April 01, 2018 Tax

Structuring Tax Dependency Post-Divorce for Noncustodial Parents

By: Thomas M. Spade & Linda J. Bradley-McKee

I. Introduction

Pop Quiz: True or false? If the divorce decree is carefully executed under state law to allow the noncustodial spouse to claim a child as a dependent, then the noncustodial spouse will automatically be able to claim the child as a dependent for federal income tax purposes.

Answer: False. Read on to discover why.

II. Tax Benefits Resulting from Claiming a Dependent Child

In many divorce agreement negotiations, a key consideration is which parent, post-divorce, will reap the tax benefits deriving from the existence of dependent children. For post-1985 divorce agreements, the custodial parent enjoys all the tax benefits unless the custodial parent unconditionally agrees to release certain tax benefits to the noncustodial parent. For federal tax purposes the “custodial parent” is, by definition, the parent with whom the child resided for more than one-half of the tax year, irrespective of what is stated in a post-2008 divorce decree. This article will explain  the tax benefits that may be granted to the noncustodial spouse, as well as the requirements for this agreement to be recognized, in which cases execution of IRS Form 8332 is required, and how to use the form for successful compliance with court orders.

Tax benefits associated with having a dependent child include the dependency exemption deduction ($4,050 for 2017), the under-age- seventeen child tax credit ($1,000 for 2017), the child and dependent care credit, the exclusion from income for dependent care assistance, the ability to file as head of household (if single or an abandoned spouse), the earned income credit, and certain education benefits addressed below.

Determining dependency has taken on a new importance as a result of the Tax Cuts and Jobs Act of 2017. The dependency exemption deduction has been repealed for tax years starting on or after January 1, 2018, but it is still critical to properly address dependency for tax purposes in divorce cases. The parent allowed to claim a child as a dependent remains eligible for all other tax benefits tied to dependency. The under-age-seventeen child tax credit has been doubled to $2,000 per child and expanded to include a new $500-per-dependent credit for dependents seventeen and older. Like the earned income credit, these credits can generate a refund even if no tax payments were made during the year.

The January 17, 2017, preamble to the proposed regulations for Internal Revenue Code (I.R.C. or Code) §152 confirms that an individual is treated as the qualifying child of only one taxpayer for all five of the child-related tax benefits to which the uniform definition of a “qualifying child” applies. The only listed exception is §152(e), which allows the custodial parent to release the dependency exemption to the noncustodial parent, but only for the dependency-exemption deduction and the under-age-seventeen child tax credit. The remainder of the tax benefits accrue to the custodial parent and require the child to physically reside with the parent (or other related person) for more than one-half of the tax year to benefit from the tax provision, per the Working Families Tax Relief Act of 2004, which established a uniform definition for a “qualifying child.”

Determining which parent gets the most benefit from the dependency exemption deduction and the child tax credit can be difficult because this depends upon the taxable income reported by each parent. The pre-2018 $4,050 dependency exemption deduction gives the larger tax benefit to the parent in the higher tax bracket unless the exemption is reduced or barred completely under the personal exemption phaseout (PEP) rules or the alternative minimum tax. In 2017, the PEP phaseout begins for single taxpayers at $261,500 of adjusted gross income, while the child tax credit phaseout begins for single taxpayers at $75,000 of adjusted gross income. As a result of the Tax Cuts and Jobs Act, the child tax credit phaseout begins for single taxpayers at $200,000 of adjusted gross income starting in 2018.

III.  Benefits the Custodial Spouse Does and Does Not Relinquish by Releasing the Dependency Deduction

The custodial spouse who releases the exemption to the noncustodial spouse gives up the pre-2018 dependency exemption deduction and the child tax credit but continues to be able to file as head of household and take both the earned income tax credit and the child and dependent care credit. The definition of “qualifying child” for the purposes of the earned income credit, the child and dependent care credit, and head of household status is established without regard to the release provision of § 152.

