It is tax season once again, and, as always, there are many questions surrounding the tax aspects relating to children.
The tax aspects that relate to children include:
- The claim of exemption.
- The child tax credit.
- The child care credit.
- The earned income credit.
- The head of household filing status.
This blog post gives an overview of the opportunities and pitfalls relating to each of these tax items.
The Claim of Exemption
Generally, for a parent to claim the exemption for a child, the child must spend more than half the overnights during the year with the parent (we will discuss an exception, below).
It must also be the case that the child does not provide more than half of the child’s own support during the year; this requirement is usually met easily.
It is important to know that, while a state may acknowledge 50-50 timesharing and parental rights, the IRS does not recognize 50-50 overnight agreements.
If the parties have a 50-50 time share and do not designate a custodial parent for tax purposes, the IRS will designate the parent with the higher adjusted gross income to be the custodial parent.
This default ‘tie-breaker’ rule could reduce the available tax benefits and may not be in the family’s best interest.
Family Law Software requires the user to designate a ‘custodial’ or ‘majority time’ parent. This designation will apply when timesharing is 50-50.
Here is an important exception to the rule stated above: divorced or separated parents typically may decide together which parent will claim the exemption for the child.
If both parents together provide more than half of the child’s support, then either parent may claim the exemption, regardless of the child’s overnights.
This is an example of a rare situation in the tax code in which taxpayers are permitted to choose the status that benefits them the most.
If the non-custodial parent will be claiming the exemption, the custodial parent must sign IRS Form 8332 or a similar declaration and give it to the non-custodial parent. The non-custodial parent then files that form with their tax return.
Parties may alternate the claim of exemption every other year. But there is no way to let the IRS know of that arrangement. And so, each year that the non-custodial parent is claiming the exemption, that parent must file Form 8332 signed by the custodial parent.
Currently the tax exemption has no direct tax effect on a federal tax return, but indirectly it has a significant effect, because the party who claims the tax exemption is also the one who can claim the child tax credit, additional child tax credit, or other dependent credit. The tax exemption may also result in state income tax savings, if the exemption results in a reduction of state tax.
Filing Status as Head of Household
Another tax benefit reserved for the majority-timesharing or custodial parent is the right to claim Head of Household filing status.
Head of Household filing status results in lower effective tax rates as well as a higher standard deduction, in comparison with filing as Single.
The Head of Household filing status is independent of the dependency exemption.
And so, even if the non-custodial parent is allocated the dependency exemption, the non-custodial parent cannot qualify for the head of household filing status.
Conversely, even if the custodial parent has given away the right to claim the exemption, the custodial parent could still claim head of household filing status, if they pay more than half of household expenses for the home they share with the child.
Child Tax Credit
The cost of raising children has steadily risen over the years.
The Child Tax Credit helps families with qualifying children receive a tax break.
The Child Tax Credit is only available to the parent who claims the exemption for the child.
When the parties negotiate over who claims the exemption for the child, they are effectively also negotiating who claims the Child Tax Credit for that child.
Most families with children qualify for the Child Tax Credit. The maximum amount of Child Tax Credit per qualifying child is $2,000 in 2023.
If you have no tax due, you can get a refund of up to $1,600 for each qualifying child in 2023.
This credit phases out for upper-income taxpayers.
Family Law Software automatically calculates the available child tax credit and possible refunds due to the parties.
Family Law Software also makes it easy to see the tax impact of switching the exemption (and thus the child tax credit), so you can decide how to maximize your combined after-tax incomes.
Child and Dependent Care Credit
Families can easily spend $1,000 or more a month on childcare.
The Child and Dependent Care Credit is a tax credit that helps families pay for childcare.
The tax credit is a percentage of expenses you incurred for childcare due to work, looking for work, or attending school.
For tax year 2023, the maximum amount of care expenses you’re allowed to consider is $3,000 for one child, or $6,000 for two or more children.
The percentage of your qualified expenses that you can claim as a credit ranges from 20% to 35%.
So the maximum credit anyone could claim is 35% of $6,000, or $2,100.
This credit is nonrefundable, meaning it can reduce the tax liability up to the amount of the taxes owed but will not result in a tax refund.
This tax benefit may only be claimed by the custodial (majority time) parent and does not follow the dependent exemption allocation.
Family Law Software will automatically calculate the appropriate childcare credit.
Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is designed to help low and moderate income workers, particularly those with children.
The purpose is to encourage people to find and keep work.
The EITC can be worth thousands of dollars for larger families of modest incomes.
There is no credit if you have no income. As income rises, the credit increases, to a point. Beyond that point, as income rises, the credit diminishes.
For the 2023 tax year, the earned income credit ranges from $600 (with no children) to $7,430 (with 3 or more children).
The EITC is a refundable credit available to the custodial parent, meaning it often results in a large tax refund for the custodial parent.
Opportunity knocks
It is very important to be thinking of these tax benefits as you negotiate the separation agreement.
- The decision with respect to who claims the exemption can affect tax dollars through its impact on the child tax credit.
- Decisions with respect to custody can affect tax dollars through the head of household filing status, dependent care credit, and earned income credit.
- If custody is 50-50, be sure to designate a “custodial parent” for tax purposes, or the IRS will choose for you.
With Family Law Software users can ensure they are addressing all these issues while maximizing clients’ tax savings.
Helpful Resources:
Family Law Software Blog “Watch Out for “Exactly Equal Parenting”: https://blog.familylawsoftware.com/2021/05/08/watch-out-for-exactly-equal-parenting/
IRS “What You Need to Know about CTC, ACTC and ODC”: https://www.eitc.irs.gov/other-refundable-credits-toolkit/what-you-need-to-know-about-ctc-and-actc/what-you-need-to-know
IRS “Child Tax Credit”: https://www.irs.gov/credits-deductions/individuals/child-tax-credit
IRS Topic No. 503 Child and Dependent Care Credit: https://www.irs.gov/pub/irs-pdf/p503.pdf
IRS Topic No. 504 Divorced or Separated Individuals: https://www.irs.gov/pub/irs-pdf/p504.pdf
IRS “Who Qualifies for the Earned Income Tax Credit (EITC)”: https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit/who-qualifies-for-the-earned-income-tax-credit-eitc
IRS Publication 501 “Dependents, Standard Deduction, and Filing Information” (2022): https://www.irs.gov/pub/irs-pdf/p501.pdf
2022 survey by ChildCare Aware of America: https://info.childcareaware.org/hubfs/2022-03-FallReport-FINAL%20(1).pdf?utm_campaign=Budget%20Reconciliation%20Fall%202021&utm_source=website&utm_content=22_demandingchange_pdf_update332022