As you've probably heard by now, the 2003 Tax Act increased the child tax credit from $600 to $1,000 for each qualifying child. This change was effective on Jan. 1, 2003. In fact, many of you have already received your advanced payment of $400 per qualifying child representing an advance payment of this increase. The thinking in Washington was to get these funds out to the taxpayers early in order to stimulate the economy.

But as I pointed out in the past, these advanced payments were based on information contained in your 2002 tax return, even though the advance payments actually represent credits against your 2003 taxes. The fact that Uncle Sam elected to pay a 2003 credit against information found in a 2002 tax return could present some real problems.

You'll certainly be required to reconcile the receipt of this advance credit on your 2003 tax return. But if you received a $400 advance child tax credit payment, and you determine that that you weren't entitled to the payment, you aren't required to refund the money to Uncle Sam. Depending on your circumstances, many families could "double-dip" the child tax credit.

Here are a few examples on how that could work:

Example #1
Brian is a single father of three children. On his 2002 return, Brian had sufficient income and paid sufficient taxes to absorb the child tax credit for all three of his qualifying children, and his income wasn't greater than the threshold allowed to claim the credit. That being the case, Brian reduced his taxes by $1,800 ($600 per qualifying child).

In August 2003, Brian received his advance child tax credit check from Uncle Sam in the amount of $1,200 ($400 per qualifying child). But, sadly, Brian's financial life went downhill fast in 2003. His income was minimal, and his tax liability was virtually non-existent. After all is said and done, Brian will prepare his 2003 tax return this spring only to find that he can't claim any of the child tax credits on his 2003 tax return. Why? Because the child tax credit can only reduce your tax to zero, but not below zero. This is a non-refundable credit.

So you might think that Brian would have to repay the $1,200 advance child tax credit that he received back in August of 2003. But that's not the case. The law and explanation indicates that Brian is not required to refund any of the advance child tax credit that he received, even though he wasn't entitled to claim the credit in 2003. Sweet.

Example #2
Paul and Mary are married with two qualifying children. They were also able to claim the child tax credit in 2002 for the full amount of $1,200. And they also received their $800 advanced child tax credit payment in August of 2003. But for 2003, they find that their income has skyrocketed. Because of the increase in income, they will not be able to claim the child tax credit on their 2003 return because of the income phase-out rules.

Again, you might think that Paul and Mary will be required to refund the $800 that they received in advanced child credits because they weren't entitled to that credit in 2003. But the good times just keep on rolling for Paul and Mary. They will be able to keep that money, and not have to settle up with Uncle Sam.

Example #3
Here is where it really gets good. Lisa and Pete were divorced in 2001. They have three qualifying children. Their divorce decree states that they will alternate claiming the kids as dependents. In 2002, Lisa claimed the children. Her income and taxes were such that she was able to claim the maximum child tax credit for 2002 in the amount of $1,800. She also received an advanced child tax credit payment in the amount of $1,200 in August 2003.

But for 2003, Pete will be claiming the kids. Pete's income and taxes are such that he'll be able to utilize all of the child tax credit for 2003, in the total amount of $3,000 ($1,000 per qualifying child). Does that mean that Lisa will have to give her $1,200 advance payment back to Uncle Sam?

Nope. According to the rules and explanation, Lisa will be able to keep that advance payment and Pete will be entitled to claim the full amount of the credit on his 2003 return. The advanced payment that Lisa received doesn't reduce Pete's full credit. So in effect, the "family" of Pete and Linda received $4,200 in credits for their three qualifying children -- well above the allowed $1,000 limitation per child. Is this a great country or what?

Here's the bottom line: Hold on to those advance payments tightly. It might seem logical that you would have to give some of those advance credits back depending on your income and tax status for 2003. But logic and taxes often don't swim in the same ocean. This is one of those cases. And if you do find yourself in a situation described in example #3, don't let an ex-spouse bully you into "signing over" your advance payment, claiming that they will not receive the full credit on their tax return. That's just not the way it works.

Related Links:
New Tax Breaks for Small Businesses
The New, Lower Tax on Dividends
New Capital Gains Tax Rates
10 Ways to Cut Your Taxes
Midyear Tax Planning

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2002: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

October 10, 2003

Reprinted by permission. Disclaimer
© Copyright 2000-2003, The Motley Fool.
All rights reserved.