The custodial spouse who releases the dependency exemption to the noncustodial spouse will not be able to benefit from the Hope Credit (American Opportunity Tax Credit for tax years 2009 and after), the Lifetime Learning Credit, or the savings bond interest exclusion, as these higher education tax benefits accrue to either the student or the person claiming the dependency exemption deduction. In fact, the parent taking the Hope Credit/American Opportunity Credit may be able to include the funds paid by the other parent in the credit calculation. The benefits of these higher education provisions are also phased out as adjusted gross incomes rise (the phaseout begins at $80,000 AGI for single filers for 2017 for the American Opportunity Credit). Note that forty percent of the otherwise allowable Hope Credit/American Opportunity Credit is refundable for the parent taking the credit.

The child of divorced parents is considered the dependent of both parents for purposes of excluding dependents’ medical reimbursements, excluding employer-provided accident or health plan coverage, treating the child as a dependent for certain fringe benefits, deducting the dependents’ medical expenses paid by the taxpayer, excluding health savings account (HSA) distributions used to pay qualified medical expenses, and excluding Archer medical savings account (MSA) distributions used to pay qualified medical expenses. These benefits are available to both spouses, whether or not the custodial spouse releases the claim to the dependency exemption, if the parents are divorced or lived apart at all times for the last six months of the calendar year, they are the parents of a child who receives over one-half of his or her support from the parents, and the child is in the custody of one of the parents and is a qualifying child of one of the parents.

Thus, for the pre-2018 dependency exemption deduction, the child tax credit, the American Opportunity Tax Credit/Hope Credit, the lifetime learning credit, and the education savings bond interest exclusion, the question of who gets to enjoy the tax benefits will turn on who claims the child as a dependent. If the noncustodial parent is allowed to claim the child as a dependent, then the noncustodial parent is granted these benefits and the custodial parent is denied them.

A.  Background: Requirements for Releasing the Dependency Exemption Deduction

In 2008, the Internal Revenue Service (IRS) issued new regulations that changed the definition of “custody” and clarified the rules regarding who qualifies for tax exemptions for dependent children. Nearly ten years later, many divorced taxpayers still find themselves in tax trouble, even though they complied with orders of the family court. When the parents of a child are divorced or separated, divorce decrees and separation agreements often include statements as to which parent is allowed to claim a dependency exemption for a child for income tax purposes. However, this assignment is generally not accepted for federal income tax purposes. Numerous recent decisions of the U.S. Tax Court have addressed this issue and have provided guidance about what the IRS expects for a parent to successfully claim a child who does not reside with that parent as a dependent.

The starting point to determine what is required depends on the date of the issued decree. There are different sets of rules for decrees dated:

  • before January 1, 1985;
  • January 1, 1985, through July 2, 2008; and
  • after July 2, 2008.

Prior to 1985, the Code allowed for an exemption to be claimed by a noncustodial parent if there was a written agreement in place and the noncustodial parent provided, generally, more than $600 in support (or, if the custodial parent claimed to provide more support than the noncustodial parent, the noncustodial parent needed to prove that he or she paid more than $1,200 in support and provided more support than the custodial parent). However, this support-provided standard caused “difficult problems of verification and substantiation” and caused the U.S. Tax Court to have more than 2,000 docketed cases of disputed exemptions per tax year.

Congress changed the law as part of the Deficit Reduction Act of 1984 to “ease the administrative burden on the IRS.” Decrees dated on or after January 1, 1985, could include language for one spouse to waive his or her right to the exemption. The decree had to include language that the custodial parent unconditionally “will not claim” the child and had to be attached to the noncustodial parent’s return. However, Congress delegated the task of designating the manner and form of the language to the Secretary of the Treasury. As a result, Temporary Regulations section 1.152-4T was issued, and the manner and form required included the following:

  • the name of the child;
  • the name and Social Security Number of the noncustodial parent;
  • the Social Security Number of the custodial parent;
  • the signature of the custodial parent and the date signed; and the tax year (or tax years) that the right to exemption would be released.

To assist taxpayers with meeting this requirement, the IRS created Form 8332. This allowed taxpayers to attach a single form, rather than the entire decree, to the return. But taxpayers could attach a copy of the decree if it “conformed in substance of [Form 8332].” Subsequent decisions of the U.S. Tax Court further clarified conformity in substance to Form 8332. As long as everything required by the regulations was included in the language, the decree would be in conformity.

