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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.

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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.

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Last month we discussed a few issues that couples should consider when they begin to live together, but don't plan to or anticipate getting married very soon.  This month, we will look at some other important life decisions which may have a huge impact on people's lives and relationships:

5.         Medical Insurance. As we covered above, living together does not equate “married” especially in the eyes of a medical insurer. Do not add your long-time, live-in girlfriend to your medical insurance as a “spouse.” The rationale that “everyone at work thinks we’re married” will not keep you from being sued by the insurance company when you eventually get caught. You just committed fraud and insurance companies have lawyers by the thousands to make sure you don’t get away with it.

If you need to find a way to get coverage, check with your insurance company and your benefits administrator. Same-sex couples have actually paved the way for committed straight couples in some companies and in some Pennsylvania municipalities to obtain coverage on their partner’s benefits.

6.         Beneficiary Status. Retirement and investment accounts allow you to designate beneficiaries on retirement accounts in the event you die. If you pass away without designating a beneficiary, the plan administrator will then follow either Federal law (i.e. ERISA) or your state’s probate laws for the estate. Without designating your partner as the beneficiary of your account or on an insurance policy, there is no way the state or the plan administrator will issue the proceeds to your partner; in the eyes of the law and the plan, your relationship to you may as well not exist.

7.         Emergency Contacts/Next of Kin. Stories have circulated in the media where a partner is barred from a hospital room because he or she is not the patient’s next of kin. Estate planning documents such as a durable power of attorney or living will can help ensure that a partner is afforded the access they need, while identifying your partner on emergency contact forms with your insurance company will only bolster the paper trail confirming their role in your life.

8.         The Break-Up. Getting all of the above in line will help plan for emergencies, contingencies, tragedies, and the peaks and valleys of a life together. It also means that you have to undo all of it if the relationship ends. This may be the single greatest deterrent to people from undertaking these tasks in the first place. Yet, what is the alternative? Protracted litigation with your partner’s family over beneficiary rights to a retirement account? A battle with your ex-partner over who gets to stay in the house; who pays the mortgage; will the house be sold or can you be bought-out?

The ugliness and long legal fights that can arise from each of these points should be sufficient justification to put aside the fear of difficult conversations or putting too much pressure on an otherwise satisfying relationship.  Spend a few hours honestly discussing these issues and understandign what both people need to feel secure in comingling lives and finances.  Once you have your plan together, you can move on with living your lives.  There may even be the added benefit of silencing the (sometimes) well-intentioned, but (always) nosy comments from your family about your relationship's "stability."

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As the national divorce rate for new marriages hovers around 50%, couples living together before marriage or in lieu of marriage is an increasingly routine arrangement. Media coverage has played a part by confirming what many people knew anecdotally: that people are choosing to live together as a committed couple without ever getting married.

What is also increasing in frequency and necessity is for cohabitating couples to be proactive in laying the legal groundwork for how they plan to live together, acquire or pay for assets, and how they should disentangle themselves from such arrangements in the event that they break-up. It can be a difficult conversation to have – no less difficult than one party asking the other for a pre-nuptial agreement – and the introduction of real world considerations may burst the romantic bubble for some, but the risks are real and people’s lives change – the boyfriend with a steady paycheck  has gone back to school and is unable to pay half the mortgage; your girlfriend can not afford her to contribute to household expenses when she loses her job; you have a child together.

The ease of cohabitation without the apparent messiness or seemingly permanence of marriage can actually create a larger quagmire of difficulty if the relationship ends. If you are considering cohabitating with your partner, there are a few things worth considering:

1.         Common Law Marriage in Pennsylvania. There isn’t any, at least any more. As we’ve discussed on this blog in the past, common law marriage in Pennsylvania was abolished by case law in 2003 and by statute in 2005. A common law marriage that pre-dates the 2005 law may be recognized by the courts, but “playing at house” in Pennsylvania after the 2005 effective date of the law will not result in the assumption that there is marital property or martial value in assets.

2.         Cohabitation Agreement. Consider having a cohabitation agreement drawn up. We are seeing more couples requesting cohabitation agreements than ever before. “Cohabitation agreement” is a catch-all phrase for a contract between two people as to how they are going to set up their finances and economic life together when they begin living together. Unlike a prenuptial agreement which has the actual marriage as the triggering event for the agreement to be in effect, a cohabitation agreement will carry the hallmarks of a contract: an offer and acceptance of terms; consideration for performance of the terms. Unlike a prenuptial agreement which would be viewed in the context of a divorce in the Family Court, if you needed to enforce a cohabitation agreement it would be done by in Civil Court.

