Federal tax law (the Internal Revenue Code or IRC) allows taxpayers a deduction for “personal exemptions,” including one for each of their dependents.1 Everyone knows how that works, right? Not necessarily.
The truth is that taxpayers often do not know whom they might be able to claim as a dependent (outside their immediate family), the conditions for doing so, and what the ramifications are. Those ramifications extend not only to several tax provisions aside from the dependency exemption deduction itself but also to health insurance requirements under the Affordable Care Act (ACA).2 Further, when a divorce or legal separation occurs, the possibility increases for uncertainty — and unintended consequences — concerning dependents.
Lawyers might need to advise clients on any or all these matters, whether or not they consider themselves tax practitioners. With that in mind, this article provides an overview of the applicable rules and pays particular attention to them in the context of the ACA and divorces or legal separations.
Determining Who Is a Dependent
The starting point is determining who is a dependent. I.R.C. § 152(a) states that a dependent is either a “qualifying child” or a “qualifying relative.”
The statute goes on to define a qualifying child as someone who bears a certain relationship to the taxpayer (usually his or her own child or a descendant of such child), but only if the child 1) has the “same principal place of abode” as the taxpayer for more than one-half of the year;3 2) is under the age of 19 or, if a student, under the age of 24 at the end of the year; and 3) has not provided more than one-half of his or her own support for the year.4
The second category of a dependent is a qualifying relative, often someone other than the taxpayer’s child.5 For a taxpayer to claim such a person as a dependent, two important conditions must be met: 1) that person must have gross income that is less than the exemption amount for the year in question – $4,050 in 2016;6 and 2) the taxpayer must provide more than one-half the support for that person.7
A common example of someone qualifying under this second category might be an elderly parent whose support is provided primarily by a taxpayer son or daughter. Given demographic trends in America, this situation is occurring with increasing frequency. Note that the dependency exemption deduction is available to the taxpayer even if the parent lives apart from the taxpayer, for example, at an assisted-living facility.
Even someone who is not a relative can be considered a qualifying
relative of a taxpayer.
The sticking point usually is whether the elderly parent has gross income below the exemption amount. But that is the case if the elderly parent’s only source of support, other than the taxpayer, derives from Social Security. Those payments are not includible in the parent’s gross income for purposes of the exemption-amount test.8
Even someone who is not a relative can be considered a qualifying relative of a taxpayer – and therefore be claimed as the taxpayer’s dependent – if (in addition to meeting the other requirements above) that person has “the same principal place of abode as the taxpayer and is a member of the taxpayer’s household.”9
Finally, in the case of divorced or legally separated parents, special rules (discussed below) determine which parent can claim a child as a dependent.
To recap, if every family comprised spouses who never separated or divorced and had their biological children living with them only until the children went to college and, immediately upon graduation, got jobs to support themselves, then the rules would be relatively simple.
In this “Modern Family” era, however, that is often not the case. Children return home to live after college for one reason or another, other relatives or even non-relatives come and go, people live together and have children without marrying, and middle-aged taxpayers often find themselves supporting elderly parents, whether or not the parents live with the taxpayers. Also, almost one-half of all marriages end in divorce, and many individuals are divorced more than once.10 Who can claim or be claimed as a dependent for tax purposes then becomes anything but simple.
What Is in a Dependency Exemption
As noted above, in 2016 each personal or dependency exemption deduction is worth $4,050.11 For a married couple with three dependents, that amounts to a potential deduction in excess of $20,000, which – depending on one’s tax bracket – could translate into tax savings of several thousand dollars. Importantly, the deduction is available whether taxpayers itemize their deductions or claim the standard deduction.12
There’s more. The definition of a qualifying child also may determine whether a taxpayer can claim 1) favorable head-of-household filing status,13 2) an earned-income credit, and 3) a child tax credit.14 Further, the child and dependent care credit applies with respect to any dependent who has not attained age 13.15 Finally, taxpayers may claim an itemized deduction (subject to significant limits) for the health care expenses of dependents.16
Jay W. Miller, James E. Rogers College of Law, Univ. of Arizona 1974, LL.M (tax), operates the Law Offices of Jay Miller, Whitefish Bay.