With  this, using the term “all future years” was deemed acceptable,  as long as the first tax year was indicated. When there were multiple children, a statement was required as to which tax year the claim for each child would be released, the signature of the custodial parent could not be substituted by that of the custodial parent’s attorney or the state court judge, and the release had to be unconditional. For example, a requirement that a noncustodial parent must be current on support obligations to claim a dependency deduction creates a condition that would cause the decree to not conform in substance to Form 8332.

The noncustodial parent could only claim the deduction if it was explicitly released by the custodial parent. The regulations provided custody would “be determined by the terms of the most recent decree of divorce,” but in the event of split custody, custody would be “deemed to be with the parent who, as between both parents, has the physical custody of the child for the greater portion of the calendar year.”

Many decrees continued to provide language that did not conform in substance to Form 8332, so the IRS issued final regulations effective July 2, 2008. These final regulations also amended Treasury Regulation section 1.152-4, which was in effect at the time. The final regulations state that Form 8332, or a form that conformed to its substance, could be used,   but they indicate that the substitute must be a stand-alone document that specifically addresses this issue. The final regulations also state that “[a] court order or decree may not serve as a written declaration” and that the form must be attached to the originally filed return.

The final regulations additionally changed the definition of “custody.” The divorce decree no longer determined custody. Rather, the custodial parent was defined as “the parent with whom the child resides for the greater number of nights during the calendar year, and the non-custodial parent is the parent who is not the custodial parent.” This is commonly referred to as the “counting nights rule.”

B.   Orders or Decrees Dated Before January 1, 1985

If the order or decree was dated before January 1, 1985, the agreement must contain language that the custodial parent released the claim to the noncustodial parent. Furthermore, the troublesome hurdle of providing “$600 or $1,200, but more than the custodial parent” must be crossed. However, it is highly unlikely that the problem will be encountered in the future. It has been more than thirty years since January 1, 1985, and the special rule for divorced or separated parents does not apply to any child that has reached the age of majority.

C.   Orders or Decrees Dated Between January 1, 1985, and July 2, 2008

If the order or decree was dated between January 1, 1985, and July 2, 2008, then either Form 8332 or a written statement conforming in substance to Form 8332 can be attached to the return. What this implies is that a decree or order dated on or before July 2, 2008, can serve as a written declaration “if it satisfies the other requirements in effect at the time of the entry.” This does not mean that simply attaching a copy of the decree to the return will be sufficient. Rather, the decree must conform to Form 8332, grant the dependency exemption unconditionally, and include all the requirements of Temporary Regulation section 1.152-4T as outlined previously.

While the decree can be relied upon to meet the written declaration provided it meets the conformity rule, the definition of custody under the old regulations no longer applies. The underlying principle is that copies of a written declaration executed on or before July 2, 2008, can be attached to returns in subsequent tax periods. For purposes of the written declaration requirement, one can look back to the rules in existence at the time it was executed. However, the final regulations are applicable to all tax years starting after July 2, 2008. For tax years subsequent to 2008, the counting nights rule must be applied to determine which parent is “custodial”    and which parent is “noncustodial.” This will determine which parent is required to execute Form 8332 and deliver it to the other parent.

D.   Orders or Decrees Dated After July 2, 2008

If the order or decree was dated after July 2, 2008, then the only way a noncustodial parent can claim a child as a dependent is for the custodial parent to execute a Form 8332 or a similar form specifically for that purpose. The form must be attached to the original return when filed. If the return is filed electronically, Form 8453 must be contemporaneously mailed to the IRS with Form 8832 or its equivalent attached.

  1. The Counting Nights Rule

    To apply the counting nights rule, consider where the child spent the night. A child is considered as residing with the parent for the night if the child sleeps at the residence of the parent or in the company of the parent. If the child sleeps at the parent’s house, then the child is considered to have resided with the parent for that night. If the child was with the parent but they were on vacation, then the child is considered to have resided with that parent for that particular night. If the child is not with either parent (for example, he or she spends the night at a friend’s house or away at summer camp), then the child is considered to have resided with whichever parent the child would have normally been spending the night with for that particular night. If that cannot be determined, then the child is considered as residing with neither parent. If a parent has to work at night, then the child is not spending the night with the parent. Under these circumstances, the child is considered as residing at whatever primary residence is registered with the child’s school.

