The  importance of carefully considering all factors with dependency deductions in divorce.

Linda J. Schaeffer and Elizabeth J. Garrett 

Many high income taxpayers have taken notice that the 2010 Tax Relief Act which extends the elimination of the phase out of personal exemptions for individuals whose Adjusted Gross Income (AGI) exceeds certain amounts to December 31, 2012.  This means that family law attorneys and mediators who had previously become accustomed to allocating the dependency exemption to the lower income spouse, have begun to rethink that position under the presumption that the higher income spouse may now receive a benefit that previously had little or no tax effect.  However, the lack of understanding about Alternative Minimum Tax and its effect to high income earners, as well as a loss of many tax credits to the lower income taxpayer, means this change in thinking could end up costing taxpayers thousands of dollars each year.

The IRS has determined that the custodial parent is generally entitled to take the dependency exemption for a child.  The custodial parent is the parent with whom the child resides for the greater number of nights during the year.[1]  If a child spends an equal number of nights with each parent, the parent with the higher income would be considered the custodial parent.  The regulations also offer several points of clarification should certain issues arise:

  1. If a child is temporarily absent from a parent’s home, they are considered to be spending the night with the parent they would normally have been with.[2]
  2. If someone other than the parents (i.e. grandparents) have normal custody of the child on certain nights, these are not considered in determining either parent’s percentage.[3]
  3. If a parent works at night but has the child a greater number of days, they would be considered the custodial parent.[4]
  4. A night that straddles two taxable years is allocated to the taxable year the night begins.[5]

For children who have reached the age of 19, neither parent is considered as having custody.  The dependency exemption may be taken by the parent who provides one-half of the child’s support if the child is a student and has not yet reached the age of 24.[6]

A noncustodial parent could take the dependency exemption if the custodial parent waives the right to the exemption.  The noncustodial parent is required to attach a written declaration to their tax return from the custodial parent stating that he or she will not take the dependent for the taxable year.  The declaration can have no conditions for the years the declaration is in effect.  The IRS form to release the dependency exemption if Form 8332.  A written declaration other than Form 8332 must conform to the substance of Form 8332 and must be a document executed for the sole purpose of serving as the written declaration to release the dependency exemption.  A copy of the settlement agreement or court order will no longer serve as authority to waive the dependency exemption.[7]  Declarations signed prior to July 3, 2008 are still valid.

The exemption phase out has been eliminated for higher income taxpayers for tax years 2010, 2011 & 2012.  However, higher income taxpayers often fall into the category of paying Alternative Minimum Tax (AMT) which limits deductions and recognizes certain income and expense items differently than regular tax.  The deduction for personal exemptions is not deductible in calculating AMT, therefore the dependency exemption could be of no value to the high income earner.  For example, a taxpayer making $350,000 per year in 2010 would get a personal exemption of $3,650 for themself and each of their dependents.  This decreases the taxpayer’s taxable income and therefore, their regular tax also decreases.  However, in calculating AMT liability, the exemption amounts are added back in determining taxable income. Frequently, the savings in regular tax is negated by the increase in the AMT tax.

In addition, the lower income parent is often eligible for both refundable and nonrefundable credits which are still subject to income phase outs and are not available unless the child is taken as a dependent.  These credits include:

  1. 1.              Dependent Care Credit. This can only be claimed if the child is a dependent on the tax return and the taxpayer actually paid the expenses for childcare. This credit begins at 35% of the actual expenses paid and is gradually reduced to 20% for taxpayers with an AGI over $43,000.
  2. 2.              Child Tax Credit.  This credit of $1,000 per child is not available to the custodial parent if the exemption is released.  It is only available to the parent to whom the exemption is allowed.  The credit is phased out by $50 for each $1,000 of AGI over $75,000 for taxpayers filing Single or Head of Household.
  3. 3.              College Tuition Credits.  These credits can only be claimed if the child is a dependent on the tax return.  If the noncustodial parent pays the tuition and the custodial parent claims the child as a dependent, the credit can be claimed by the custodial parent.[8]  These credits are also phased out at AGI levels of $90,000 or $60,000 depending on the type of education credit claimed.

The following example demonstrates the differences in taxes paid by both parents in varying situations of splitting four possible dependents.  This example considers the elimination of the dependency exemption phase out, as well as tax credits accompanying the dependency exemption.

Father – Single

Mother – HOH

 No Dep

 2 Dep

 4 Dep

 4 Dep

 2 Dep

 No Dep

Income

Wages

    350,000

    350,000

   350,000

   24,000

    24,000

   24,000

Alimony

    (60,000)

    (60,000)

   (60,000)

   60,000

    60,000

   60,000

Adjusted Gross Income

    290,000

    290,000

   290,000

   84,000

    84,000

   84,000

Deductions

Personal Exemptions

         3,650

       10,950

      18,250

    18,250

     10,950

      3,650

Standard or Itemized

       55,706

       55,366

      55,026

      8,400

      8,400

      8,400

Taxable Income

   230,644

   223,684

   216,724

   57,350

   64,650

   71,950

Tax

Regular

       61,229

       58,932

      56,636

       9,191

     11,016

     12,841

AMT

         5,110

        7,407

        9,703

          312

Dependent Care Credit

       (960)

        (960)

Child Tax Credit

    (3,550)

     (1,550)

Making Work Pay Credit

       (220)

        (220)

       (220)

Total Federal Tax

     66,339

     66,339

    66,339

     4,773

     8,286

   12,621

Assumptions:

Property Tax – $12,000

Standard Deduction Taken, Mortgage Interest – $30,000

Child Care – $4,800

State Taxes prepared during year

The table shows that because the father owes Alternative Minimum Tax, any reduction of regular tax due to the additional dependency exemptions is lost with the increase in AMT, making the net tax savings zero.  However, because the mother has some earned income, and is responsible for paying childcare, she receives tax credits in addition to the dependency exemption which are both lost upon the reduction in dependents.  Over five years, this could amount to approximately $40,000 additional Federal tax paid by the mother, while the father receives no Federal tax savings.

It is important for both Family Law attorneys and financial experts to examine the tax considerations of any settlement agreement closely to determine if the provisions included are beneficial to the taxpayer receiving the purported tax savings.  Agreements can often be structured in such a way that both parties can maximize their tax savings.

Don’t freely agree to sign away the dependency exemption.  It can be very valuable!


Endnotes

[1] Reg. § 1.152-4.

[2] Reg § 1.152-4(d)(3)(i).

[3] Reg § 1.152 4(d)(3)(ii).

[4] Reg § 1.152-4(d)(5).

[5] Reg § 1.152-4(d)(2).

[6] IRC § 152(c)(3)(A)(ii)

[7] Reg. § 1.152-4(e)(ii)

[8] Reg §1.25A-5(b)(3).

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Linda Schaeffer, CPA, CVA, CFE, CFF,  is a Partner and Beth Garrett JD, CPA , is a Manager  at Frazier & Deeter  in Atlanta, Georgia. The firm’s website is www.frazierdeeter.com.