The earned income tax credit is one of the most complex the Internal Revenue Service offers. It's refundable, which means that if it amounts to more than what you owe the IRS, the IRS will send you a check for the balance. This makes it particularly attractive, but it involves several complicated rules that make it easy for taxpayers to err and potentially raise red flags at the IRS -- possibly even leading to an audit.
The EITC is limited to taxpayers with low to moderate incomes. Your income must be earned, such as from a job or self-employment, and your unearned income, such as interest from investments, can't exceed $3,200. You and your qualifying child dependents must have valid Social Security numbers. If you're someone else's dependent, you don't qualify, and if you're married, you can’t file a separate return. One of the strictest rules is that if you claim a child as your dependent, he must actually live with you for more than six months of the year. It doesn't matter if your ex has given you the dependency exemption for your child. The six-month rule can't be overridden.
Calculating the EITC
After you determine that you meet all the rules for qualifying, you're faced with figuring out just how much of an EITC you're entitled to and this can be complicated too. The IRS publishes a scale and worksheets every year that determine how much of the credit you can claim based on your earned income, your adjusted gross income, and your number of qualifying child dependents. For example, if you’re single and if you have three or more qualifying children, you can earn up to $45,060 as of the 2012 tax year and qualify for the EITC. You don't have to have qualifying children, but if you don't, you can't earn more than $13,980 if you're not married. If you inadvertently claim a child who didn't live with you for half a year or more, your credit will come out to more than it should be, which will affect the income limits, and this in turn can trigger an IRS examination.
The IRS zeroes in on EITC mistakes by using a computer system to scan returns and compare them against other national databases. For example, if you're claiming you have a child dependent, the computer checks against the Federal Case Registry for a corroborating court order that confirms you really are the child's custodial parent. The IRS also maintains its own dependent database. The computer compares the Social Security numbers included in your return against the Social Security Administration's records and confirms that the income you’re claiming corresponds to W-2 and 1099 forms. Many examinations are simply the result of calculating the amount of the credit wrong -- your facts are correct, but you didn't apply them correctly.
If the IRS computer flags your return, you'll receive a notice that its not going to allow the EITC credit. The notice will tell you what information the computer has flagged as erroneous. You can respond with documentation proving the facts of your case, such as custody, or you can write to the IRS and request a review because you believe your math was right when you calculated your credit. The IRS will assign your case to an examiner to sort through the problem. At this point, your examination becomes an audit.
If the IRS computer is right and you're wrong – you really don't qualify for the EITC, or at least not for as much of a credit as you claimed – you'll have to submit Form 8862 with your tax return if you attempt to claim the credit in future years. The form provides information about the examination or audit. You're barred from claiming the credit for two years if your error was the result of "reckless or intentional disregard for the rules," and for 10 years if your mistake was fraudulent in nature.