Definition of a Qualifying Foster Child
An Analysis of the Law and Relevant Cases

By Lynn Comer Jones

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The Tax Relief Act of 1997 (TRA 1997; P.L. 105-34) created the CTC, effective for 1998. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001; P.L. 107-16) aligned the EITC’s qualifying child residence abode test for foster children and other dependents effective for 2002. Historically, foster children had to live in the home for the entire year, while nonfoster children had to live in the home for only more than half the year (IRC section 152).

The Working Families Tax Relief Act of 2004 (WFTRA; P.L. 108-311) created a uniform definition of “child” for purposes of the dependency exemption (IRC sections 152 and 151), the CTC (IRC section 24), the EITC (IRC section 32), the dependent-care credit, and head-of-household status [IRC section 2(b)]. The legislative changes were effective for tax year 2005.

Changes and uncertainties make tax preparation difficult, and planning nearly impossible. Foster parents may not be able to claim their foster children even though the WFTRA streamlines the definition for a qualifying child. The residence abode test requirements for their foster children may not be met because of the transitory nature of the foster system. Foster parents’ tax-planning options include a charitable contribution deduction for care of the child in lieu of the dependency exemption.

Additionally, foster parents who would otherwise be able to claim the qualifying (foster) child as a dependent may be eligible for age exceptions for special-needs children. Specifically, they may be able to waive the age test for the dependency exemption, the EITC, and the child and dependent care credit. The age waiver does not apply to the CTC [IRC section 24(c)].

Law and Analysis

An eligible foster child (placed with the taxpayer by an authorized placement agency or by a court) is included in the WFTRA definition of a qualifying child [IRC section 152(f)(1)(C)]. The WFTRA aligned the residence abode test to greater than half the year among the dependency exemption, the EITC, and the CTC. Previously, a foster child who did not reside in the foster home for the entire year could be claimed only for purposes of the EITC (see the Exhibit).

Under the law, a foster child residing in the home for longer than six months can be claimed for the dependency exemption, the EITC, and the CTC. A foster child who resides in the home for six months or less is not eligible for the above tax benefits. Under certain circumstances, however, foster parents may be able to claim a charitable deduction for the care of the foster child.

The availability of a charitable deduction can be easily overlooked. The IRS clarified its position on Revenue Ruling 77-280 (1977-2 CB 14) via two Chief Counsel Advice (CCA) memoranda: CCAs 199919034 and 200007030. Per Revenue Ruling 77-280, when foster parents render gratuitous services to a charitable organization, the payments received from the organization are not income, and any unreimbursed out-of-pocket expenses are considered charitable contributions to the charity [Revenue Ruling 84-61, 1984-1 CB 39, following Rockefeller v. Commissioner, 676 F.2d 35 (2nd Cir. 1982), aff’g. 76 TC 178 (1981)].

As long as the nonprofit or welfare agency places, monitors, and has the authority to remove the child, the foster parents are not profit-seeking. Payments received from the agency are advances or reimbursements for the cost of care, and, accordingly, are not included in gross income. Similarly, because the foster home is not considered a business, no business deductions (IRC section 162) are permitted. The foster parents are permitted a charitable deduction (IRC section 170) for unreimbursed out-of-pocket expenses incurred for the care of the child. (See Revenue Ruling 77-280 situations 1 and 2.)

The 1999 memorandum deleted the language that foster parents cannot claim a dependency exemption for the foster child. The 2000 memorandum was a response to an IRS Centralized Quality Review Site (CQRS). The CQRS wanted clarification on Revenue Ruling 77-280 and CCA 199919034 because it appeared that a dependency exemption and charitable deduction could be taken. The IRS’s chief counsel concluded that a foster parent may not allocate unreimbursed foster care expenditures so as to take both a dependency deduction and a charitable deduction. A foster parent may not choose between a dependency deduction and a charitable deduction. And in some situations, the unreimbursed foster care expenditures will not qualify for the charitable deduction. [The foster care expenditures may qualify as support under IRC section 152(a).]

The conclusion is clear: The law requires the foster parents to claim the dependency exemption when the IRC section 152–qualifying (foster) child conditions have been met. Because the foster system is transitory, the primary condition that must be met is the residence abode test.

Under the law, eligible foster children would be claimed as dependents when they lived with a family for more than six months. Otherwise, the foster child cannot be claimed as a dependent. Three recent cases discussed in the 2000 memorandum address whether, if the foster child is not a dependent, the foster parents can take a charitable deduction for unreimbursed out-of-pocket expenses.

