David and Judy Brown have three children, a business profit, a business loss, and nontaxable earned income.

David and Judy Brown have three children--Karl, age 4, and twins, Karin and Susan, age 2. David worked and earned $17,200. He asked his employer to contribute $1,200 of his pay to a 401(k) plan, so he will pay tax on only $16,000 ($17,200 - $1,200). He received $1,500 in unemployment compensation. David also began a consulting business. After expenses, David had a loss of $1,000. Judy made crafts and sold them at a flea market. She had a profit of $706. In addition, David and Judy received $50 in interest from a savings account.

Judy completes Schedule C-EZ and reports the $706 profit. She also completes Schedule SE and figures self-employment tax of $100. She puts this figure on line 52 (Form 1040) and deducts $50, one-half of her self-employment tax, on line 27 (Form 1040).

David completes Schedule C and reports his $1,000 loss. David and Judy combine their Schedules C and C-EZ to report a loss of $294 ($706 - $1,000) on line 12 of their Form 1040. David will not complete Schedule SE because he does not have any net earnings from self-employment.

David and Judy follow the steps in their Form 1040 instructions to claim the EIC. The only investment income they have is the $50 interest from their savings account. They find out in Step 3 of the Form 1040 instructions that, because they are claiming a loss on line 12 of Form 1040, they must use Publication 596 to see if they can take the EIC. When they receive Publication 596, they read Table 2, Where to begin if you were sent here from the instructions for Form 1040 or Form 1040A, on page 2 and find that they can start with Rule 6 on page 8. In Rule 7, they determine that all three children are qualifying children. In chapter 4, the Browns figure their nontaxable earned income to be $1,200 (David's contribution to a 401(k) plan) and their taxable earned income to be $16,000. They complete Worksheet 3 (shown here) and figure their modified AGI to be $17,427.

Worksheet 3: Modified AGI for Form 1040

Completing EIC Worksheet B. Because the Browns have self-employment income and want to figure their credit themselves, they complete EIC Worksheet B (shown here).

Part 1. David and Judy begin EIC Worksheet B with Part 1 because Judy is self-employed and will file Schedule SE. They enter $706 and $50 from Judy's Schedule SE on lines 1a and 1d respectively. They figure line 1e to be $656 ($706 - $50).

Part 2. Because David is not filing Schedule SE, the Browns enter David's $1,000 loss on lines 2b and 2c. They skip Part 3 because neither David nor Judy is a statutory employee.

Part 4. The Browns combine lines 1e, 2c, and 3 and enter the result on line 4a. They enter their nontaxable earned income of $1,200 on line 4b and their taxable earned income of $16,000 on line 4c. They figure their total earned income on line 4d to be $16,856. Because that amount is less than $31,152, they qualify for the credit, so they enter their total earned income on line 6.

Part 5. David and Judy look up the amount on line 6 ($16,856) in the EIC Table for Two children. They enter the amount of $3,007 on line 7. They enter their modified AGI amount ($17,427 from Worksheet 3) on line 8 and see that it is different from the amount on line 6. They look up $17,427 in the EIC Table and enter the amount of $2,891 on line 10. They enter $2,891 on line 11. This is the smaller of the line 7 amount ($3,007) and the line 10 amount ($2,891).

Part 6. The Browns do not owe AMT (line 12) so they enter their EIC of $2,891 on line 13. They also enter that amount on line 60a of their Form 1040. They enter "$1,200" and "401(k) contribution" on line 60b to show their nontaxable earned income. They will now complete Schedule EIC (not shown), including information for two of their three children, and attach it to their return. They will keep EIC Worksheet B for their records.

Browns' EIC Worksheet B, Page 1

Browns' EIC Worksheet B, page 2

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