For many divorced or legally separated parents, one of the best ways to minimize what they lose to the Internal Revenue Service each year is to take maximum advantage of dependency exemptions for their children and child tax credits for children under age 17. But they might need to check whether changes in the rules about who gets these exemptions after parents split affects their eligibility for those tax breaks.
Congress recently overhauled many of the rules for dependency exemptions, including those for children after parents split. The exemption changes became effective with returns for 2005 that are filed in 2006. They are included in legislation enacted in 2004 known officially as the Working Families Tax Relief Act of 2004.
What complicates the situation is that the folks on Capitol Hill then decided to cancel a new rule that affects only divorced parents. They tacked the repeal-what government officials characterize as a technical correction-onto the Gulf Opportunity Zone Act of 2005, legislation enacted in December 2005 mainly to provide tax and other kinds of relief for communities battered by Hurricanes Katrina, Rita and Wilma. The 2005 legislation slightly changed the 2004 law by restoring the pre-2005 rule for assigning exemptions to non-custodial parents. But, as our legislators occasionally do during filing seasons, they passed the restoration after the IRS had released filing instructions for 2005 returns, leaving it up to the agency to alert affected parents not to rely on a portion of the instructions that accompany their returns. (This is described in more detail, below.)
Like tax brackets and standard deduction amounts, dependency exemptions are indexed--that is, adjusted annually to reflect inflation, as measured by increases in the Consumer Price Index. Each exemption reduces taxable income by $3,200 for 2005 and $3,300 for 2006. For the filing season just passed a $3,200 exemption trims taxes by $320 and $480 for individuals in the 10 percent and 15 percent brackets, respectively--the brackets most filers fall into.
The revised exemption rules for 2005 and beyond are designed to make things simpler and more rational for most divorced or separated parents--those who together or separately provide more than half of their child's total support and one or both of whom have custody of the child for more than half of the year. (For example, if each parent has custody for two months, and a grandparent has custody for eight, neither parent can claim the child.)
Parents are able to take advantage of these special rules only if they satisfy several requirements. Here's how the special rules apply to a couple we'll call Brenda and Carl, divorced parents of Alan.
The support test is straightforward in most cases. One or both parents have to provide more than half of his total support for the year in question. Support includes outlays for the following: food, shelter, clothing, education, medical and dental care (including health insurance premiums), recreation and entertainment (including computers, TV sets, summer camps, singing and dancing lessons and musical instruments), transportation and similar expenses.
What if, say, Brenda has remarried? The law makes clear that Brenda's outlays include support for Alan that is provided by her new spouse.
Another prerequisite is that Brenda and Carl fit in one of these three categories:
Divorced or legally separated under a decree of divorce or separate maintenance
Separated under a written separation agreement
Living apart at all times during the last six months of the year
The IRS liberally defines "living apart," applying it to parents who have married and to biological parents who have never married and live apart--perhaps an acknowledgement by bluenose bureaucrats of the general easing of sexual attitudes throughout the country.
In addition, Alan must be in the custody of Brenda, Carl or both for more than half the year. Here, too, the IRS cuts some slack and will not disqualify Brenda and Carl just because of temporary absences by Alan attributable to education, vacations, sickness, etc. But the agency will not permit Brenda and/or Carl to claim Alan when, say, a doting grandmother or aunt--whether out of generosity or necessity--provides more than half of his support or has custody of him for more than half the year.
Let's say that Brenda and Carl pass all the tests. That means the [child] exemption belongs to the custodial parent--the parent with whom he shared the "same principal place of abode" (IRS-speak for residence) for more than half the year.
What if Brenda and Carl divorce or separate during the year and have joint custody of Alan before the split? According to the filing instructions for Form 1040, his exemption goes to the parent who has custody for the greater part of the rest of the year.
Suppose, as in most cases, the custodial parent is the mother, Brenda, and the non-custodial parent is Carl. Consequently, the special rules bestow the exemption on her, not him.
Both the special rules for 2005 and later years and the regulations for pre-2005 years are subject to an important exception that authorizes a non-custodial parent like Carl to claim Alan's exemption. It requires the custodial parent (Brenda) to agree to sign IRS Form 8332--Release of Claim to Exemption for Child of Divorced or Separated Parents--thereby awarding the exemption to Carl.