Court Cases

The 2000 memorandum deliberates when the charity deduction is not available. It discusses Tate v. Commissioner [59 TC 543, 550 (1973)], Thomason v. Commissioner [2 TC 441 (1943)], and McMillian v. Commissioner [31 TC 1143 (1959)]. The major theme of these three cases is that the out-of-pocket expenditures may benefit both the foster child and the charitable organization, and, therefore, are not charitible deductions. In Tate, the biological parent attempted to claim expenditures made on behalf of her son to a church as a charitible deduction. The son participated in a church trip to Europe, which was advertised as a sightseeing and cultural trip. The court’s opinion was that the costs did not primarily benefit the church and were, therefore, not deductible.

The Thomasons, potential adoptive parents, cared for a ward of the Illinois Children’s Home and Aid Society for 12 years, after which the ward was returned to the society. The Thomasons agreed to pay for the ward to attend a private, for-profit educational institution. Although the Thomasons made their checks payable to the society, they were restricted to the tuition payment at the for-profit institution. The court denied the payments as charitable deductions because the payments benefited a particular individual and not the society in general, and the ward secured privileges and advantages that the society would not have furnished without the Thomasons’ financial support.

In a similar case, McMillian, the court determined that the potential adoptive parents had made expenditures to further their objective of adopting the child. An interesting parallel in Thomason and McMillian is that the potential adoptive parents initiated the placement rather than the agency placing the child in the respective home.

The 2000 memorandum does not show when the deduction is available. Furthermore, none of the cases discussed mimic a typical foster care placement. A more recent case, K.K. Babcock (TC Memo 1996-89), is representative of a typical foster placement. The Babcocks, certified by the New York County Department of Social Services, boarded several foster children over an 11-year period. They received a child via Social Services placement and maintained a blended family (foster child, adopted child, and biological child). The Babcocks received Social Services payments for board, clothing allowance, and special allowance. In New York, board and clothing payments are based on a child’s age. Board covers items such as food, personal care items, cost of shelter, and transportation to school or recreational events, shopping, and church. As long as the foster parents maintain records showing that their expenditures exceed the amount received from the charitable agency (Social Services), a deduction equal to the excess is allowed [Treasury Regulation sections 1.170A-1(g)]. The Babcocks received $9,539 from Social Services ($8,559 for board, $509 for clothing, and $471 for special allowances). The court decided that only unreimbursed, direct out-of-pocket expenditures are allowed as a charitible deduction. Ultimately, the Babcocks were allowed a charitible deduction of $3,726 for unreimbursed clothing, toys, babysitting, and medical expenditures.

Strategies

If a taxpayer cannot itemize deductions, the only tax benefits available are a function of meeting the definition of a qualifying (foster) child. Thus, the foster child would need to reside in the home for more than six months. If the taxpayer can itemize and fails to meet the residence abode test, then a charitable deduction may be available based on the taxpayer’s individual situation. Recordkeeping is required to substantiate the unreimbursed out-of-pocket expenses. Qualifying expenses include food, shelter, clothing, personal needs, school supplies and dues, youth organization memberships, school transportation and other travel expenses, a spending allowance, and other support (Revenue Ruling 77-280). Additionally, Babcock includes toys, education, medical care, babysitting, and recreation expenditures.

Given the existing case law, an alternative for families considering adoption is the adoption tax credit (IRC section 23) and the income tax exclusion for employer-provided adoption expenses (IRC section 137). Furthermore, taxpayers may claim the full adoption credit for a special-needs child because it is assumed that the maximum amount of qualifying expenses has been incurred [IRC sections 23(a)(3), 23(d)(3)].

Other tax benefits for special-needs children apply to the definition of a qualifying (foster) child. The age limit is waived for the following:

• The dependency exemption, when permanently and totally disabled [IRC section 152(c)(3)(B)];
• The child and dependent care deduction, when physically and mentally incapable of self-care [IRC section 21(b)(1)(B)]; and
• The EITC, when disabled [IRC section 152(c)(3)(B)].

Filing an Amended Return

Because the qualifying (foster) child requirements have been stable for two years, it may be practical to determine whether one should file an amended return. Specifically, foster parents may not have been aware of the longer-than-six-months residency abode test that made them eligible for the dependency exemption and the child and earned-income tax credits for the care of their qualifying (foster) children. Generally, tax returns filed in 2005 can be amended through 2008 [IRC section 6511(a)].

If a taxpayer was unable to claim the qualifying child, it is possible a charitable deduction could have been claimed. A thorough analysis of direct and indirect expenses may be warranted. The charitable agency placing the child in foster care should be able to provide detailed descriptions for payments or reimbursements. Only excess direct out-of-pocket expenses may be claimed as a charitable deduction.

©2009 The New York State Society of CPAs. Legal Notices