Thursday, January 22, 2015

Dependency Exemption for Children of Divorced Parents

The income tax results of this topic are often overlooked during the divorce process, especially considering the personal and emotional toll incurred at the time. But, it is also could be a time for tax planning.
The rules for claiming a child are set in stone, and are not ambiguous. First, one or both parents must provide more half the cost of the child’s support. That is, a grandparent can’t be providing more than half of the child’s support and the parents expect to claim the child.
Second, the default rule is that the exemption automatically goes to the parent having custody of the child. However, the custodial parent can release his or her claim to the exemption on Form 8332. The parents can decide between themselves who will claim the exemption. This issue is often negotiated between the parents, and made part of the divorce or separation agreement. The exemption can even alternate between the parents on a year-by-year basis, if they like, provided Form 8332 is prepared and signed by the other parent.
If each parent has custody for part of the year, the custodial parent is considered to be the one who has custody for the greater portion of the year. “Joint custody” is a common term in separation and divorce agreement and for legal purposes, the spouses may be considered to have the child 50% of the time each. The Tax Code for dependency exemptions does not marry to this definition. The dependency exemption will go to the parent with the greater physical custody for that year. Where the custody is supposed to be 50/50, it will be extremely difficult to determine who has the most physical custody during the year. The relief for this is simply for the spouses to prepare and sign Form 8332 for each year. Consider it an insurance policy in the event of an audit. The completed form must be attached to the parent’s tax return who is claiming the child’s dependency exemption.
As for tax planning, the spouse who will benefit most from deducting the exemption should take it. That is, arrange for the parent who will save the most tax from the exemption. Then, the tax savings from the exemption can be shared. However, if the situation is less than cordial, it might be difficult to agree who gets what, so we have suggested just putting the tax savings into the child’s college fund or bank account.
The worst case scenario we run across is were both spouses claim the child’s dependency exemption. This not only throws a monkey wrench into the E-File process, but now the IRS will get involved on a very personal level in an attempt to solve the question. That situation is time consuming and expensive and should be avoided if possible.
For anyone going through a divorce or separation, it is a tumultuous time. But, it is important that you and your legal counsel are familiar with, and consider the economic effects of your child’s dependency exemption.