    The regulations also explain what happens on New Year’s Eve. What if the child is still up at midnight to celebrate the New Year? In this case, the child is considered as residing with the parent that he or she was with (or would have been with) when the night began. Suppose the child was with the father from 4:00 p.m. on December 31 until 12:30 a.m. on January   1, but then the mother picked the child up. The child literally spent the night at the mother’s house. However, because the night straddled taxable years and the child was with the father when the night began, the child is considered as residing with the father for that night. On any other day of the year, the child would be considered as residing with the mother for that night.

    In some cases, a child may spend an equal number of nights with each parent. This is rare, but still possible. In this case, the custodial parent is the parent with the higher adjusted gross income.

    On occasion, the parents may not have legal custody of their children. Legal custody may, in this case, belong to a relative. In order for the special rule to apply, either or both parents must “have the right under state law to physical custody of the child for more than one-half of the calendar year.” If at least one of the parents did not have legal custody for more than half of the year, the special rule would not apply and the determination of who would claim the child would be determined by the qualifying child or qualifying relative rules.

    A child is treated as residing with neither parent if emancipated under state law.  Furthermore, the special rule only applies if the child is in  the custody of one or both parents for more than half the calendar year. In the year that the child reaches the age of majority, whether or not the counting nights rule applies depends on the child’s birthday. If the child is under the age of majority for more than half the year, then the counting nights rule applies based on the number of days the child was under the age of majority. But if the child were under the age of majority for less than or equal to half the year, then neither the counting nights rule nor Treasury Regulation section 1.152-4 would apply. In this case, the regular rules of determining eligibility to claim a qualifying child or qualifying relative under §152 would be used to determine who is eligible to claim the dependency exemption. For example, imagine that a child turns eighteen on July 31. In this situation, the counting nights rule would be based on the two hundred and eleven-day period from January 1 through July 30 (assuming a three hundred sixty-five-day year). However, if the child’s birthday were February 2, then the child would be considered in the custody of one or both parents for only thirty-two days. As this is less than half of the year, the dependency exemption would be determined by the qualifying child or qualifying relative rules.

    In the U.S. Tax Court and the IRS, the burden of proof falls to the taxpayer in most cases. Accordingly, adequate and contemporaneous documentation should be maintained as to where the child spends each night. This can further be substantiated with school and medical records showing the child’s registered primary address.
  2. When Form 8332 Is Not Attached to the Return

    While the regulations specifically require Form 8332 or its equivalent to be attached to the return, the IRS may allow some leeway if it is not. The Internal Revenue Manual (IRM) contains  the  official  guidelines for IRS employees to follow.  If a taxpayer files a paper return claiming  a dependency exemption that has already been claimed on a previously filed return and the return does not include Form 8332, the IRM instructs the employee to first review the earlier processed return for the other taxpayer claiming the same dependent, as well as its attachments. It will disallow the exemption on the paper-filed return, then send the taxpayer a notice along with a blank Form 8332, instructing the taxpayer to have the custodial parent sign it and release the dependency exemption. It will then adjust the taxpayer’s account upon receipt of the completed Form 8332. If the IRS receives a response that does not clearly show that the taxpayer is entitled to claim the dependency exemption, the correspondence received, as well as the return, is to be forwarded to examination. For example, if the IRS were to receive a response in the form of a decree dated after July 2, 2008, the return would be subject to an audit.

IV. Unsuccessful Reliance on the Decree: Tax Court Cases

In many states, the allocation of dependency exemptions can be tied  to staying current on child support. However, the IRS, as well as the U.S. Tax Court, pays no attention to state court orders on the basis that the IRS “cannot be expected to police divorce decrees and separation agreements or determine taxpayer compliance therewith.” So, for purposes of filing the tax returns, the Internal Revenue Code and the related regulations govern who can claim a dependency exemption. In order to enforce compliance with decrees and the primary sources of tax law, orders and decrees should be drafted in conformity with the substance of Form 8332. Although decrees after July 2, 2008, cannot be accepted by the IRS as a written declaration, drafting them in conformity of substance leaves no room for misunderstanding or misinterpretation.

