One of the most misunderstood and seldom thought-out areas of family law are the requirements and interplay of claiming children as dependents, claiming head of household status, claiming child-related credits and the kiddie tax. The following is a general review of these areas. As is typical of income tax law, there are nuances and exceptions too numerous to discuss in this brief article. However, it is hoped that the following will raise the attorney and client’s awareness of the tax consequences related to children and custody.
Before we dive into the specifics of divorcing or separating, let’s take a look at the general requirements for claiming a dependency deduction for a child:
- The child cannot be claimed as a dependent of another.
- The child is a US citizen, US resident alien, US national or a Canada/Mexico resident for some part of the year.
- The child cannot claim the exemption on his or her own return
- The child is either a “Qualifying Child” or a “Qualifying Relative”.
A Qualifying Child must be the taxpayer’s son, daughter, stepchild, foster child, brother, sister, half brother or sister, stepbrother, stepsister or descendant of any. The child must not have provided more than half of his or her own support and cannot file a joint return for the year. Additional requirements:
- The child is either:
1. under 19 at the end of the year and younger than the taxpayer and spouse;
2. under 24 at the end of the year, a full time student and younger than the taxpayer and spouse;
3. permanently disabled (no age limit);
- The child actually lived with the taxpayer for more than half of the year.
Only one person can treat a child as a qualifying child. A parent will trump any other relationship. The parent with primary physical custody will trump the other. In the case of two parents with equal physical custody, the parent with the higher gross income will trump the other.
A Qualifying Relative is either an actual relative or an individual that lived with the taxpayer as a member of the household for the entire year. The relative’s income must be less than $3,650 and the taxpayer must have provided more than half of the relative’s support for the year. Finally, the relative cannot be the Qualifying Child of anyone else.
If multiple parties provide support for the child, each party must apply the above tests and follow the priority set forth.
If the child is in college, the parent to whom the child returns when not in school receives credit for the time in college for determining where the child “lives”.
For 2011 the exemption amount is $3,700 and is no longer subject to phase outs. Thus, both parents can benefit from this deduction regardless of income level.
Dependency Exemption – Divorce Situations
There is a special rule for children of divorced or separated parents under IRC §152(e). The custodial parent will be entitled to claim the child as a dependent if all of the following apply:
- The parents are divorced, separated or otherwise living apart for the last six month of the year.
- The parents together provide more than half of the child’s support.
- The child is in the custody of one or both parents for more than half the year.
Custody is determined either:
- Legally – according to the written separation agreement or court order.
- Physically – based on which parent has the child for the greater number of nights during the year. If there is a tie, the parent with the greater adjusted gross income will be deemed the custodial parent. Fortunately, there are 365 days in most years so one parent should have at least one more night than the other.
The custodial parent may release the exemption to the non-custodial parent by completing and signing a Form 8332 “Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent”. The non-custodial parent must attach this form to his or her return in order to claim the child as a dependent.
The IRS is very particular about using this form and has become more strict in recent years. Currently, a settlement agreement or court order will only replace this form if there is an unconditional assignment of the dependency exemption to the non-custodial parent and the agreement’s only purpose is for this assignment. In other words, a provision in the overall divorce settlement will not work. Furthermore, any provision conditioning the assignment of the dependency exemption on the current payment of child support will also not be accepted. The IRS is not interested in getting involved in and making determinations regarding the status of child support payments between parents.
Form 8332 can be signed for a single year or for multiple years. If it is anticipated that obtaining the signature of the custodial parent is going to be a problem, then a form applying to all future years should be prepared and signed at the time of the judgment or settlement. On the other hand, if the custodial parent is concerned about receiving child support payments, he or she may want to sign a Form 8332 each year once the support has actually been received.
An emancipated child is not considered in the custody of either parent and thus, these special rules do not apply.The child must qualify under the general dependency rules as outlined above. This situation typically occurs while the child is in college. When determining who paid the child’s support, consideration should be given to the cost of the household to which the child returns as well as the costs of college, room and board.
Head of Household Filing Status
Head of household filing status provides greater tax benefits in the form of lower tax rates and more beneficial thresholds. A taxpayer may claim head of household if they are unmarried or considered unmarried on the last day of the year. Additional requirements:
- The taxpayer paid more than half the cost of maintaining a home for the year.
- A “qualifying person” lives with the taxpayer for more than half the year. A child will be continued a “qualifying person” if they are:
1. Qualifying child – whether or not the child is claimed as a dependent by the taxpayer.
2. Other child that lives with and can be claimed as a dependent of the taxpayer.
Head of household is based on actual custody and cannot be negotiated between the parties. Thus, while a custodial parent can release the dependency exemption to the non-custodial parent (by signing a Form 8332), he or she alone retains the ability to file as head of household.
Child Tax Credit
Eligible taxpayers may claim a credit for each qualifying child under age 17 that can be claimed as a dependent. The maximum credit amount for 2010 and 2011 is $1,000. This credit is phased out for taxpayers with adjusted gross income (AGI) exceeding certain amounts. The credit is reduced by $50 for each $1,000 of AGI over $110k for joint filers, $75k for single/head of household taxpayers and $55k for married filing separate taxpayers.