Inescapably, this means additional paperwork at filing time. To claim Alan, Carl must attach Form 8332 to his tax return and continue to do so each year that he claims Alan as a dependent. The return must list the number of dependent children who do not live with him because of divorce or separation.
The instructions also require that Brenda give a Form 8332 to Carl even if there is a written divorce decree or written separation agreement that specifies he is entitled to the exemption. There is a way to sidestep the Form 8332 requirement [see box on page xx], but it hardly cuts down on the paperwork.
If there is no decree or agreement that awards Alan's exemption to Carl, it might be worthwhile for him to negotiate for the exemption. That strategy could save more tax for him if he falls into a higher bracket than Brenda.
Brenda has two options. The first is to sign Part I of Form 8332 and release the exemption for only the year in question. The second is to sign Part II and release it for either a specified number of years or all future years.
In general, the first option makes more sense for her. A one-year-at-a-time release dictates an annual renegotiation. This tactic might, the instructions note, "help ensure" that Carl makes timely child support payments.
Furthermore, the second option cannot be undone, as the following case illustrates: The IRS programs its computers to catch someone like Joann Bramante who signs Part II and [later] takes the exemption. When Joann's marriage ended, she had little income, so she signed away the exemptions for her two kids to her husband. Several years later, Joann started working and claimed both exemptions, as did her ex-husband. Joann contended that at the time she signed Part II, she never intended to relinquish the exemptions for future years when she might land a job. Her argument fell flat with the United States Tax Court, which ruled that Part II's wording controls and that the husband gets to keep the exemptions.
The regulations for 2005 and beyond spell out how to resolve situations when the special rules do not apply and both Brenda and Carl claim an exemption for Alan on separate returns. In that event, new "tie-breaker rules" grant the exemption to the parent with whom Alan has resided for the longest period of time during the year.
How do the tie-breaker rules work when Brenda and Carl have joint custody of Alan and his residency period with both of them is exactly the same? The rules specify that the "winner" of the exemption is the parent with the higher AGI.
Arguably, the tie-breaker rules operate inequitably when the parent with the lower AGI spends more on Alan's support. That acknowledged, the rules are sensible from the standpoint of reducing administrative burdens for the IRS and the courts. After all, joint custody, more common now than ever, can cause tax problems, as many parents have belatedly learned. Consider, for example, a couple of Tax Court cases that resolved joint-or split-custody disputes and how the tie-breaker rules would have helped had they then been applicable.
In a 2003 decision, the court held that the exemption goes to the parent who has actual, physical custody--and not just the right to custody--for the greater portion of the year. For the year in question, the son's time was evenly divided between his mother, Marvina J. Dail, (from 6 pm Thursday until 8 am Monday morning) and his father (the remaining three-and-a-half days of each week). But the judge noted that the son resided exclusively for two weeks with Marvina in the summer when she visited an ailing relative. Those extra weeks meant the exemption belonged to Marvina, who also would have won under the tie-breaker rules.
A previous decision in 2002 favored the IRS in a case that pitted it against Jennifer Ann Rogers of San Francisco and her ex-husband, William R. Lautenberger of Pacifica, Calif. They had joint custody of their 14-year-old daughter, Diana. While the parents agreed that their daughter spent about an equal amount of time with each of them, Jennifer and William both took a dependency exemption for Diana for 1998.
The IRS disallowed both exemptions, but was willing to allow one, provided the parents came to an understanding about who would claim Diana. The agency's eminently reasonable offer was spurned by the parents, who were adamant that their dispute go to court. Unfortunately for Jennifer and William, they wound up before a judge who took a Solomon-like approach, ruling that Diana spent exactly six months with each parent. Consequently, said the judge, "neither parent is entitled to a deduction." Here, the dispute would never have wound up in court had the tie-breaker rules been on the books, as there would have been a clear-cut victor--the parent with the higher AGI.
But let's return to Brenda and Carl, for whom more is at stake than just Alan's exemption. The parent entitled to an exemption for a child is the parent who gets to claim the child tax credit for a qualifying child under age 17. Under current law, the credit is $1,000 for each child, making dependency exemptions more valuable. Hence, negotiating for exemptions becomes even more important.
