Count only taxable wages in the child and dependent care credit's earned income limit

changelog.d/fix-4007-cdcc-earned-income-deferrals.fixed.md

@@ -0,0 +1 @@
+Count only wages includible in gross income (after traditional 401(k)/403(b) deferrals and other pre-tax payroll deductions) in `adjusted_earnings`, the earned income limit of the child and dependent care credit, the IRC 129 dependent care exclusion and the state credits that inherit them, per IRC 32(c)(2)(A)(i) and Treas. Reg. 1.21-2(b)(3); California's credit limit, exclusion and AMT child exemption use California wages, which keep the payroll HSA contributions California taxes, net of any business loss, and New York's 2026 credit keeps counting the deferrals under Tax Law 606(c-2)(2)(C), also net of any business loss. California's credit now applies its own FTB 3506 expense, employer benefit and earned income limits in every year, not only 2021, and its AMT child exemption uses California's own minimum ($9,750 for 2025) instead of the federal amount.

policyengine_us/parameters/gov/irs/income/amt/exemption/child/in_effect.yaml

@@ -7,8 +7,8 @@ values:
   # 55(d)(4), so the limitation stays off. The IRS still publishes the
   # inflation-adjusted section 59(j) amount (child/amount.yaml), but Form 6251
   # applies the normal exemption to every filer from 2018.
-  # ca_amt_exemption.py still reads child/amount.yaml; this federal switch
-  # does not change California's use of that amount.
+  # This federal switch does not change California: ca_amt_exemption.py reads
+  # California's own amount (gov.states.ca.tax.income.amt.exemption.child).
   2018-01-01: false
 metadata:
   unit: bool

policyengine_us/parameters/gov/states/ca/tax/income/amt/exemption/child/amount.yaml

@@ -0,0 +1,25 @@
+description: California limits the alternative minimum tax exemption of certain children under age 24 to their earned income plus this amount.
+values:
+  2021-01-01: 7_850
+  2022-01-01: 8_300
+  2023-01-01: 8_950
+  2024-01-01: 9_450
+  2025-01-01: 9_750
+metadata:
+  uprating: gov.states.ca.cpi
+  unit: currency-USD
+  period: year
+  label: California AMT minimum exemption amount for certain children
+  reference:
+    # California publishes its own amount, which differs from the federal
+    # IRC 59(j) amount (for example, $9,750 against $9,550 for 2025).
+    - title: 2021 Instructions for Schedule P (540), line 22, Exemption Worksheet line 7
+      href: https://www.ftb.ca.gov/forms/2021/2021-540-p-instructions.html
+    - title: 2022 Instructions for Schedule P (540), line 22, Exemption Worksheet line 7
+      href: https://www.ftb.ca.gov/forms/2022/2022-540-p-instructions.html
+    - title: 2023 Instructions for Schedule P (540), line 22, Exemption Worksheet line 7
+      href: https://www.ftb.ca.gov/forms/2023/2023-540-p-instructions.html
+    - title: 2024 Instructions for Schedule P (540), line 22, Exemption Worksheet line 7
+      href: https://www.ftb.ca.gov/forms/2024/2024-540-p-instructions.html
+    - title: 2025 Instructions for Schedule P (540), line 22, Exemption Worksheet line 7
+      href: https://www.ftb.ca.gov/forms/2025/2025-540-p-instructions.html

policyengine_us/parameters/gov/states/ca/tax/income/credits/child_dependent_care/input.yaml

@@ -1,15 +1,19 @@
-description: California uses this input for the state child/dependent care credit, based on year.  
+description: California uses this input for the state child/dependent care credit, based on year.
 values:
+  # FTB 3506 applies the federal decimal (line 7) to California's own
+  # expense and earned income limits (lines 3-6), not to the federal credit.
+  # R&TC 17052.6 has done so since 2000, so the California computation
+  # applies in every year, including years before 2021.
   2012-01-01:
-  - cdcc
-  2021-01-01:
   - ca_federal_capped_cdcc
-  2022-01-01:
-  - cdcc
 metadata:
   unit: list
-  period: year 
+  period: year
   label: California child/dependent care credit input
-  reference: 
+  reference:
     - title: Details of Public Law 117-2, section 9631
       href: https://www.ftb.ca.gov/about-ftb/data-reports-plans/Summary-of-Federal-Income-Tax-Changes/index.html#PL-117-2-9631
+    - title: 2025 FTB 3506, Part III, lines 3-10
+      href: https://www.ftb.ca.gov/forms/2025/2025-3506.pdf#page=1
+    - title: California Revenue and Taxation Code 17052.6(a)(1)
+      href: https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=17052.6

policyengine_us/tests/core/test_eitc_elective_deferral_invariants.py

@@ -1,10 +1,12 @@
 """Differential coverage of payroll exclusions across vectorized tax units.
 
