Whenever there are children, the question of tax exemptions arises.
By Dan Caine, Attorney
Federal tax law allows the parties to decide which parent should claim the exemption. There is no residency requirement. There is no requirement that the party claiming the exemption pay support. (These factors do figure in the head of household filing status determination, though.)
The law simply allows the parties to decide between themselves who will claim the child as an exemption. This is one of the few situations in the tax law where the law allows parties to make their own arrangements in a way that minimizes taxes.
That leads to the question, what should they do? Should the high-income taxpayer or the lower income taxpayer claim the exemption?
The answer is: it could be either one.
How do we decide? From a tax perspective, what we do is to look at the combined after-tax income of both parties. We look at the combined after-tax income if one party claims the exemptions, and compare that to the combined after-tax income if the other party claims the exemptions. We opt for the situation that results in higher combined after-tax income. (One party can then compensate the other, to make both parties better off.)
When we do this comparison, we keep everything else constant and change only “who claims the exemptions.”
The situation that results in the higher combined income is the one we recommend, from a tax perspective.
Here are some of the factors that will affect the outcome:
- Marginal tax rates. All else equal, the party with the higher marginal tax bracket will get more tax benefit from the exemption, and thus would be the recommended party to claim the exemption. But often, all else is not equal, as we shall see.
- Earned income credit and other credits. For taxpayers earning around thirty thousand dollars a year, or less, if they are eligible to claim the earned income credit, they end up with little or no income tax. Often, the combination of the earned income credit, the child tax credit, and the child care credit results in so many credits that the government is actually paying the taxpayer. In this situation, the exemption yields no benefit, because there was no tax being paid in the first place.
- Alternative minimum tax. The Alternative Minimum Tax is really an entire parallel tax system. All taxpayers compute their tax under both systems and pay the higher tax. For higher-income taxpayers, the higher tax often comes under the “Alternative” system. We say that those taxpayers are “subject to the Alternative Minimum Tax.” One effect of the Alternative Minimum Tax (“AMT”) can be to eliminate the benefit of tax exemptions. Thus, for taxpayers who are subject to the AMT, it would not provide any tax savings for them to claim the exemption.
- Child credit. This now may be claimed only by the parent who claims the exemption. The same applies to the Hope and Lifetime Learning credits (credits primarily for college expenses).
As a result of these factors, it is hazardous to attempt to guess which party should claim the exemptions. It could be the higher-income taxpayer, because of the benefit of the higher marginal rate. But then the higher-income taxpayer could lose the benefits because of the AMT. But then the lower-income taxpayer could lose the benefits because of the credits.
So how do you know? The only way to do it correctly is to calculate the taxes for those parties both ways, and see which maximizes combined after-tax income.
One quick and easy way to do this is to use software that can quickly analyze both ways.
We look below at two scenarios created using Family Law Software. The mortgage and other tax details did not change between the scenarios, only the parties’ incomes.
In both scenarios, the husband has higher income than the wife, but the results as to who should claim the exemptions are different.
In the first scenario, Ken is the higher income party, and, as generally expected, he is the one who is better off claiming the exemptions, by about $1,500 per year.
In this second scenario, Ken earns even more, $20,833 per month (Millicent earns $2,500 per month), and yet Millicent is now the better party to claim the exemptions, by more than $4,000 per year.
From this little example, we see two things: first, that it is really hard to know without running the numbers which party should claim the exemption. And, second, that with software it can be a snap to figure it out.
PS: If the parties conclude that the parent with whom the child primarily lives will not be claiming the exemption, then that parent should complete and file Form 8332 with the IRS, to give up the right to claim the exemption. The party who is claiming the exemption should also be specified in the divorce decree or settlement agreement.
Dan Caine is a Massachusetts-based attorney and is an active founder of Family Law Software, Inc., along with Wendell Smith, both of whom were also partners in the company that developed the critically-acclaimed and best-selling income tax software program “TaxCut,” which was sold to H&R Block, and who continue to market the product today.