Although the credits phase out (or are reduced) for incomes above a certain level, they remain an important consideration to many taxpayers. For example, in 2016 a married couple with three or more qualifying children may claim an earned-income credit that does not phase out completely unless or until their adjusted gross income reaches $53,505.17
But being able to claim someone as a dependent is no longer unadulterated tax bliss. Under the ACA, any “applicable individual” is required to “ensure” a minimum level of health insurance (referred to in the statute as “minimum essential coverage”) for himself or herself and any “dependent.”18 The term “dependent” is defined under I.R.C. § 15219 – the same definition that applies for all other tax purposes. Treas. Reg. § 1.5000A-1(c)(2)(i) adds this: An individual is the dependent of another if he satisfies the I.R.C. § 152 test “regardless of whether the taxpayer [actually] claims the individual as a dependent”on the tax return. (Emphasis added.) If the applicable taxpayer does not maintain that insurance, the taxpayer faces a potential penalty.
If a taxpayer can claim anyone (not just a child) as a dependent, the responsibility for minimum essential coverage stays with that taxpayer. The IRS provides that “the adult or married couple who can claim a child oranother individualas a dependent for federal income tax purposes is responsible for [paying the penalty] if the dependent does not have coverage or an exemption.”20 Taxpayers with qualifying religious exemptions or whose income falls below the threshold for filing tax returns are exempt from the penalty.21
The penalty is the higher of a flat amount or a percentage of income.22 For 2015, the IRS announced that the maximum penalty is $2,484 for a single individual and $12,420 for a family of five or more.23 It is expected that the penalty will be even higher in 2016. What all that means is that the penalty, which started out as the equivalent of a slap on the wrist, is now becoming more like a body blow for taxpayers with dependents who think they may be better off foregoing insurance coverage.
The taxpayer can see whether he or she has met the minimum coverage rules under the ACA by completing his or her tax return and, in particular, line 61 of Form 1040. Either the minimum coverage for taxpayers and all dependents is met (or an exemption is applicable) or it is not. If it is not, taxpayers use IRS Form 8965 instructions to figure out the penalty.
Divorce or Separation and Dependency Requirements
If spouses with children divorce, obtain a legal separation, or otherwise “are living apart at all times during the last 6 months of the calendar year,” they must decide who should claim any qualifying child as a dependent. The tax law provides that the “custodial parent,” that is, the parent having custody for the “greater portion of the year,”24 is generally entitled to claim the dependency exemption deduction and the accompanying tax credits and deductions potentially associated with it.
The general rule, however, does not address the following situations: 1) the family court overseeing the divorce (or separation) awards joint custody, with the child living an equal amount of time with each parent; 2) the parties intend for the noncustodial parent to claim the dependency exemption deduction; or 3) because of a misunderstanding or otherwise, both parents claim the same dependency exemption deduction. Nor does the rule state how these alternative scenarios affect which parent is entitled to the tax credits available with a qualifying child, as well as being subject to the minimum essential coverage under the ACA.
The definition of a
qualifying child also
may determine whether
a taxpayer can claim
an earned-income credit,
and a child tax credit.
Joint Custody. The first situation is answered easily enough. If parents have joint custody of a child for “the same amount of time” during the taxable years, the child is the dependent of the parent with the higher adjusted gross income.25 Note that with the progressive income tax system, the tax benefit potentially will be worth more to the parent with the higher income. On the other hand, the parent with the lower adjusted gross income might have a greater need for the tax benefit. When confronted with these facts, whoever is representing the parent with the lower adjusted gross income might want to negotiate an offset for the tax benefit that accrues to the parent with the higher adjusted gross income.
Parties Want Noncustodial Parent to Claim Dependency Exemption Deduction. This is an issue that taxpayers, their lawyers, and the family court sometimes mishandle. Regardless of what a family court decrees, the custodial parent must sign a “written declaration,” which the noncustodial parent, in turn, attaches to his or her return to enable the noncustodial parent to claim the child as a dependent.26 The tax regulations are very clear that for tax years beginning after July 2, 2008, “a court order or decree or a separation agreement may not serve as a written declaration.”27 Case law is equally clear that it is the “written declaration” that controls, not what the court orders.28
The written declaration must be “an unconditional release of the custodial parent’s claim to the child as a dependent for the year or years for which the declaration is effective.”29 If, for example, the release is conditioned on the noncustodial parent keeping current with child support payments, the release will not be given effect for tax purposes and the noncustodial parent will not be allowed the dependency exemption deduction.30 This is so even if the noncustodial parent does in fact meet the condition.31
If the parties have agreed that the noncustodial parent should claim the dependency exemption for a particular year or years, the better course is to use the official form the IRS has designated as a written declaration: IRS Form 8332. As with any written declaration, the form must be signed by the custodial parent and attached to the noncustodial parent’s return for the year(s) in question.