 Replacing gross wages and pre-tax deductions with the same W-2 box 1 wages
-must leave federal EITC and ACTC earnings/credits unchanged. California must
-retain taxable payroll HSA amounts, while gross earned income and the AMT
-earnings cap must remain independent of payroll deductions. The paired runs
-also remove dependents' wages to check that they cannot enter filer earnings.
+must leave federal EITC and ACTC earnings/credits and the CDCC earned income
+limit unchanged. California must retain taxable payroll HSA amounts, while
+gross earned income must remain independent of payroll deductions. The paired
+runs also remove dependents' wages to check that they cannot enter filer
+earnings. (The AMT child earnings cap applies only before 2018, so
+eitc_earned_income.yaml covers it.)
 Additional California pairs retain payroll HSA deductions when substituting
 California taxable wages, so YCTC must agree even with business losses.
 """
@@ -54,9 +56,6 @@ def _situations():
         tax_units[f"unit_{i}"] = {
             "members": members,
             "takes_up_eitc": {YEAR: True},
-            # Force the existing cap to isolate its gross earnings dependency.
-            "amt_kiddie_tax_applies": {YEAR: True},
-            "amt_income": {YEAR: 200_000},
         }
         households[f"household_{i}"] = {
             "members": members,
@@ -101,8 +100,6 @@ def _situations():
         tax_units[f"unit_{i}"] = {
             "members": members,
             "takes_up_eitc": {YEAR: True},
-            "amt_kiddie_tax_applies": {YEAR: True},
-            "amt_income": {YEAR: 200_000},
         }
         households[f"household_{i}"] = {
             "members": members,
@@ -156,8 +153,9 @@ def _run(situation):
         "ca_eitc_earned_income",
         "ca_yctc",
         "earned_income",
-        "adjusted_earnings",
-        "amt_exemption",
+        "head_earned",
+        "spouse_earned",
+        "min_head_spouse_earned",
     )
     return {name: simulation.calculate(name, YEAR).copy() for name in outputs}
 
@@ -175,6 +173,9 @@ def test_payroll_exclusions_match_equivalent_taxable_compensation():
         "ctc_phase_in_relevant_earnings",
         "ctc_phase_in",
         "filer_adjusted_earnings",
+        "head_earned",
+        "spouse_earned",
+        "min_head_spouse_earned",
     ):
         np.testing.assert_allclose(
             with_deductions[name],
@@ -214,7 +215,7 @@ def test_payroll_exclusions_match_equivalent_taxable_compensation():
     )
     assert np.all(with_deductions["ca_yctc"][yctc_pairs] > 0)
 
-    for name in ("earned_income", "adjusted_earnings", "amt_exemption"):
+    for name in ("earned_income",):
         np.testing.assert_allclose(
             with_deductions[name],
             no_deductions[name],

policyengine_us/tests/policy/baseline/gov/irs/credits/cdcc/dependent_care_assistance_exclusion.yaml

@@ -404,3 +404,30 @@
     cdcc_treated_as_unmarried: true
     # min($6,000 benefits, $5,000 unmarried cap, $38,000 earnings) = $5,000.
     dependent_care_assistance_exclusion: 5_000
+
+# IRC 129(e)(2) gives earned income the IRC 32(c)(2) meaning, which counts
+# wages only if includible in gross income. Form 2441 lines 18 and 19 figure
+# it the same way as lines 4 and 5 (Form 1040 line 1z).
+- name: Section 129(b) limit uses the lower earner's wages after a 401(k) deferral
+  period: 2025
+  input:
+    people:
+      head:
+        age: 40
+        employment_income: 50_000
+        dependent_care_employer_benefits: 5_000
+      spouse:
+        age: 38
+        employment_income: 4_000
+        traditional_401k_contributions_desired: 1_500
+      child:
+        age: 4
+    tax_units:
+      tax_unit:
+        members: [head, spouse, child]
+        filing_status: JOINT
+  output:
+    # Spouse: 4,000 wages - 1,500 deferral = 2,500.
+    min_head_spouse_earned: 2_500
+    # min(5,000 benefits, 5,000 joint cap, 2,500 earned income) = 2,500.
+    dependent_care_assistance_exclusion: 2_500

policyengine_us/tests/policy/baseline/gov/irs/credits/cdcc/integration.yaml

@@ -256,3 +256,44 @@
     count_cdcc_eligible: 2
     cdcc_relevant_expenses: 6_000
     cdcc: 1_200
+
+# IRC 21(d)(1)(B) caps expenses at the lower-earning spouse's earned income,
+# which counts wages only if includible in gross income (Treas. Reg.
+# 1.21-2(b)(3); IRC 32(c)(2)(A)(i)). Form 2441 line 5 starts from Form 1040
+# line 1z, which leaves out the spouse's traditional 401(k) deferral.
+- name: Lower-earning spouse's traditional 401(k) deferral lowers the earned income limit
+  absolute_error_margin: 0.01
+  period: 2025
+  input:
+    people:
+      head:
+        age: 40
+        employment_income: 56_000
+      spouse:
+        age: 38
+        employment_income: 4_000
+        traditional_401k_contributions_desired: 1_000
+      child1:
+        age: 5
+      child2:
+        age: 3
+    tax_units:
+      tax_unit:
+        members: [head, spouse, child1, child2]
+        tax_unit_childcare_expenses: 9_103
+    households:
+      household:
+        members: [head, spouse, child1, child2]
+        state_code: TX
+  output:
+    # Spouse: 4,000 wages - 1,000 deferral = 3,000 taxable wages.
+    spouse_earned: 3_000
+    min_head_spouse_earned: 3_000
+    # min(9,103 expenses, 6,000 two-child limit, 3,000 earned income).
+    cdcc_relevant_expenses: 3_000
+    # AGI 56,000 + 3,000 = 59,000: 35% - 22 points
+    # (ceil((59,000 - 15,000) / 2,000)), floored at 20%.
+    # 3,000 * 20% = 600 (gross wages would give 4,000 * 20% = 800).
+    # Tax before credits: (59,000 - 31,500) taxable income
+    # -> 2,385 + 12% * 3,650 = 2,823, so the credit is not limited.
+    cdcc: 600

