Divorce & Taxes

Divorce & Taxes

Who Gets the Dependency Deduction and Why do We Care?

Nothing is worse than a bitter divorce – except possibly tax problems coming to light years later. When the letter finally arrives from the Internal Revenue Service, the couple has probably already gotten their final judgment. Working through the tax issues means a possibly painful meeting about a subject no one wants to discuss anyway, whether divorced, single or married. This article provides information on only a few of the tax issues that occur during, or after, a divorce. Depending on the complexity of the problems, you may wish to consult with a tax professional.

Filing Status

Couples who are splitting up but not yet “officially” divorced by December 31, have the option of filing a joint return, so long as both parties agree.1 One party can unilaterally decide to file as married filing separately, even though substantial tax savings are generally produced by filing jointly. The court cannot order the parties to file a joint return.2

The parties must be legally married in order to file federal joint returns3. Unfortunately registered domestic partners (RDPs), whether same-sex or opposite-sex, are not treated as married for federal tax purposes.4 However same-sex married persons (SSMP) are treated as married persons by both the California Franchise Tax Board and the IRS.5

In the year the divorce decree becomes final, the parties lose the option to file a joint return. In other words, your marital status as of December 31 of each year controls your filing status for that entire year.6 If a court has entered a judgment of legal separation prior to year end, either party can file as single or head of household, if they otherwise qualify.7

Head of Household

If your client can’t file a joint return for the year because he or she got their final judgment on or before New Year’s Eve, the next best option is to see if they qualify to file as head of household. The client will get the benefit of a bigger standard deduction and lower tax brackets.

Who gets the deduction for the kids (and thereby head of household status) is often overlooked in a divorce agreement—until both parents claim the deduction and the IRS swoops in to investigate. Your client will qualify for head of household status if he or she was: 1) unmarried on the last day of the year and 2) had at least one dependent who was a “qualifying child.”8

There are four requirements to claim a “qualifying child:” 1) The client must have paid more than half of the cost of maintaining the home of the child for more than one-half of the year;9 2) the child must be a U.S. citizen or resident;10 3) the child must be under age 19 as of the close of the calendar year, be totally disabled (no age bar) or, if a student, under age 24 as of the close of the calendar year; and 4) the child must not be providing more than half of their own support.11

In short, only one of the parties to a divorce can continue to claim the child as a dependent on their tax return and be identified as the “custodial parent” for tax purposes.

Tiebreaker Rules

If both parents claim the child as a qualifying child and both claim the head of household status, the IRS splits the baby by using the “Tiebreaker Rules.” Rule No. 1: the IRS treats the child as the qualifying child of the parent with whom the child lived for the longer period of time during the year. So your client’s time share is important as are calendars and logs.12 Rule No. 2: The IRS says that the custodial parent is the parent with whom the child resides for the greater number of nights during the calendar year.13 Rule No. 3: If the child lived with each parent for the same amount of time, the IRS will treat the child as the qualifying child of the parent who had the higher adjusted gross income (AGI) for the year.14

Dependency Exemptions

The reason filing status should be a hot topic in a divorce is because only one parent is entitled to a dependency exemption for each child they support. A dependency exemption works just like a tax deduction: It reduces your taxable income so you end up paying less income tax. The exemption amount is adjusted each year for inflation. Each taxpayer is entitled to claim a personal exemption for himself or herself (two exemptions on a joint return) and another for each eligible dependent. The exemption is $4,050 per child or dependent for 2016.15

Why is This Important?

As discussed, only one of the parties can treat the child as a qualifying child. The party that loses the tiebreaker tug of war becomes ineligible for many other tax benefits including: the child tax credit; head of household filing status; the credit for child and dependent care expenses; the exclusion for dependent care benefits; and the earned income credit.

One bright spot – either parent can still take the medical expense deduction for unreimbursed healthcare costs. Unfortunately, they can only deduct, on Schedule A (Form 1040), the amount of the child’s medical and dental expenses that are more than 10% of their adjusted gross income.16 Realistically, this means that healthcare expenses are not generally deductible, except in the case of a catastrophic illnesses.