The tax regulations allow taxpayers to use a form other than Form 8332. The qualifications, however, are quite restrictive: “A written declaration not on the form designated by the IRS [that is, Form 8332] must conform to the substance of that form and must be a document executed for the sole purpose of serving as a written declaration.…”32 (Emphasis added.) This would seem to rule out marital settlement agreements ever qualifying as written declarations unless language awarding the dependency exemption deduction to the noncustodial parent is put in a separate document that is signed by both parties and attached to the noncustodial parent’s return.
What should the parties, and their lawyers, do if they intend for the noncustodial parent to claim the dependency exemption deduction but the agreement they provided for such purpose does not meet the tax law requirements of a written declaration? The best option would be to amend their agreement to include a properly executed Form 8332 or its equivalent. Absent that, and so long as only one parent claims the dependency exemption deduction on his or her tax return, the IRS might not scrutinize the situation. Still, upon a random audit the issue could nevertheless arise, and the parties should be prepared for that event.
Both Parents Claim the Same Dependency Exemption Deduction. The situation sometimes arises that, because of a misunderstanding or by intention, both parties claim a dependency exemption deduction for the same child or children for the same year. The IRS will catch this duplication and disallow the deduction for the noncustodial parent – no matter what the family court has decreed – unless Form 8332 or its substantive equivalent has been properly executed.
When that is not the case, the only tax recourse for the noncustodial parent will be to seek an order from the family court that the custodial parent sign the Form 8332 (or face contempt charges) and to file it with the IRS. But even this process does not ensure the noncustodial parent will receive the dependency exemption deduction. In Armstrong v. Commissioner,33 judges expressed conflicting views on whether a late-submitted written declaration can be considered.
One thing is certain. If the noncustodial parent seeks such an order after expiration of the statute of limitation for a tax deficiency assessment against the custodial parent, the noncustodial parent will be denied the dependency exemption deduction. The tax court in Shenk v. Commissioner34 so ruled in precisely that situation.
Then, the noncustodial parent’s only remedy will rest with the family court, seeking relief for the tax benefit he or she is otherwise entitled to based on an agreement approved by the family court but not in compliance with the tax rules. Watch out, however. If, for example, that results in the family court reducing child support payments from the noncustodial parent, the ultimate losers might be the children.35
The Noncustodial Parent and Dependent-related Tax Provisions. If a noncustodial parent properly claims the dependency exemption, does that mean he or she can also file head-of-household filing status and claim the various credits, that is, child, child or dependent care, and earned-income credits, assuming all the other requirements are met? The answer depends on the particular provision.
In the case of head-of-household filing status and the dependent-care and earned-income credits, the tax law clearly states that the noncustodial parent is never allowed to claim such benefits.36 It appears, however, that a noncustodial parent could claim the child tax credit.
As far as the ACA is concerned, the IRS has stated that “the adult or married couple who can claim the child or another individual as a dependent for federal income tax purposes will generally owe” a responsibility for providing minimum essential coverage for the child.37 Therefore, if a noncustodial parent is able to claim the child as a dependent, he or she also bears the ACA responsibility with respect to that child.
If, however, there is a court order requiring the custodial parent to pay for minimum essential coverage, a question arises: does that suffice for the noncustodial parent to “ensure” coverage under I.R.C. § 5000A(a), or does the noncustodial parent expose himself or herself to a penalty? Here is what one commentator has said on the subject: “The concern for parents who split or alternate these [dependency] exemptions is that one parent may be legally entitled to claim a child as a dependency exemption …. but may incur a penalty for doing so because the other parent provides insurance coverage.”38 Although this scenario seems far-fetched, it cannot be ruled out completely.
To avoid the prospect of these unintended consequences and complications, the preferable course (at least in the absence of unusual circumstances) might be to have the custodial parent claim the dependency exemption and the related tax benefits associated with having dependent children and also bear the ACA responsibility. Any financial reconciliation with the noncustodial parent could be done separately with adjustments to alimony or a property settlement – but, one would hope, not at the expense of the children.