If the decree was dated after July 2, 2008, then Form 8332 or its equivalent must be attached to the noncustodial parent’s return. For a pre– July 2, 2008, decree, the decree may be attached to the return, but it must conform in substance to Form 8332. If it does not, then it will not be accepted. Furthermore, custody is now determined by the counting nights rule. There have been numerous Tax Court cases in which the court has been sympathetic to the plight of taxpayer’s reliance on the decree to claim the dependency exemption but have found in favor of the IRS.

A.   Calderon v. Commissioner

A post–July 2, 2008, decree awarded sole physical custody of the three minor children to the mother. However, the decree stated that the father could claim the dependency exemptions for the three children provided he stayed current with child support payments. Form 8332 or its equivalent was not executed and not attached to his 2011 return and, upon examination, the IRS disallowed the dependency exemptions. The Tax Court noted that the proper documentation was not attached to the return. Furthermore, the requirement to stay current with child support obligations made the release conditional, which is not permitted because the release of the exemption must be unconditional. The Tax Court ruled in favor of the IRS, stating: “We do not doubt that the petitioner has fulfilled his obligations under the consent decree. But it is the Internal Revenue Code which ultimately governs a taxpayer’s entitlement to claim a Federal Income Tax Deduction, and Federal law is strict in allowing those deductions.”

B.   Shenk v. Commissioner

A pre–July 2, 2008, decree awarded primary physical custody of the three minor children to the mother. It allowed the father to claim one of the children in odd-numbered years and two in even-numbered years provided he was current with his child support payments at the end of the year. This provision also required the mother to be employed and earning income; if she was not employed and earning income in an odd-numbered year, the father would be allowed to claim two of the children.

In tax year 2009, the mother was not employed and earning income, the father was current with his child support payments, and the father claimed two children in accordance with the terms of the decree. The Tax Court agreed that this was a reasonable interpretation of the decree; however, the conditions applied to the release of the exemptions caused this agreement to not be in conformity of substance. Furthermore, all three children resided with the mother for more than fifty percent of the year. The Tax Court also agreed that

as far as the state court was concerned, Mr. Shenk was entitled to the disputed deduction. But ultimately it is the Internal Revenue Code and not State court orders that determine one’s eligibility to claim a deduction for Federal income tax purposes, and Mr. Shenk does not meet the criteria of the Code for claiming the disputed dependency exemption deduction. He is the noncustodial parent, and the custodial parent did not sign the required declaration.

The father did ask the Tax Court to leave the matter open to try to obtain Form 8332 from the mother, but the Tax Court denied this request because the mother had claimed the children as dependents on her return and the statute of limitations had expired for the IRS to examine her return.

C.   Armstrong v. Commissioner

Two children stayed in the custody of the mother; however, according to the terms of the original order from 2003, the father was entitled to claim a dependency exemption for one of the children if he stayed current with his child support obligations. The order was subsequently changed, but it still allowed the father to claim one of the children so long as he stayed current with his child support obligations, which he did. However, the new order required the mother to execute Form 8332 and provide it to the father each year by January 31 of the following year to ensure the parties’ compliance with the Internal Revenue Code as well as with the order to timely pay child support. The mother, however, did not comply with the state court order and did not provide it to him for tax year 2007. The father claimed the dependency exemption and attached a copy of the original order to the return. The return was examined by the IRS, the exemption was disallowed, and the matter was brought before the Tax Court. The Tax Court ruled that the order was not in conformity of substance due to the condition that the father must stay current with child support payments  to earn the deduction. As for the mother’s failure to provide a properly executed Form 8332, the Tax Court opined:

Mr. Armstrong’s case is quite sympathetic. He was up to date on his child sup- port, and under the State court order, [the mother] was obliged to sign Form 8332 and release the exemption deduction to him. We are obligated, however, to follow the statute as written, whether the resulting disadvantage is (as here) suffered by a noncustodial parent who bore the burden of child support but did not receive an executed Form 8332, or whether the disadvantage is suffered  by a custodial parent who executed a Form 8332 but then bore an undue and unintended burden of child support.

