested generosity" and not in return for past or future services or from motives of anticipated benefit (Comm'r v. Duberstein, 363 U.S. 278 (1960)). Under this standard, the Court said, transfers made in connection with employment could constitute gifts only in the "extraordinary" instance. 13
In certain circumstances, if an award to an employee could constitute an excludable gift under prior law, the employer's deduction was subject to limitation under section 274(b). That section expressly defines the term "gift" to mean any amount excludable from gross income under section 102 that is not excludable under another statutory provision.
Section 274(b) generally disallows business deductions for gifts to the extent that the total cost of all gifts of cash, tangible personal property, and other items to the same individual from the taxpayer during the taxable year exceeds $25. Under an exception to the $25 limitation provided by prior law, the ceiling on the deduction was $400 in the case of an excludable gift of an item of tangible personal property awarded to an employee for length of service, safety achievement, or productivity. In addition, the prior-law ceiling on the employer's business gift deduction was $1,600 for an excludable employee award for such purposes when provided under a qualified award plan, if the average cost of all plan awards in the year did not exceed $400.
A further rule that may be relevant with respect to a prize or award arises under section 132(e), which provides that de minimis fringe benefits are excludable from income. A de minimis fringe generally is defined as any property or service the value of which is (taking into account the frequency with which similar fringes are provided by the employer to the employer's employees) so small as to make accounting for it unreasonable or administratively impracticable.
Reasons for Change
Charitable achievement awards
A prize or award generally increases an individual's net wealth in the same manner as any other receipt of an equivalent amount that adds to the individual's economic well-being. For example, the receipt of an award of $10,000 for scientific achievement increases the recipient's net wealth and ability to pay taxes to the same extent as the receipt of $10,000 in wages, dividends, or as a taxable award; nonetheless, such an award was not treated as income under prior law. Also, as in the case of other exclusions or deductions, the tax benefit of the prior-law section 74(b) exclusion de
13 Under Duberstein, the determination of whether property transferred from an employer to an employee (or otherwise transferred in a business context) constituted a gift to the recipient was to be made on a case-by-case basis, by an "objective inquiry" into the facts and circumstances. If the transferor's motive was "the incentive of anticipated benefit," or if the payment was in return for services rendered (whether or not the payor received an economic benefit from the payment), then the payment must be included in income by the recipient.