Taxpayers who received unemployment benefits in 2020 are facing an unexpected reckoning in the 2021 filing season. Many are just now becoming aware that income from unemployment is taxable and that while states typically withhold for federal income taxes, most do not withhold for state income taxes. So many taxpayers were facing unexpected tax bills related to their unemployment compensation that some states are providing relief—at least as far as income taxes are concerned. What is only now becoming clear, however, is that the Covid-related unemployment benefits that provided a lifeline to many taxpayers are causing additional unintended consequences:
- Requiring repayment of the Advanced Premium Tax Credit (APTC)
- Reducing or eliminating the Earned Income Credit (EIC)
- Subjecting income to Kiddie Tax
Advanced Premium Tax Credit Repayment
The APTC is a subsidy provided for people who purchase healthcare insurance through a state marketplace. The amount of the subsidy is determined by estimating household income during open enrollment, which typically begins the October before the enrollment year. For example, a couple purchasing healthcare insurance for 2020 needed to estimate their 2020 annual household income in October of 2019. Given what we know now, it’s clear that estimating 2020 income in late 2019 was little more than guessing. Once the enrollment year begins, taxpayers are supposed to report any events that could change their income to the marketplace in real time so that the subsidy amounts can be adjusted up (if the taxpayer, for example, loses their job) or down (if household income increases for any reason). Taxpayers often forget to do this and the consequences, especially when household income increases, can be dire.
APTC amounts are reconciled on Form 8962 which is attached to a taxpayer’s annual Form 1040. The APTC is available for taxpayers whose adjusted gross income (AGI) is up to 400% of the federal poverty level (FPL). As income increases the subsidy is reduced; any excess subsidy must be repaid. The repayment amounts are capped unless the taxpayer’s AGI exceeds 400% of the FPL. At 401% of the FPL, the entire subsidy must be repaid. Repayment amounts can be in the five figures.
Sabrina Cook, a solo CPA practicing in Hickory, North Carolina, has seen this repayment cliff affect her clients. One spouse was self-employed and the other was retired and helped with the business. The amount of unemployment received by the self-employed spouse helped to push the couple’s income well beyond 400% of the FPL. Their APTC repayment came in at about $11,000 according to Cook. Well informed tax professionals can sometimes, but not always, offer potential solutions including looking at ways to reduce AGI or at the possibility of allocating the subsidy across different members of a tax household. Nevertheless, many taxpayers don’t think about unemployment income as affecting benefits such as the APTC just as many taxpayers were unaware until recently that unemployment benefits were taxable.
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Reducing Or Eliminating The EIC
The EIC is a tax credit designed to help low-income working taxpayers. The amount of the credit is calculated based on both earned and unearned income and is distributed in a bell curve. The credit amount increases up to a certain amount of income and then begins to be reduced until it is eventually reduced to zero. To help taxpayers whose income was reduced in 2020 the Taxpayer Certainty and Disaster Tax Relief Act of 2020 included a lookback provision that allows a taxpayer to use their 2019 income to calculate the EIC if it results in a higher credit. Fred Stein, CPA owner of BQ Tax & Accounting, Ltd., recently realized that the lookback provision wasn’t helpful once unemployment compensation was considered. Stein was preparing a return where the client’s 2019 wages were $20,600 and their 2020 wages were $8,450. Stein says, “I immediately thought, great, the lookback period is going to help this client.” Then he checked the box that told his software to use the 2019 earned income instead of 2020. The results gave the same amount of EIC. Why? Unemployment income was increasing the client’s AGI. Stein says he realized that the total AGI calculations created a “bubble” where certain clients receive less EIC because their unemployment income pushes them to the downward slope of the bell curve. Because the unemployment was so generous, the EITC was reduced. If the unemployment compensation is too generous and the taxpayer worked during the year or had other income, the EIC could be completely eliminated. Stein also mentions that the reduced EIC is not necessarily “a bad thing” because the taxpayers received more money throughout the year from unemployment than they lost in EIC. Nevertheless, he points out that this may surprise many taxpayers and result in confusion. Taxpayers may find themselves asking “How come my EIC is $500 less than last year when they told us we could use last year’s numbers?”
Kiddie Tax is a tax on the unearned income of dependent children under age 19. Kiddie tax is calculated on Form 8615 which is then filed with the child’s Form 1040. Under the current rules, a dependent child’s unearned income up to $2,200 is taxed at the child’s rate and avoids the Kiddie Tax. Income above $2,200 is subject to the tax and taxed at the parent’s highest tax rate. That does not bode well for parents of teens who lost their part-time jobs and were eligible for unemployment in 2020, especially parents in higher tax brackets. While most parents of dependent children who have large amounts of investment income are aware of Kiddie Tax and plan for it, parents whose children are not normally subject to Kiddie Tax are discovering that unemployment income is unearned income and can be subject to Kiddie Tax. Albert Campo, CPA owner of AJC Accounting Services in Manalapan, New Jersey, is finding himself explaining to clients and their children that the child’s unemployment income is subject to Kiddie Tax, which can come as an unpleasant surprise to both the child, who may be expecting a refund, and the parents. Unfortunately nothing can be done, and this was not a consequence that even seasoned tax professionals were able to foresee given the speed with which so much Covid-related relief was passed.
The 2021 filing season is already more challenging than last year for taxpayers and tax practitioners. Despite being much more prepared for Covid-related changes related to remote work and providing contact-free service, tax practitioners are still grappling with a compressed filing season, limited guidance for business tax issues, and a host of unintended consequences for individual taxpayers. So please, taxpayers, be kind to your tax practitioner and remember not to shoot the messenger.