In a subsequent case, Swint v. Commissioner, the taxpayer argued that the previous decision in Armstrong should be reconsidered along with Shenk v. Commissioner and Miller v. Commissioner. However, the Tax Court declined, stating that the cases “correctly considered the statutory and regulatory requirements in existence at the time the writings were created.

All three of these cases, as well as the others cited throughout, share a similar thread: If the decree or order was dated before July 2, 2008, then it must conform to the substance of Form 8332 and it, as well as Form 8332 or an equivalent form, must be attached to the original return. Alternately, for a pre–July 2, 2008, agreement, the applicable pages of the divorce agreement (if conforming) can be attached to the original return. If the decree or order was dated after July 2, 2008, then Form 8332 or   an equivalent form must be attached to the original return. Furthermore, adding conditions such as staying current on child support invalidates reliance on prior decrees, and the counting nights rule must be considered. And finally, it is tax law that determines eligibility for a dependency exemption, not a state court order. If the courts did not consistently apply the law in accordance with congressional intent, precedent would be set, allowing for a return to assigning resolution of the “difficult problems   of verification and substantiation” of these matters to the IRS and the  Tax Court.

V. Continued Compliance with Federal Law and Regulations is Necessary

Currently a divorce decree should include language that Form 8332 must be executed by the noncustodial parent (as defined by I.R.C. §152 and related regulations) for each child and that a separate Form 8332 must be completed for each child. The form can be executed concurrently with the execution of the decree or order and specifically state for which future years the custodial parent releases the exemption. A copy of Form 8332 should then be attached to the tax return each subsequent year and copies should be provided to an escrow agent to ensure availability of the form in case either party loses his or her copy.

If, in the future, the terms of the order are changed, the dependency exemption issue must be readdressed. Previous Forms 8332 can be revoked by completing Part III of a new Form 8332; however, a copy of this Form 8332 must also be filed each year that a dependency exemption is claimed for tax years previously released.

For example, suppose that a mother and father have joint legal custody of their two children, Jessica and Jason. The mother has full physical custody of the children pursuant to an order issued in 2016 but releases the dependency exemption for Jessica to the father. The mother completes Form 8332, releasing the claim for the dependency exemption to the father for 2016 and all future years. Under the rules of the state, the release of the dependency exemption is denied if the father does not stay current on child support payments.

In April 2017, the father moves out of town, unannounced, with his new girlfriend. The order is changed, allowing the mother to claim both children. The mother should then complete Part III of Form 8332, revoking her previous release of the claim to Jessica, and attempt to deliver it to the father. The mother would then be required to attach a copy of this Form 8332 to her 2017 return and all future returns until she no longer claims Jessica as a dependent. She must also keep in her records, in case of IRS examination, proof of delivery to the father or documentation of reasonable attempts to provide delivery. If she does not complete the revocation, she will not be able to claim Jessica as a dependent on her tax return. Although the state court says she is entitled to the deduction, the IRS and the U.S. Tax Court will not allow it unless the regulations are followed. In all cases, Form 8332 should be properly executed and revoked if necessary.

VI. Summary

There are multiple tax benefits that may flow from the dependency exemption for a minor child, but the rules and required documentation for these benefits can be confusing. Parents may be in conflict over claiming these tax benefits.

To ensure that dependency exemptions are properly claimed, IRS Form 8332 or its equivalent should always be attached to a return. Timely completion of the form should be required by the decree. To ensure its timely completeness, the form should be completed contemporaneous to the issuance of an order or decree, when possible. If it is not possible, its completion should be enforced by the court. If it is not properly completed and submitted with subsequent returns, parties to a divorce case may receive sympathy from the taxing authorities, but they will nevertheless be bound to enforce the laws passed by Congress.

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Thomas M. Spade

M.S., CPA

Linda J. Bradley-McKee

Ph.D., CPA