The credit is refundable to the extent of 1) 15% of the taxpayer’s taxable earned income over $3,000 or 2) if three of more children, the social security taxes paid in excess of the earned income credit. Earned income is required for the credit to be refundable, but no earned income is required to use the credit as an offset to the tax liability.
The parent who actually claims the dependency exemption will also claim the child tax credit. Thus, if the custodial parent releases the exemption to the non-custodial parent, he or she is also releasing the child tax credit.
Dependent Care Credit
This credit is allowed for employment-related expenses incurred for the care of a child. Generally, only expenses for a child under that age of 13 who lives with the taxpayer for most of the year will qualify for the credit. As with most child-related benefits, there is an exception to the age requirement if the child is disabled/handicapped and incapable of self-care.
The maximum credit is 35% and the minimum credit is 20% of qualifying expenses. The phase-out begins at $15k AGI and is reduced to 20% at $43k AGI or more (regardless of filing status). The credit is limited to the tax liability and is non-refundable.
The maximum amount of expense that can be considered is $3,000 for one child or $6,000 for two or more children. Qualifying expenses include daycare, camp, nanny and any other expense that allows the taxpayer to be gainfully employed.
The custodial parent will be entitled to claim this credit since he or she will have has physical custody of the child for most of the year. Thus, if the custodial parent releases the exemption to the non-custodial parent, he or she retains the ability to take the dependent care credit.
One of the most overlooked areas when separated parents are evaluating the tax aspects of the children is the impact of the so-called “kiddie tax”.
The kiddie tax first appeared in 1986 to discourage parents from shifting income to their children’s returns in order to have it taxed at a lower rate. In general terms, the kiddie tax allows a child’s earned income to be taxed at the child’s tax rate, but requires that the child’s unearned income in excess of the standard deduction for dependents (currently $950) be taxed at the parent’s rate. Interest, dividends, royalties and trust income are frequent sources of unearned income.
The kiddie tax originally only applied to children under the age of 14. However, in 2006, the applicable age increased to 18. The kiddie tax was expanded again in 2008 and continues to apply as follows:
- Child 17 and Under - Child has excess unearned income.
- Child 18 – Child has 1) excess unearned income and 2) earned income of less than 50% of his or her support.
- Child 19-23 – Child has 1) excess unearned income, 2) earned income of less than 50% of his or her support and 3) is full time student.
In general, the kiddie tax will apply to children that can be claimed a dependent on a parent’s return.
For unmarried taxpayers, the custodial parent’s tax rate will be used to calculate the kiddie tax. For married taxpayers filing separately, the rate that will apply will come from the parent with the higher taxable income.
When calculating the proper rate to use, the income from all children subject to the kiddie tax is added to the parent’s income. This calculated tax rate is then applied to the excess unearned income of all the children.
The kiddie tax is calculated and reported on a separate return filed for the child. However, the parent may elect to report the kiddie tax on his or her return if the following applies:
- Child only has interest and dividends
- Child’s gross income is greater than half of the limited standard deduction
- Child’s gross income is not greater than 10 times the limited standard deduction
- No estimates were made under the child’s name or social security number
- No income taxes were withheld from the child’s income
Electing to report the child’s income may impact the parent’s overall tax rate whereas filing separately will not.
As indicated, the tax impacts of children for divorcing or separated parents involve more than just negotiating the dependency exemption. More often than not, the ability to file as head of household will have a more significant impact than the benefit of a dependency deduction. Furthermore, the ability to claim a dependent care credit and the requirement to report kiddie tax will fall on the custodial parent regardless of whether the dependency exemption is released to the non-custodial parent.
Leslie O. Dawson is a partner with Glenn & Dawson, LLP in Walnut Creek. She is a Certified Public Accountant (CPA), a Certified Valuation Analyst (CVA), Certified in Financial Forensics (CFF) and Accredited in Business Valuations (ABV) by the American Institute of Public Accountants. She received her B.A degree in accounting, cum-laude, from Sonoma State University and her M.S. degree in taxation from Golden Gate University. Ms. Dawson has been providing family law forensic accounting services since 1991. She is a member of the California CPA Society family law section and serves as volunteer for the statewide family law conference, the coordinator of the East Bay “Tax Issues In Divorce” mini-conference and the coordinator of the East Bay pro-bono program. Ms. Dawson serves on the board of directors for Kids Turn, Ujima Family Recovery Services, Mount Diablo Interpretive Society and is the past chair of the Walnut Creek Chamber of Commerce. She has recently been appointed to the Community Blue Ribbon Task Force on Fiscal Health by the Walnut Creek City Council.
Articles on Taxes from the Family Law practice area perspective:
- New Tax World for Registered Domestic Partners by Don Read
- Help! I Think my Spouse Is Cheating (On His Taxes) by Jonathon Watts
- Divorce, Children and Taxes by Leslie Dawson, CPA
Filed Under: Spotlight