Eliminate Income Tax - EIC Loophole

Am I the only one who realizes that someone really screwed up
when they conceived and implemented the Earned Income Credit?

Let me explain.

Let's assume someone has absolutely no income, but they "pretend" to be self-employed.

For this example, we will use fingernail and toenail clipping business. Charge for this service $100.00. Owner: Generous Joe, the Nail Clipper.

Let's say that Joe the nail clipper charges Jane $100. After Jane gives Joe $100, generous Joe may decide to make a gift of, oh let's say $100, right back to someone in the Jane's immediate family. That's why Joe didn't deposit the $100 into his bank. His records record the $100 sale along with other sales that are very similar to this one.

Total 2008 business expenses: $30.00 to purchase scissors.

Below are some examples of how much Joe would have had in tax liability (ha!) for the year 2008.

Example 1: 3 sales @ $100/ea = $300.00.
Net income = $270.00 ($300 minus $30 for the scissors)

Form 1040 Line #	Description	Single - no dependent children		Single - 1 dependent child
22	Total Income		$ 300		$ 300
38	Adjusted Gross Income		300		300
40	Standard Deduction		5,450		5,450
41	Subtract 40 from 38		- 5,180		- 5,180
42	Deduction Exemptions		3,500		7,000
43	Taxable Income		0		0
64a	Earned Income Credit		94		94
71	Total Payments		94		94
72	Overpaid		94		94
73a	Refund to you		$ 94		$ 94

So, Joe has paid nothing in as federal income tax but gets a refund of $94.00. That's not a lot of money, but wait! It gets worse.

Example 2: 20 sales @ $100/ea = $2,000.00.
Net income = $1,970.00 ($2,000 minus $30 for the scissors)

Form 1040 Line #	Description	Single - no dependent children		Single - 1 dependent child
22	Total Income		$ 1,970		$ 1,970
27	1/2 of Self Empl. Tax		139		139
38	Adjusted Gross Income		1,831		1,831
40	Standard Deduction		5,450		5,450
41	Subtract 40 from 38		-3,619		-3,619
42	Deduction Exemptions		3,500		7,000
43	Taxable Income		0		0
57	Self Employment Tax		278		278
64a	Earned Income Credit		621		621
71	Total Payments		621		621
72	Overpaid		343		343
73a	Refund to you		$ 343		$ 343

In this case, Joe receives a refund of $343.00 (again, he paid nothing in). What happens if he earns even more??? We'll find out in Example 3.

Example 3: 100 sales @ $100/ea = $10,000.00.
Net income = $9,940.00 ($10,000 minus $60 for the scissors -- needed two pair this time)

Form 1040 Line #	Description	Single - no dependent children		Single - 1 dependent child
22	Total Income		$ 9,940		$ 9,940
27	1/2 of Self Empl. Tax		703		703
38	Adjusted Gross Income		9,237		9,237
40	Standard Deduction		5,450		5,450
41	Subtract 40 from 38		3,787		3,787
42	Deduction Exemptions		3,500		7,000
43	Taxable Income		287		0
44	Tax		29		0
57	Self Employment Tax		1,405		1,405
61	Total Tax		1,434		1,405
64a	Earned Income Credit		2,917		2,917
66	Add'l child tax credit		0		111
70	Recovery rebate credit		300		600
71	Total Payments		3,217		3,628
72	Overpaid		1,783		2,223
73a	Refund to you		$1,783		$ 2,223

In this example, Joe the filer (both nail filer and income tax filer) will pay NO FEDERAL TAXES and yet receive a refund of $1,783.00. If Joe the filer has a dependent child, he would receive $2,223.00. In addition, Joe is contributing to Social Security by "paying" self-employment tax. Of course, Joe does not pay the tax -- the real taxpayers (like us) are paying it for him.

Example 4: 150 sales @ $100/ea = $15,000.00.
Net income = $14,940.00 ($15,000 minus $60 for the two pair of scissors)

Form 1040 Line #	Description	Single - no dependent children		Single - 1 dependent child
22	Total Income		$ 14,940		$ 14,940
27	1/2 of Self Empl. Tax		1,056		1,056
38	Adjusted Gross Income		13,884		13,884
40	Standard Deduction		5,450		5,450
41	Subtract 40 from 38		8,434		8,434
42	Deduction Exemptions		3,500		7,000
43	Taxable Income		4,934		1,434
44	Tax		493		144
57	Self Employment Tax		2,111		2,111
61	Total Tax		2,604		2,255
64a	Earned Income Credit		2,917		2,917
66	Add'l child tax credit		0		808
70	Recovery rebate credit		493		600
71	Total Payments		3,410		4,325
72	Overpaid		806		2,214
73a	Refund to you		$ 806		$ 2,214

In this final example, Joe the filer has earned nearly $15,000. This time, there is a big difference in the refund depending on whether or not he has a dependent. If Joe has a dependent, he will receive just about the same amount as Example 3, when the nail sales were $10,000. The primary difference is that the self-employment tax paid is a whopping $2,111, and again, Joe the 'taxpayer' did not have to pay the tax. Instead he receives a refund of $2,214.

If Joe has no dependents, he should have quit doing nails when he hit $10,000 in sales, because his tax refund was reduced from $1,783 to $806. In essence, he is penalized for having a higher income (just as most of us hard-working taxpayers are) due to the progressive nature of our income tax.

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