Nonetheless, if the parties insist on the noncustodial parent claiming the dependency exemption deduction, make sure that the Form 8332 or its equivalent is used as directed to ensure that such intent is respected.
Although the rules surrounding the dependency exemption deduction may be perceived as straightforward, they often are not. The stakes are high, even more so with the recent enactment of the ACA. They conjure a host of complications that are compounded when couples divorce or legally separate. To minimize those complications, take the path most traveled – the one of least resistance – to avoid a controversy with the IRS. That will serve your client well.
1 I.R.C. § 151(c). Likewise, taxpayers are usually allowed personal exemption deductions for their spouses and themselves.
2 Pub. L. No. 111-148.
3 Being away on a vacation or at college counts as time spent at the same principal place of abode as the taxpayer parent for purposes of this test. See Treas. Reg. § 1.152-1(b).
4 The term “qualifying child” also can include a taxpayer’s “brother, sister, stepbrother or stepsister of the taxpayer or a descendant of any such relative,” if the other statutory requirements are met. I.R.C. § 152(c)(2)(B).
5 It is possible, however, for a taxpayer’s child to be considered a “qualifying relative” if he or she is not a “qualifying child.” That could happen, for example, when the child does not meet the age requirement for a qualifying child. The full array of relationships, of which there are many, that may qualify for qualifying relative status is found at I.R.C. § 152(d)(2).
6 The exemption amount is adjusted each year for inflation. See I.R.C. § 151(d)(4). For example, the exemption amount for 2015 was $4,000.
7 Compare the support requirement for a “qualifying relative” to that for a “qualifying child.” In the former instance, the test depends on whether the taxpayer claiming the dependent has provided more than one-half the support, whereas in the latter case the test depends on whether the person to be claimed as a dependent has not provided more than one-half his or her own support.
8 Social Security benefits are excluded from gross income if one’s overall income is below a prescribed exemption amount (aside from the Social Security). The taxpayer’s payments probably would also be excluded from gross income as a gift. See I.R.C. § 102(a).
9 See I.R.C. § 152(d)(2)(H).
12 The dependency exemption deduction amount is phased out for taxpayers whose adjusted gross income exceeds a certain amount. I.R.C. § 151(d)(3). In 2015, the dependency exemption deduction began to phase out for married taxpayers filing jointly with adjusted gross income of $309,900.
13 For a parent who is not married (or is legally separated) at the end of the taxable year, it is more favorable to file as head of household than as single (or married filing separately) and that status depends, inter alia, upon having a household that includes a “qualifying child” or other dependent. See I.R.C. § 2(b)(1)(A)(i), (ii).
14 See I.R.C. § 2(b); I.R.C. § 32(c)(3); I.R.C. § 24(c).
15 See I.R.C. § 21(b)(1).
16 See I.R.C. § 213(a).
17 A tax credit is offset dollar-for-dollar against the income tax owed. Moreover, the taxpayer receives a refund if his or her earned-income credit exceeds what would otherwise be the tax liability.
18 See I.R.C. § 5000A(a).
19 I.R.C. § 5000A(b)(3)(A).
21 See I.R.C. § 5000A (d)(2), (e).
22 See I.R.C. § 5000A(c).
23 Rev. Proc. 2015-15.
24 See I.R.C. § 152(e)(4)(A).
25 I.R.C. § 152(c)(4)(B)(ii).
26 See I.R.C. § 152(e)(2).
27 See Treas. Reg. § 1.152-4(e)(1)(ii); Treas. Reg. § 1.152-4(g), Example 18.
28 See Shenk v. Commissioner, 140 T.C. 200, 206 n. 3 (2013); Armstrong v. Commissioner, 139 T.C. 468, 472, n. 6 (2012), aff’d, 745 F.3d 890 (8th Cir. 2014).
29 Treas. Reg. § 1.152-4 (e)(1)(i).
31 See Armstrong, 139 T.C. at 474; see also Swint v. Commissioner, 142 T.C. 131, 133-36 (2014).
32 Treas. Reg. § 1.152-4(e)(1)(ii).
33 Armstrong, 139T.C. at 479-81, 481-508.
34 140 T.C. 200, 2009 (2013).
35 See Armstrong, 139 T.C. at 490 n.6.
36 See I.R.C § 2(b)(1)(A)(i); I.R.C § 21(e)(5); I.R.C § 32(c)(3)(A).