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Unwelcome Surprises in the Child Tax Credit

The enhanced child tax credit created by the American Rescue Plan Act of 2021 (P.L. 117-2) is one of many recent Congressional efforts designed to help taxpayers financially weather the pandemic. However, this relief is different from others. Stanley Rose CPA, a Managing Partner in the tax practice of Baker Newman Noyes, explains.

The child tax credit is unlike other tax benefits and practitioners should educate their clients now to avoid any unpleasant April 15 surprises.

The enhanced credit is built on the original child tax credit found in IRC Sec. 24.  When paired, the result is a more robust combined credit available only for tax year 2021. For tax year 2022, the enhanced credit disappears, and the original credit survives. 

The 2021 combined credit is unique in four notable ways:

1. It is fully refundable.

2. The enhanced portion of the credit phases out at lower income levels than the original portion.

3. Part of the combined credit is paid to taxpayers in advance.

4. Unlike other forms of pandemic relief (like the advance stimulus payments), some portions of this credit may need to be paid back if 2021 income is higher than the IRS projects.

Fully Refundable

For 2021 only, the full amount of the credit is fully, rather than partially, refundable. 

Credit Amount and Phase-Outs

The original portion of the credit provides of up to $2,000 per qualifying child (one who qualifies as a dependent and is under the age of 17). It is phased out by $50 for each $1,000 of modified AGI exceeding $200,000 ($400,000 for married taxpayers filing jointly).

The enhanced portion provides an additional $1,000 credit and extends it through (rather than under) age 17. It also adds another $600 for each child under age six. The enhanced portion is phased out in the same manner described above, but beginning at the more modest levels of $150,000 for joint filers, $112,500 for heads of households, and $75,000 for other filers. 

Note that because this is a phase-out based on dollars rather than percentages, the amount phased out is sensitive to income and headcount of eligible children. A family with two or more children can retain some amount of the credit at income points where a family with one child will lose it.

Advance Payments

In creating the enhanced credit, Congress did not alter the existing credit, not much anyway. It primarily created an overlay potentially allowing a higher credit. One significant exception is that Congress instructed the IRS to pay half of the estimated combined credit to taxpayers in six payments spread over the last half of the 2021 year. This has already begun, and it is based on the most recent tax returns available to the IRS (generally 2020 if already filed, and 2019 for those who filed 2020 extensions). 

Taxpayers who do not care for this feature can turn it off, but for some, that process could best be described with a new word: “hurdlesome.” Taxpayers are required to establish an account with the IRS, using a third-party (non-government) entity called ID.me, and the process is a bit more intrusive than what has been required historically when checking the status of a refund or even redirecting last year’s stimulus payments from paper checks to direct deposit.

The steps involve online provision of the taxpayer’s Social Security Number as well as a state or federally issued photo ID and use of a mobile phone camera to scan the taxpayer’s face with facial-recognition technology. Some will be comfortable with this; many will not.

April 15 True-up

Many taxpayers are familiar with the three rounds of stimulus payments (also known as “recovery rebate credits” or “economic impact payments”) paid during 2020 and early 2021, consisting of varying amounts with base payments of $600; $1,200; and $1,400 delivered via check, direct deposit, or debit cards. One thing that the stimulus payments and advance payment portions of the child tax credit share is that they are estimates of the current year’s tax situation, based on facts derived from a prior year’s filing.

Finalized 2021 returns will compute what the amounts should have been. At that point, mechanically the stimulus payments and the child tax credit part ways, because if the IRS transferred excessive stimulus payments to taxpayers based on outdated prior year specs, the taxpayer does not have to return those amounts.

However, the taxpayer can collect more funding if there was a shortfall, meaning the true-up can only work in the taxpayer’s favor. This is not true with the advance child tax credit payments, they truly are advances of to-be-determined, but fixed amounts.

The eventual true-ups can move in either direction, resulting in additional amounts due by the taxpayer by April 15, or reducing an overpayment receivable. A safe harbor exists, however, that will spare those with relatively low incomes from an unfavorable true-up.

What to Do

Even savvy taxpayers may be surprised by the resolution of the advance child tax credit payments when their 2021 returns are filed. They are accustomed to being on the favorable end of the “heads I win, tails you lose” feature of last year’s stimulus payments, and may be expecting April 15,2022 to track as well or better, not realizing that the cash they receive now puts a dent in what they otherwise could receive later.

Those whose children cross the age-related eligibility thresholds in 2021 (no longer qualifying for the credit) might be surprised, along with whose incomes climb high enough to phase them out of the credit. Taking this into consideration, some taxpayers may wish to create an IRS account and eliminate remaining advance payments of the credit.

For others, education can help avoid surprises. Practitioners should begin simply by explaining to clients that these payments are different than others they have received, and clients need to be ready to settle up by mid-April. 

(by Stanley Rose CPA)

Stanley Rose, CPA

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