Sidney Kess ()
One of the most basic write-offs in tax law is the dependency exemption ($3,900 per dependent for 2013; $3,950 per dependent for 2014) (Code Sec. 151(d)(1)). This deduction is supposed to offset some of the cost of supporting a child or other person. There is no cap on the number of dependency exemptions that can be claimed. However, a variety of specialized rules may limit the dependency exemption or impact who can claim the deduction for a certain dependent.
A taxpayer who claims a dependency exemption for a child may also be eligible for other tax breaks, such as head of household filing status, the earned income tax credit, the child tax credit, and the dependent care credit.
However, being eligible for a dependency exemption does not automatically guarantee eligibility for other tax breaks. This is because a child may entitle a taxpayer to an exemption because he or she is treated as a qualifying relative (Code Sec. 152(d)) but not as a qualifying child (Code Sec. 152(c)). An adopted child and a foster child can be treated as a qualifying child (the formalities of the relationship must be proven). A qualifying relative can include an individual with no blood ties, such as the child of a significant other. So merely claiming an exemption does not establish eligibility to other tax breaks.
For example, in one case, a taxpayer with no biological relationship to a minor he was supporting was able to claim a dependency exemption and use head-of-household filing status, but could not take an earned income credit and child tax credit (Cooper, TC Summary Opinion 2013-59). The earned income and child tax credits apply only to a qualifying child and, in this case, the minor was not a qualifying child because of his lack of any biological relationship to the child (the child was treated as his qualifying relative).
Taxpayers with adjusted gross income (AGI) over a threshold amount may lose some or all of their deduction for a dependency exemption (Code Sec. 151(d)(3)). The reduction is 2 percent of the exemption amount for each $2,500, or portion thereof, of AGI over the threshold amount ($1,250 for married persons filing separately); the threshold amount depends on filing status.
The threshold amounts for the start of the phase-out for 2013 (and 2014) are:
• Married filing jointly: $300,000 ($305,050)
• Head of household: $275,000 ($279,650)
• Single: $250,000 ($254,200)
• Married filing separately: $150,000 ($152,525)
College Students. A high-income parent may want to waive the dependency exemption. Doing so allows the student to claim the American opportunity or lifetime learning tax credit if otherwise eligible; the student cannot take a personal exemption. This strategy is useful if the parent is subject to the phase-out of the exemption and/or is barred from claiming an education credit because income exceeds eligibility limits and the student has taxable income that can be offset by the credit.
In the case of a child with parents who are divorced, legally separated, or never married, there is a special rule for determining which parent can claim the child as a dependent. As a general rule, the custodial parent—the parent with whom the child lives for the greater part of the year—is entitled to the dependency exemption. This rule applies as long as one or both parents provides over half the cost of the child’s support and the child is in the custody of one or both parents for more than half the year.
Determining the custodial parent. In determining this, count the number of nights during the year that the child resided with a parent. Count temporary absences (e.g., a stay in a hospital or at summer camp) as nights with a parent if the child would otherwise have been there at that time.
If the number of nights with each parent is equal, then a tie breaker rule applies. Here, the parent with the higher adjusted gross income is treated as the custodial parent.
Waiving the exemption. The custodial parent otherwise entitled to the exemption may waive it in favor of the non-custodial parent. This may be required by a divorce decree or legal separation agreement or desired because of tax savings if the custodial parent is subject to the phase-out for high-income taxpayers. The waiver is made by signing IRS Form 8332. The waiver can be permanent or made annually. However, a waiver must be timely. In one case, a waiver for the 2008 tax year that was executed in 2013 was not timely because it was provided after the statute of limitations for 2008, which would have been April 15, 2012 (Katz, TC Summary Opinion 2013-98).
For a divorce decree or separation agreement after 2008, the IRS form is the only way to waive the exemption. For pre-2009 legal actions, a noncustodial parent entitled to claim the exemption can attach a copy of the relevant pages from the decree or agreement; this amounts to a waiver by the custodial parent.
Unusual Family Situations
The era of Leave It To Beaver has given way to Modern Family, with taxpayers providing support for various people. Recent cases illustrate some of the tax hurdles that must be overcome to claim a dependency exemption.
Nephew. A taxpayer cared for his infant nephew in his home even though the child’s mother was the legal guardian. The IRS objected to his claiming a dependency exemption for the nephew, but the Tax Court allowed it (Oliver, TC Memo 2013-117). The nephew was his qualifying child because he satisfied the four requirements in the law (Code Sec. 152(c)):
1. The child bears a specified relationship to the taxpayer (a child of a sibling qualifies).
2. The child and taxpayer share the same abode (here they lived together during the year).
3. The child is under age 19, or under age 24 and a full-time student (the child was an infant).
4. The child does not provide more than half of his/her support (the infant had no income).
Multi-Generations. In another case, a child and her mother resided with the grandmother who paid all housing costs and claimed the child as her dependent; the child’s mother did not. The grandmother was entitled to this exemption because the child was her grandson who lived with her, and was under age 19, and the child did not provide more than half of his support (Coultman, TC Summary Opinion 2013-36). Had the child’s mother also claimed an exemption for the boy, then the tie-breaker rule would come into play and the mother likely would have prevailed.
Clan Relative. Another taxpayer who was a member of the Navajo Indian Nation claimed a dependency exemption for a clan member who was not biologically related to her. The Tax Court denied her an exemption because the child was not a qualifying child (Begay, TC Memo 2013-17). The relationship classifications in the tax law were held not to violate the Equal Protection and Free Exercise of Religion clauses in the U.S. Constitution.
Multiple Support Agreements
If two or more taxpayers together contribute more than half of a qualifying relative’s support but no one contributes more than 50 percent, they can decide among themselves who will claim the exemption. The person claiming the exemption must contribute at least 10 percent toward support in order to qualify for the deduction. For example, three daughters support their elderly mother, with daughter #1 contributing 40 percent, and daughters #2 and #3, 30 percent each. The daughters can decide which of them should claim the exemption for their mother; each is eligible to do so.
Each contributing person must sign IRS Form 2120, Multiple Support Declaration. The person claiming the exemption attaches the form to his or her return.
The phase-out of the exemption for high-income taxpayers can impact the decision about who should claim the exemption. Revisit this question each year.
Alternative Minimum Tax
Claiming a significant number of dependency exemptions can trigger or increase exposure to the alternative minimum tax (AMT). This is because this deduction is not allowed for AMT purposes. The alternative minimum tax is a shadow tax system designed to ensure that those with significant income who are able to shelter it with deductions and other tax strategies pay at least some income tax.
The fact that the AMT is supposed to make sure that wealthy taxpayers paid at least some income tax does not mean it cannot be applied to middle-income taxpayers. The U.S. Court of Appeals for the Tenth Circuit, affirming the Tax Court, held that middle-class parents of 10 children were subject to the AMT (Klaassen, 182 F.3d 932 (10th Cir. 1999), aff’g TC Memo 1998-241). Unfortunately, the plain language of the AMT rules apply to taxpayers regardless of what might have been congressional intent. As a result, these taxpayers effectively lost the tax benefit of their dependency exemptions.
The simple dependency exemption is not so simple after all. When faced with unusual situations, make sure that the requirements for a qualifying child or qualifying relative are met.
Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink, consulting editor to CCH, author and lecturer.