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Earned Income Credit – What Is It and How Does It Work?

NOTE: Effective January 1, 2011 the option for advanced EIC payments has been eliminated. Employers are not longer able to advance a portion of the credit with each paycheck.

Earned Income Credit (EIC) can be referred to several ways, such as Earned Income Tax Credit (EITC) or Advanced Earned Income Credit (AEIC).

What is EIC?
EIC is a tax credit for certain individuals who don’t earn a high income and qualify for EIC.  They would receive the tax credit when they file their personal tax return.

Who qualifies for EIC?
An individual must have earned income from employment, self-employment, AND meet special rules.  To help determine if your employee qualifies, you can use the EITC Assistant on the IRS website.  The employee also needs to give you a completed and signed W-5 form (Earned Income Credit Advance Payment Certificate).  The form expires each year on December 31st.  The employee must give you a new form each year.  This form shows four criteria that must all be met for an employee to be eligible.  Below is an excerpt from the 2010 IRS W-5 form:

You are eligible to get advance EIC payments if all four of the following apply.

  1. You (and your spouse, if filing a joint return) have a valid social security number issued by the Social Security Administration.
  2. You expect to have at least one qualifying child and to be able to claim the credit using that child. If you do not expect to have a qualifying child, you may still be eligible for the EIC, but you cannot receive advance EIC payments.
  3. You expect that your 2010 earned income and adjusted gross income (AGI) will each be less than $35,535 ($40,545 if you expect to file a joint return for 2010). Include your spouse’s income if you plan to file a joint return…
  4. You expect to be able to claim the EIC for 2010.

How is the EIC given to the employee?
Normally your payroll system will handle the calculation of the tax credit amount, assuming you correctly indicate that the employee is eligible for EIC.  Depending on how the employee completes their W-5 Form, you would indicate whether the employee’s filing status is Single, Married with One Certificate, or Married with Two Certificates (meaning each spouse is eligible to get the EIC).

It’s important to note that the W-5 Form expires each December 31st.  Therefore, you will need to update the EIC information in your payroll system before the first pay in January to ensure accuracy, especially if the employee no longer qualifies.

Also worth noting is that it is possible that the employee could still have federal tax withheld even though they’re getting a tax credit, depending on how they complete their W-4 form.

How will the EIC appear in a payroll?
Depending on your payroll system, the EIC will appear as a separate line item in the employee’s earnings.  It will not be included with gross pay, as it is not taxable.

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