February 2005

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Smart use of dependency exemptions

Generally, you can claim a tax deduction of $3,100 (for 2004) for each child who qualifies as a dependent. However, as children grow older and either start working or leave for college, the issue of who is entitled to the dependency exemption often arises. In divorce situations and in situations involving support of parents or other relatives, it is especially important to know the rules in order to minimize taxes for all parties involved. In general, five tests must be met to claim a dependency exemption:

1. Generally, you must provide over 50% of the dependent’s support.

2. The dependent cannot earn more than $3,000, except for children under age 19 and full-time students under age 24.

3. Generally, the dependent cannot file a joint return with a spouse.

4. The dependent must be a U.S. citizen or national, or meet certain residency requirements.

5. The dependent must be a qualifying relative or meet the “member of household” test.

A dependency exemption cannot be given to a child simply because the parents would rather let the child claim him or herself. If the parents are entitled to the exemption, the child may NOT claim him or herself on his or her own return. However, if there are ways to meet or to avoid meeting one of the above tests, there may be good reasons to shift the exemption from one return to another.

One reason is the difference in tax rates. For example, for parents in the 28% tax bracket, the exemption is worth $868 in 2004. For a child in the 15% tax bracket, the exemption is worth only $465. Additionally, parents who claim the child as a dependent may qualify for available education credits.

Another instance when it would be better to have a child NOT qualify is if you are a high-income taxpayer, you can lose some or all of the dependency exemption. Also, taxpayers subject to the alternative minimum tax cannot deduct dependency exemptions.

Please contact me for additional information regarding dependency exemptions. As you can see, planning the best use of dependency exemptions can be complex.

The information presented in the Tax Newsletter is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly, cannot be regarded as legal or tax advice. Please contact your tax advisor for more information on the subject and how it pertains to your specific situation.

For more information
For the current limits and other information, review IRS Publication 501 - Exemptions, Standard Deduction, and Filing Information.