New Rules for Dependency Exemptions

By John D. Zook and Bruce A. Leauby

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MARCH 2006 - The Working Families Tax Relief Act of 2004 (WFTRA) affected many areas of the Internal Revenue Code (IRC). Its primary purpose was to reduce the federal tax burden of married taxpayers with children. One of the new definitions from the WFTRA is the uniform definition of a qualifying child. This establishes a consistent definition for not only the dependency exemption for a child, but also for the dependent care credit, the earned income credit, the child tax credit, and head-of-household filing status.

Under the new law, dependents have been reclassified into two groups: qualifying child and qualifying relative. For 2005, the dependency exemption is $3,200 per qualifying child or qualifying relative, indexed annually for inflation. (This exemption is partially or completely phased out for higher-income taxpayers.)

Background

Prior to the WFTRA, dependency exemptions were allowed for any individual who met five tests. Those tests remain in effect for qualifying relatives (or a member of the taxpayer’s household) as defined under IRC section 152(d). Those five tests are essentially the same, with the exception of the income test for dependent children (modified by the qualifying child definition). The five tests for qualifying relatives, under IRC section 152, are:

  • The taxpayer must provide greater than half of the individual’s support.
  • The individual is a relative or a member of the taxpayer’s household.
  • The individual earns less than the current year’s exemption amount. Under prior law, this was a major exception for children of the taxpayer. It is no longer applicable for the qualifying child test.
  • Individuals shall not be treated as dependents if required to file a joint federal tax return with their spouses.
  • The individual is either a citizen or resident of the United States, or a resident of a country contiguous to the United States (exceptions exist for certain legal adoptions).

All five tests must be met in order for the taxpayer to claim the dependency exemption for that individual.

Qualifying Child

The definition of a qualifying child is provided under IRC section 152(c) and establishes a five-pronged test, which includes the following:

  • Relationship: The individual must be a child of the taxpayer or a descendant of such a child, or a brother, sister, stepbrother, or stepsister of the taxpayer or a descendant of any such relative.

Individuals legally adopted by the taxpayer have the same status as a natural-born child. In addition, foster children placed by an authorized placement agency or by judgment, decree, or court order are also treated as natural-born children.

  • Age: The individual must, at the close of the taxable year, be under 19 (under 24, if a full-time student). Individuals are also treated as meeting the age requirement if they are permanently and totally disabled [IRC section 22(e)(3)] at any time during the year, regardless of their age.
  • Domicile: The individual must have the same principal place of abode as the taxpayer for more than half of the year. The prior law exemption regarding situations as absences due to illness, education, business, vacation, or military service remains the same.
  • Support: The individual cannot provide more than half of their own support in the taxpayer’s calendar year. (The joint return test also applies in this case.) A qualifying child who provides over one-half of her own support, however, may constitute a qualifying child of another taxpayer for purposes of the earned income tax credit.
  • Citizenship/residency: The individual is either a citizen or resident of the United States, or a resident of a country contiguous to the United States.

Note that the gross income test no longer applies to a qualifying child.

Tiebreaker Rules

If a child is determined to be a qualifying child for multiple taxpayers and they do not file jointly, then the individuals can mutually decide who will claim the child on their tax return (e.g., a child lives with his mother and grandmother in the same residence). In the event that more than one taxpayer claims a qualifying child as a dependent, the tiebreaker rules determine who can legally claim the dependency exemption. See the Exhibit for the tiebreaker rules.

Qualifying Relative

If an individual fails the qualifying child test, the child may be claimed as an exemption under the qualifying relative test. Consider a 25-year-old son who is unemployed and lives at home. He would not meet the qualifying child test, due to his age. If all five dependency tests are met, however, the son can be claimed as a qualifying relative.

Additionally, someone who has no family relationship to the taxpayer, but is a member of the household for the entire year, could be a qualifying relative.

Other Relevant Issues

The WFTRA modifies the definition of “head of household” (HOH) to require that a taxpayer be unmarried (and not a surviving spouse) and pay more than one-half of the cost of maintaining a household which is the principal place of abode for more than one-half the year for a qualifying child or an individual for whom the taxpayer may claim a dependency exemption.

The new law has changed the qualifying individual language and no longer references “son, stepson, daughter, or stepdaughter of the taxpayer, or descendent of a son or daughter of the taxpayer” in IRC section 2(b)(1)(A)(i), and instead uses the new term “qualifying child.”

Under prior law, a taxpayer could claim HOH status if an unmarried child lived with him, even if the taxpayer could not claim the child as a dependent. The new law requires that a child living with the taxpayer must be a qualifying child or must qualify as a dependent (qualifying relative) in order for the taxpayer to claim the HOH status.

If a qualifying child is married at the end of the year, both of the following must apply to file as HOH: A joint return cannot be filed unless it is filed only as a claim for a refund and no tax liability would exist for either spouse if they filed separate returns. A child must also meet the citizenship or residency requirements (with the exception of certain adopted children).

For children of divorced or legally separated parents, the present law allows the custodial parent to release the claim to a dependency exemption and the child care credit to the non-HOH filing; however, the custodial waiver rule is disregarded and the definition for a qualifying child must be met.

The prior rule of claiming HOH status with respect to a parent for whom the taxpayer may claim a dependency exemption and who does not live with the taxpayer is still valid under IRC section 2(b)(1)(B).

Clarification and Impact

The WFTRA has clarified the complexity of the current statutory language of defining a child and has reclassified individuals claimed as a dependent as either a qualifying child or a qualifying relative. The rules for a qualifying child eliminate the gross income test and relax the existing support test. Rules for qualifying relatives have retained the prior requirements for dependency classification.

The consistent application of the definition of a qualifying child should help reduce confusion and allow for greater compliance with the tax code, especially in the earned income credit reporting area. The tiebreaking rules should make it easier for accountants faced with such situations.


John D. Zook, CPA, is an associate professor of accounting at La Salle University, Philadelphia, Pa., and is the managing director and founder of Zook, Dinon & Roman, P.A., Moorestown, N.J. Bruce A. Leauby, PhD, CPA, CMA, CFE, is an associate professor of accounting at La Salle University, Philadelphia, Pa.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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