Social benefit programs are often administered through the tax code through refundable tax credits. A refundable tax credit is one that can generate a refund for a taxpayer even if it exceeds the taxpayer’s tax liability. Examples of refundable tax credits for tax year 2020 include the earned income credit, the additional child tax credit, the premium tax credit, and the 2020 recovery rebate credits due to COVID-19.
In some ways, it makes sense to provide these benefits through the tax law, as most taxpayers must file a tax return, and the income on that tax return can determine a taxpayer’s eligibility for various social benefits. One major problem with this approach is that the refunds generated on the tax return are one-time lump sum payments that do not help ongoing financial needs.
I started my career at a large H&R Block store in downtown Philadelphia and prepared many tax returns for families claiming earned income credit and other refundable credits. They’d routinely get $7,000+ refunds on not much income. Almost all of my clients indicated the money was already spent — paying down debt, catching up on rent, or purchasing things like new appliances or clothes for children. They’d often use bank products with fees to get the money faster. These credits reduced a financial deficit, but never helped the clients to avoid a deficit in the first place.
One option for refundable credits is to provide advance payment of the credits; then, at the time of tax return preparation, the taxpayer reconciles the actual credit against the advance payments. We have seen use of this process used with the earned income credit (2010 was the last year), the premium tax credit, and the 2021 modifications to the child tax credit.
The main benefit with advance payment of refundable tax credits is that the cash gets into a taxpayer’s hands immediately, which helps to alleviate any immediate financial insecurity. It avoids, or reduces, the accrual of financial deficits.
But there are a myriad of problems with the advance payment of refundable tax credits:
The taxpayer may have an unpleasant surprise repayment if the advance payments exceed the actual credit amount on the return.
Many taxpayers choose to opt-out of the advance payments, often fearing a perceived reduction in the total tax refund received.
The IRS could issue advance payments to individuals who ceased being U.S. persons, with no way to get those payments back.
Tax return complexity increases, along with tax preparation fees, due to reconciliation requirements.
There is an increased compliance burden on the IRS from increases in tax return errors due to the reconciliation process.
Let me propose an alternative to the advancing of refundable tax credits:
The taxpayer calculates the refundable tax credits he or she is entitled to on the current year tax return.
The refundable tax credits do not generate an immediate refund upon filing of the tax return to the extent they exceed the tax liability on the return.
The IRS pays out the amount by which the refundable tax credits exceed the tax liability in 12 monthly installments beginning in the July following the tax return unextended due date. The taxpayer cannot elect out of the monthly payments, and no interest is paid on the monthly installments.
Let’s quantify this with a very basic example using 2020 tax law: a head of household taxpayer with one child, age 10, has $30,000 in wages and $2,000 in federal tax withholding. The taxpayer’s federal tax liability before tax credits is $1,138, and the child tax credit offsets the entire tax liability, so the taxpayer gets a $4,737 refund:
$2,000 in withholding,
$862 in advance child tax credit, and
$1,875 in earned income credit.
Under the alternate system, the taxpayer would get a $2,000 refund upon filing of the tax return, which is the withholding. The $2,737 in refundable tax credits would be paid to the taxpayer in monthly installments of $228.08 per month for 12 months starting the following July.
Here are the main benefits as I see them to this alternate way of paying refundable tax credits:
The delayed payment schedule reduces the overall cost of the credit program since the federal government gets to keep the funds for a longer period of time.
Delays in time in issuing refundable tax credit payments gives the IRS additional time to cross-check or examine returns and stop the issuance of some erroneous refundable tax credits.
The taxpayer will have a known stream of payments for the next year that they can use to budget and plan, allowing them to be proactive with their money.
Taxpayers will not have a surprise balance due or reduced refund on the tax returns, giving them peace of mind that they can actually use the funds they receive and they do not have to potentially pay them back.
Of course, there will be a one-time readjustment to this new system: taxpayers will not get their lump-sum refund and will have to wait a few months for payments to start. However, after the initial transition period, there will be an uninterrupted stream of payments going forward provided the taxpayer maintains eligibility.
Changing to this alternate system will definitely cause a shift in how millions of taxpayers are used to getting these credits. I would recommend phasing in the change: in the first year, 50% of the credits are paid with the return refund, and 50% are monthly payments. In the second year, the entire refundable credit amount is paid in monthly payments.
Articles I Recommend
Amber Gray-Fenner discussed the evolving tax industry in Not Your Mama’s TaxPro - The Evolution Of Professional Tax Return Preparation.
Procedurally Taxing had a great post on the IRS’s use of math error authority, which is problematic in many ways for taxpayer rights.
Last Month’s Paid Subscriber Content
If you aren’t a paid subscriber, you missed an overview on the collection statute of limitations and why you can deduct a contractor payment even if the taxpayer did not issue Form 1099-NEC last month.
Next week, I’ll be digesting IRS Notice 2021-49 and its impact on the COVID-19 employee retention credit (hint: pretty significant) in a paid subscriber post.
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