For married same-sex couples, a cohabitation agreement may be a worthwhile document to draft if you were legally married in another state and move into Pennsylvania. Pennsylvania may not recognize a pre-nuptial agreement which uses marriage as a condition of the agreement, nor will Pennsylvania’s courts recognize the same-sex marriage from another state; by entering into a cohabitation agreement, same-sex couple may at least be able to address their property rights in Pennsylvania without having to relocate to another state just to establish residency and seek a divorce. Until same-sex marriages are afforded the same full faith and credit among all of the states, a cohabitation agreement may insulate couples from finding themselves in a situation in which they can not clearly separate and divide their economic lives from each other.

3.         Deeds and Titles. Title property appropriately. There are a variety of ways to title property and how it is done can significantly impact parties’ rights to that property. A jointly titled checking account may assume that all monies deposited are “equally” owned. If the parties specified a right of survivorship or titled the asset in a way that reflects their intent, then whether it is a break-up or one party pre-deceasing the other, the passage of the asset to the owner will be clean and unambiguous.

Legal ownership in assets also means legal liabilities should be considered, too. When someone decides to bear the cost of purchasing an asset, there should not be any ambiguity as to how it is paid for between the couple if they break-up. How that asset is legally titled will determine who has responsibility for the continued payment or liability for the asset. If it is only titled in one person’s name, then they may considerable difficulty securing contribution from the other.

4.         Taxes. Find and use an accountant. Can you claim your partner as a dependent? Are there child care costs that can be claimed for your child? Unmarried couples can not file in the (usually) most tax advantaged designation of “married, filing jointly,” but an accountant can help you maximize your credits, deductions, and exemptions, particularly if you have children together and especially if one party earns considerably less income than the other.

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In the second installment, we will cover issues related medical insurance, beneficiary rights, emergency contacts, and "the break up."

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Not surprisingly, the two year rule has been coming under fire in Congress with the introduction of legislation by presidential candidate and Minnesota Representative Michele Bachmann, as well as a demand by Senate Finance Committee Chairman Max Baucus that the IRS review the two year deadline.

With respect to divorce, particularly in Pennsylvania where two years of separation is not an uncommon occurrence, people could easily sign a joint tax return as a routine action, without taking the time to carefully review the contents of the filing. Factor in abuse, fear, and intimidation and it is not a surprise that truly "innocent spouses" are being denied the right to raise that defense due to the two year limitation.

For most families, filing joint taxes is a routine affair – seldom is the time when filing under a different designation other than "married filing jointly" place a family in the most advantageous tax position. For couples who are separated, continuing to file jointly may continue to make the most sense.

There are times, however, when one spouse has no knowledge of the family’s financial affairs. If the situation warrants it, that spouse could claim relief from the IRS under the "innocent spouse" rule. This rule is designed to protect taxpayers who should not be responsible for the tax liability incurred by the culpable spouse, even in situation where a joint return was signed by the "innocent spouse."

A recent article, however, highlighted how the IRS has persistently struck down appeals by "innocent spouses" due to their failure to seek relief within two years of their receipt of an IRS tax collection notice. What makes these decisions particularly difficult to accept is that they are being made against battered spouses or other parties who were not in a position to know about the tax liability due to abuse or estrangement from the other spouse.  Consequently, they often do not even know there is a problem before the two year limit lapses.

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Each year I get phone calls from clients around the tax filing deadline asking for advice regarding tax filings.  First of all, your attorney likely is not an accountant and certain tax issues need to be discussed directly with an accountant.  However, there are some important things to consider when doing your taxes during a separation and/or divorce proceeding.

The first question is how are you going to be filing - married filing jointly, married filing separately, etc.  If you are still married on the last day of the tax year then you can file married filing jointly.  If you are filing separately, the second question becomes, who will be claiming the children?  Typically, the parent who has the children the majority of the time gets to claim the dependency exemption. However, the court has discretion to allocate the dependency exemption to the non-custodial parent wherein it would result in a higher net income to that party.  Of course, the parties can always agree to share the dependency exemption, and to do so, they would have to fill out, sign, and file the appropriate federal tax form.

It is important to note that if one party's income is not documented you should be cautious about signing and filing a tax return with that person.  An attorney can prepare an indemnification form to help prevent financial liability, but the Court could possibly hold your spouse to the income reported on the tax return for purposes of support because you signed off on the "income" - meaning your support award could be less.

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