Tax issues are an important component of equitable distribution cases and the Pennsylvania support code specifically allows the Court to allocate child tax exemptions between parties. Matt Levitsky, a tax and estate attorney in our Blue Bell, Pennsylvania office, recently took the time to elaborate on the issue of child tax exemption and the dispute that can arise as to which parent may claim the child/ren. 

Matt and some of his colleagues in the tax and estate practice group will be launching a tax blog soon which will be a great source of information on current personal and corporate tax issues. Check back soon with Fox Rothschild’s roster of blogs for the launch of the tax blog or take some time to explore other areas of interest.

 

Matt Levitsky:

 

 

Who Gets To Claim a Child as a Dependent if There is 50/50 Custody?

 

 

With the battle over assets being the primary one in a divorce, tax issues may often be overlooked which can have an definite economic impact on a client. One such tax issue is the benefit of who gets to claim children as dependents. In 2012, a taxpayer may receive a $3,800 federal income tax exemption for each child that he or she can claim as a dependent. If a child is young at the time of divorce, this has a substantial economic benefit.

 

A child can be a dependent of a taxpayer only if he or she is a “qualifying child” of the taxpayer (the child can also be a “qualifying relative”, but this is beyond the scope of this blog entry). In order for a child to be a qualifying child of a taxpayer, four (4) requirements must be met. First, the child must be (i) a child of the taxpayer or a descendant of such child, (ii) a brother, sister, stepbrother, or stepsister of the taxpayer, or (iii) a descendant of any such relative. Second, the child must have the same “principal place of abode” as the taxpayer for more than one-half (1/2) of the taxable year. Third, the child must be under the age of nineteen (19), a student under the age of twenty-four (24), or permanent or totally disabled at some time during the taxable year. Finally, the child cannot provide more than one-half (1/2) of the child’s own support during the taxable year.

 

Generally, under § 152(e) of the Internal Revenue Code (the “Code”), a child is a dependent of the custodial parent unless a divorce decree or written separation agreement between the parents entitles the noncustodial parent to the dependency exemption. But what if the parents share custody 50/50 and the divorce decree or separation agreement hasn’t been entered into or does not address the issue?

 

If both parents can claim the qualifying child under the four step test above, you must look at the tie-breaker rule of § 152(c)(4)(B) of the Code. Under the tie-breaker rule, the parent with whom the child resided with for the longest period of time during the taxable year can claim the child as a dependent. But what if the child resides with both parents for same amount of time during the taxable year? In this case, there is a second tie-breaker rule. The child is treated as a dependent of the parent with the highest adjusted gross income (“AGI”).

 

At first thought, determining the parent with the higher AGI seems fairly clear cut. However, what if one of the parents is employed while the other is a stay at home parent because his or her new spouse works. Do we include the new spouse’s income in the AGI determination? Surprisingly, this issue is not addressed in the Code nor the Treasury Regulations. 

 

Section 152(d) of the Code concerns claiming “qualifying relatives” as dependents. In clarifying a similar one-half (1/2) support requirement to the four (4) part test above, § 152(d)(5)(B) clearly states that “in the case of remarriage of a parent, support of a child received from the parent’s spouse shall be treated as received from the parent.” Clearly in this context, Congress considered the effect of remarriage. Therefore, one could argue that if Congress wanted a new spouse’s income to be included in the AGI computation, then it would have so provided. On the other side, one could argue that the new spouse’s income should be included in AGI because a stay at home parent should not be penalized because he or she is staying at home and allowing his or her spouse to go out and earn an income.

 

We recently discussed this AGI issue informally with the IRS. The Service told us that the consensus among those who deal with § 152(e) is that the income of the new spouse is not included in the AGI tie-breaking test. This issue is actually one that the IRS intends to address this year, as indicated in Item 22 under General Tax Issues in its 2011-2012 Guidance Plan ( http://www.irs.gov/pub/irs-utl/2011-2012_pgp_3rd_update.pdf. ).

 

If you have any questions on any of the issues discussed above, please feel free to contact us.

           

The allocation of child tax dependency exemptions is a topic of discussion among our clients on a frequent basis. While the guidelines issued by the I.R.S. dictate who is eligible to claim the children, in Pennsylvania the issue may be raised in the context of child support under Pennsylvania Rule of Civil Procedure 1910.16-2(f). The stated purpose of this rule is to "maximize the total income available to the parties and children" and, therefore, the Court has the authority to award the exemption to either party and, when awarding it to the non-custodial parent (i.e. the party who may not be eligible to claim the exemption under the I.R.S. guidelines), order the custodial party to execute the I.R.S. waiver allowing the other parent to claim the exemption.

Leslie Spoltore, a partner in our Wilmington, Delaware office, recently wrote about a Delaware Family Court case which deals with the allocation of the exemption and articulates a much more specific set of criteria for deciding which party should be awarded the exemptions. It is a worthwhile read and gives some insight into a different way to deal with this issue in a family law case.

 

 

 

Generally, Pennsylvania law provides that the parent who has primary physical custody of the child is entitled to claim the dependency exemption, and the child tax credit, on his or her income tax return.  If the parents share physical custody, the parent who earns more income is entitled to claim these tax benefits. However, this is negotiable in divorce and child support actions.

The ability to claim the child on your income tax return can benefit a parent by changing the filing status from “single” or “married filing separately” to “head of household”, a more beneficial filing status under the tax code.  This may decrease the amount of tax you owe.  However, the dependency exemption may be a greater benefit to the non-custodial parent and, therefore, may be worth negotiating in a divorce or support action.

For example, if claiming the child as a dependent will save the non-custodial parent $5,000.00 in tax, but will only save the custodial parent $1,000.00 in tax, then the non-custodial parent should claim the child as a dependent and pay the custodial parent the $1,000.00 she would otherwise would have saved.  The net savings to the non-custodial parent is $4,000.00. (And, a good lawyer could even negotiate sharing this $4,000.00 tax savings between the parties!)

A second benefit for the parent claiming the child is the Child Tax Credit.  The Child Tax Credit allows you to claim $1,000.00 for each qualifying child. So, in a family with three children, the credit is worth $3,000.00.  This credit also reduces the tax you owe.  However, the Child Tax Credit is phased out for certain higher income tax payers.  Specifically, the amount of the credit allowable is reduced by $50.00 for each $1,000.00 of modified adjusted gross income above a threshold amount.  That threshold amount is $110,00.00 on a joint return, $75,000.00 for single and head of household filers, and $55,000.00 for married individuals who file separate returns.  This means, for example, that a married couple filing jointly who have one qualifying child would be entitled to a credit of $950.00 if their modified adjusted gross income is more than $110,000.00, but not more than $111,000.00.  They lose the credit completely if their modified adjusted gross income is more than $129,000.00.

It is important to understand how the Filing Status, Dependency Exemption and Child Tax Credit can affect your personal income tax return.  It also is important to understand how they can affect the other parent’s income tax return. Your accountant and attorney should discuss these tax benefits and how they will affect your tax returns before you file your 2007 taxes, and in the foreseeable future.  There are very specific financial benefits that could be negotiated in your divorce and support actions, in a way that positively affects both you and your spouse or former spouse.  It always feels good to find a way to pay less taxes, even if it saves your "ex" some money too.