Waiving or Alternating the Exemption

At times, divorcing couples may reach agreement to alternate the exemption between them. The non-custodial parent can claim the exemption for a dependent child if the custodial parent signs a Form 8332 waiver or its equivalent17. The IRS will not accept a dissolution judgment, marital settlement agreement or written separation agreement for this purpose.18

But beware. Giving a completed Form 8332 to the noncustodial parent gives up more than just an exemption. For example, as discussed above, additional tax-saving options are only available to the person who is able to claim the child as a dependent. However, the releasing custodial parent can still qualify for head of household filing status even though they aren’t claiming an exemption for the child, so long as they meet the head of household test.19

If the custodial parent releases his or her claim to the exemption for the child for any future year, the non-custodial parent must attach a copy of the signed Form 8332 to their tax return for each future year that they claim the exemption.20

Getting the Exemption Back

On the Form 8332, the custodial parent must release the exemption to the non-custodial parent for a specified number of tax years. Luckily, the custodial parent can unilaterally get the exemption back.21 If your custodial parent client is to start claiming the exemption again, after it having been released to the noncustodial parent, they can do so by completing part three of Form 8332, indicating whether the election is for the specific tax years, or for “all future years.”22

Note that reclaiming the exemption isn’t effective until the tax year after the calendar year in which the client provided the noncustodial parent with Form 8332. So, if one party releases the exemption and signs the form in 2016, the earliest they can regain the exemption is on the 2017 tax return, which they will file in 2018.23

[1] See Etesam v. Commr., TC Memo. 1998-73
[2] See Moore v. United States (Ct. Cl. 1941) 37 F.Supp. 136, 139-140; IRS Pub. 17, p. 20
[3] See IRC § 6013(a)
[4] See Regs. § 301.7701-18(c)
[5] See United States. v. Windsor (2013) 133 S.Ct. 2675, 2693-2695 (invalidating Defense of Marriage Act (DOMA, 1 USC § 7)
[6] IRC §§ 1(d), 7703(a)
[7] IRC §§ 1(d), 7703(a). To claim head of household: 1) you must be unmarried or considered unmarried on the last day of the year; 2) you must have paid more than half the cost of keeping up a home for the year; and 3) a qualifying person lived with you in the home for more than half the year.
[8] IRC § 152(a)
9] IRC § 152(c)(1); Louis v. Commr., TC Memo. 2010-217; see Sergienko v. Commr., TC Memo. 2014-56
[10] See IRC § 152(b)(3)(A); Carlebach v. Commr. (2012) 139 TC 1
[11] IRC § 152(c)(1)(C) & (3)(A); Louis v. Commr., supra
[12] IRC § 152(c)(4)(B)(i); see also Bjelland v. Commr., TC Memo. 2009-297, aff’d Knochelmann v. Commr. (6th Cir. 2011) (Although father provided more than half of child’s support, exemption given to mother who clocked in at 173 hours every 2 weeks versus father at 163 hours).
[13] Regs. § 1.152-4(d)(1); see also Davis v. Commr., TC Memo. 2014-147
[14] IRC § 152(c)(4)
[15] IRC § 151
[16] IRC § 213(a)
[17] IRC § 152(e)(2)(A) & (B); see IRS Pub. 501, p. 22; IRS Pub. 504, p. 9
[18] Regs. § 1.152-4(e)(1)(ii)
[19] https://www.irs.gov/help-resources/tools-faqs/faqs-for-individuals/frequently-asked-tax-questions-answers/filing-requirements-status-dependents-exemptions/filing-status/filing-status-3
[20] https://www.irs.gov/pub/irs-pdf/f8332.pdf
[21] Regs. § 1.152-4(e)(3)(i)
[22] While it is true that in California the court can allocate the dependency deduction to the noncustodial parent, the order will be ineffective unless the court also orders the custodial parent to complete the Form 9332 or the custodial parent voluntarily does so. Monterey County v. Cornejo (1991) 53 C3d 1271, 1280.
[23] Regs. § 1.152-4(e)(3)(iii)