There are restrictions on who qualifies for the credit. Neither Brenda nor Carl is eligible if they are upper-income individuals. The credit begins to phase out when modified AGI exceeds $110,000 on a joint return, $75,000 on a single return, and $55,000 for marrieds filing separate returns. Alan must be under age 17 as of the close of the year and a U.S. citizen or resident.
The child credit and other credits are subtracted from the tax itself, resulting in dollar-for-dollar reductions of the tax otherwise owed. Write-offs for exemptions and other deductions merely result in reductions of the amount of income on which to figure taxes--a distinction that is critical. Whereas a deduction of $1,000 is worth only $250 for someone in a 25 percent bracket, dropping to just $100 for someone in a 10-percent bracket, a tax credit of $1,000 reduces the taxpayer's tab by $1,000, whatever the bracket happens to be.
The IRS also has crafted regulations for medical expenses. At one time, a divorced or separated parent could deduct a child's medical expenses only if that parent could claim an exemption for the child. Now, however, it no longer matters which parent receives the exemption. Under the current rules for divorced or separated parents, Brenda and Carl can each deduct those medical expenses that he or she pays for Alan, subject to a nondeductible 7.5 percent floor.
Special rules or tie-breaker rules aside, in an increasing number of situations it becomes pointless for parents to squabble about exemptions for their children. For instance, Brenda may be disqualified from claiming an entire exemption for Alan because her income is too high.
Exemptions start to phase out, that is gradually vanish, when AGI surpasses certain levels that are adjusted upward yearly to account for inflation. The disallowance affects all exemptions that can be claimed on a return, including those for a spouse and dependents.
In 2006, the disallowance process for exemptions begins when AGI exceeds these amounts: $150,500 (up from $145,950 for 2005) for singles; $225,750 (up from $218,950) for joint filers; $188,150 (up from $182,450) for heads of household; and $112,875 (up from $109,475) for married persons filing separately.
But unless the law changes, from 2006 to 2009, the phasing out of exemptions itself will disappear in stages. On IRS 1040 forms for 2006 and 2007, the required phasing out declines to just two-thirds of what would otherwise be phased out. On returns for 2008 and 2009, the required phasing out further declines to just one-third of what would otherwise be phased out. After 2009, the phase-out officially ends, unless reinstated by Congress.
There is yet another tax trap: Brenda cannot claim any exemptions for Alan or herself if she is subject to the alternative minimum tax (AMT).
By the way, the AMT does not infringe on the personal religious beliefs of individuals who raise large families. While it might have the effect of making the observance of some religious beliefs more expensive, the Tax Court has ruled that it does not render the AMT an unconstitutional infringement of free exercise of religion under the First Amendment. The Tax Court's decision was upheld by the United States Court of Appeals for the 10th Circuit.
In short, being a parent is expensive; being a divorced parent is more so. But if you're up on the rules, you can make it a little easier for your clients.
Julian Block is a syndicated columnist and attorney based in Larchmont, N.Y. His books include Marriage And Divorce: Savvy Ways For Persons Marrying, Married Or Divorcing To Trim Their Taxes To The Legal Minimum. Information about his books is at www.julianblocktaxexpert.com.
Another Way to Go
It may not be simpler, but there is an alternative to Form 8332 for divorced or separated couples who want to shift the ability to claim dependent children as deductions to the non-custodial parent. According to Mark Luscombe, principal analyst for CCH, instead of Form 8332, Carl can attach certain pages from the divorce decree or written separation agreement, provided the decree or agreement states all three of the following:
1. Carl can claim Alan without regard to any condition--payment of support, for example.
2. Brenda will not claim Alan.
3. The years for which Brenda releases the claim.
In addition, Carl must attach all of the following pages from the decree or agreement:
1. Cover page (including Brenda's Social Security number).
2. The pages that include all of the information identified in items 1-3, above.
3. Signature page with Brenda's signature and date of agreement.
This is an annual obligation; Carl must attach the required information even if he submitted it with a 1040 form for a previous year.