Children & Taxes: The Details
How custody and support can impact your tax situation
Separation and divorce trigger numerous tax consequences; some of the tax rules related to divorce are straight forward, while others can get fairly complex. One of the more simple rules to understand, however, relates to how the federal tax code treats child support payments. The IRS has mandated that child support payments are never deductible and never taxable. Despite the fact that child support payments are neither taxable nor deductible, there are various other child related tax implications that must be addressed upon divorce and separation.
The Dependency Exemption
The dependency exemption is a tool that allows parents to reduce their taxable income. The exemption works like a deduction works, reducing the taxable income by a specific amount. For the year 2014 the exemption amount is $3,950, however it may change from year to year. Many parents may argue over who may claim the children as dependents as there is an obvious financial benefit bestowed upon the parent who claims the children as dependents. In situations where parents cannot agree over who gets to take the exemption, the IRS has set forth certain rules to determine which parent may claim the dependency exemption after separation. Exemption Designated by Agreement Before we discuss the applicable rules, it is worth noting that the parents can always simply come to an agreement regarding the dependency exemption without following the IRS guidelines; the guidelines are simply there in case there is a disagreement over which parent may claim the children. Frequently, however, parents are able to reach an agreement. There are several ways in which parents may chose to compromise regarding this exemption if both parents wish to claim the children as dependents. You cannot split the exemption, allowing both parents to claim half of it, but there are some creative ways for parents to share the exemption. One way to share the exemption is to simply alternate which year each parent can take the exemption. For instance, in all even numbered years the wife may claim the children as dependents, and in all odd numbered years the husband may do the same. Another popular way to compromise with regard to the dependency exemption is to “split the children,” so to speak. If there are two children, each parent can claim one of the children. An additional issue that arises with this approach is that most of the time the children will be different ages. Whoever is permitted to claim this oldest child will lose the ability to claim the exemption once the child reaches the age of majority, which will be sooner than the younger child. Of course, parents can also agree to simply allow one parent to claim the exemption without sharing the benefit. Allowing your spouse to have the dependency exemption may give you more bargaining power in negotiations. Exemption Determined by IRS If the parents are unable to reach an agreement over how to approach the dependency exemption, then the rules set forth by the IRS will determine which parent is entitled to it. According to the IRS, when parents are divorced or separated, the dependency exemption should apply to the “custodial parent.” The code further clarifies that the custodial parent is the parent who has custody for the greater portion of the calendar year. In situations where the child has resided with both parents for the same number of nights, then the parent with the higher income is permitted to claim the deduction. Sometimes it is difficult to determine which parent has had custody a greater number of nights, and occasionally there are factors that will complicate this calculation. For instance, what if a parent works nights? Or what if the child spends a night elsewhere while it is technically the custodial time allocated to one parent? The IRS has made provisions for each of these circumstances. In the situation where a parent works at night, then the number of days that parent has custody will be the number used in the calculation. And, in the situation where the child spends the night elsewhere, that night will be attributed to the parent who the child would have stayed with otherwise. So, allowing the child to spend the night at a friend’s house does not decrease the number of nights the child stayed with you for the purposes of determining which parent is entitled to the deduction. If a parent anticipates there being any dispute as to who will qualify as the custodial parent, that parent should be sure to document which nights the children resided with him or her. Even if this documentation is as rudimentary as marking in a day planner which nights the children have resided with that parent, it can help establish the number of nights the children resided with that parent if there is a dispute. One thing to keep in mind in situations where parents reach agreement regarding the exemption is to be sure to submit the correct paperwork when filing. If the parent who would otherwise be entitled to claim the exemption (because that parent is the custodial parent) is allowing the other parent to claim the deduction, the non-custodial parent must attach IRS form 8332 to their tax return. The custodial parent who otherwise would be entitled to claim the deduction must sign this form. If pursuant to the agreement the non-custodial parent is permitted to claim the deduction for future years as well, a copy of the original 8332 form must be submitted with each subsequent year’s return.
Child Related Tax Credits
In addition to the dependency exemption, you may be eligible to claim a child tax credit as well. The tax credit allows a parent to reduce federal income tax by as much as $1,000 per child. The amount of the credit is dependent on the applicable modified adjusted gross income. For married couples filing separate returns, the amount of the credit begins to decrease if your income is $55,000, and for divorced parents the threshold is $75,000. This credit is only available to the parent who claims the dependency exemption. This means that it is not permissible to allow one parent to claim the exemption and the other to claim the credit; the two go hand in hand. Because these two cannot be separated, make sure you are taking this into consideration when negotiating which parent will be able to claim the dependency exemption. There is also a credit called the “child and dependent care credit” that is completely separate from the aforementioned child tax credit. This credit allows a parent to get credit for a portion of childcare expenses necessary to allow the parent to be employed. A legally separated parent who either has custody of a disabled child, or a child under the age of 13 (and claims the dependency exemption for this child) can claim a child and dependent care credit. Generally speaking, the custodial parent is entitled to claim this credit regardless of how the dependency exemption is being allocated. That is to say, even if the noncustodial parent is permitted to claim the dependency exemption, he or she would not be permitted to claim this credit. This is different from the child tax credit as that is only available to the parent claiming the deduction. Lastly, there is a deduction applicable for medical expenses paid on behalf of a child. Regardless of who claims the dependency exemption, a parent who is divorced or legally separated may claim a deduction on medical expenses that cost more than 7.5% of that parent’s adjusted gross income. This includes expenses on diagnosis, treatment, prevention, transportation and other medical expenses. Similar to the child and dependent care credit, this deduction can be claimed regardless of which parent claims the dependency exemption.