policyengine_us/tests/policy/baseline/gov/irs/credits/earned_income/eitc_earned_income.yaml

@@ -360,7 +360,7 @@
     eitc_earned_income: 8500
     filer_adjusted_earnings: 8500
 
-- name: AMT kiddie-tax exemption retains its pre-2018 gross earnings cap
+- name: AMT kiddie-tax exemption caps at taxable earnings before 2018
   period: 2017
   absolute_error_margin: 0.01
   input:
@@ -384,11 +384,14 @@
   output:
     filer_adjusted_earnings: 8000
     # Ordinary exemption = 54,300 - 0.25 * (200,000 - 120,700) = 34,475.
-    # Historical cap uses gross earnings: 10,000 + 7,500 = 17,500.
-    # amt_exemption = min(34,475, 17,500) = 17,500.
-    amt_exemption: 17500
+    # IRC 59(j) earned income (IRC 911(d)(2)) counts amounts received; the
+    # deferral is not made available to the child (IRC 402(e)(3)), and the
+    # 2017 Form 8615 instructions use Form 1040 line 7 (taxable) wages.
+    # Historical cap: (10,000 - 2,000) + 7,500 = 15,500.
+    # amt_exemption = min(34,475, 15,500) = 15,500.
+    amt_exemption: 15500
 
-- name: AMT kiddie-tax exemption has no gross earnings cap from 2018
+- name: AMT kiddie-tax exemption has no earnings cap from 2018
   period: 2022
   absolute_error_margin: 0.01
   input:

policyengine_us/tests/policy/baseline/gov/irs/income/adjusted_earnings.yaml

@@ -0,0 +1,55 @@
+# IRC 32(c)(2)(A)(i) counts employee compensation only if it is includible in
+# gross income. Treas. Reg. 1.21-2(b)(3) (CDCC) and IRC 129(e)(2) (dependent
+# care exclusion) use that definition, and Form 2441 lines 4 and 5 start from
+# Form 1040 line 1z (W-2 box 1).
+
+- name: Traditional 401(k) deferral is left out of adjusted earnings
+  period: 2025
+  input:
+    employment_income: 4_000
+    traditional_401k_contributions_desired: 1_000
+  output:
+    # Gross earned income keeps the deferral: 4,000.
+    earned_income: 4_000
+    # W-2 box 1 wages: 4,000 - 1,000 = 3,000 (IRC 402(e)(3)).
+    irs_employment_income: 3_000
+    # 4,000 - (4,000 - 3,000) excluded wages - 0 SE adjustment = 3,000.
+    adjusted_earnings: 3_000
+
+- name: Roth deferral stays in adjusted earnings, other pre-tax payroll deductions do not
+  period: 2025
+  input:
+    employment_income: 10_000
+    roth_401k_contributions_desired: 1_000
+    pre_tax_health_insurance_premiums: 500
+    health_savings_account_payroll_contributions: 1_000
+  output:
+    # Designated Roth contributions are includible in gross income
+    # (IRC 402A(a)(1)); the cafeteria-plan premium and HSA payroll
+    # contribution are not (IRC 106, 125).
+    # 10,000 - 500 - 1,000 = 8,500.
+    irs_employment_income: 8_500
+    adjusted_earnings: 8_500
+
+- name: Deferral and self-employment income together
+  absolute_error_margin: 0.01
+  period: 2025
+  input:
+    employment_income: 4_000
+    traditional_401k_contributions_desired: 1_000
+    self_employment_income: 10_000
+  output:
+    # SE tax: 10,000 * 0.9235 * 0.153 = 1,412.96.
+    # Adjustment: 0.5 * 1,412.955 = 706.48.
+    # 4,000 + 10,000 - 1,000 excluded wages - 706.48 = 12,293.52.
+    adjusted_earnings: 12_293.52
+
+- name: Self-employment loss larger than taxable wages floors adjusted earnings at zero
+  period: 2025
+  input:
+    employment_income: 2_000
+    traditional_401k_contributions_desired: 1_000
+    self_employment_income: -3_000
+  output:
+    # max(0, 2,000 - 3,000 - 1,000 excluded wages - 0) = 0.
+    adjusted_earnings: 0