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Sunday, April 9, 2006

Tax teaser

It's tax time again across this great nation, and here's a federal income tax question that's come across my desk. I throw it out here for discussion among any seasoned tax practitioners out there who think they might have a definitive answer.

Here's the setup. Prototypical family of four: mom, dad, two little kids. The kids are the parents' dependents. They all live together in the same house. The parents' income is too great to qualify for the $1,000-per-child child credit, which "phases out" once one's income starts to enter upper-middle-class, for either child.

The older of the two kids (call him Dave) has some income from investments that the parents have put in his name -- so much so that Dave owes a small amount of income tax for the year.

Is it true that Dave can take the child credit for his brother, Ricky, on Dave's tax return?

Under recent changes to the tax laws, Ricky would be a "qualifying child" both as to the parents and as to Dave. If the parents claimed the child credit for Ricky, Dave clearly couldn't do so. But the parents are claiming only the dependency exemption, a deduction, for Ricky -- not the child credit.

So, can Dave take the child credit for Ricky? Before you say "no," consider that:

(a) There's a Form 8901 on which Dave could list Ricky as a "qualifying child" who's not Ricky's dependent; and

(b) On the Form 1040, there's a box that the parents check to show whether Ricky, though listed as dependent, is or is not their "qualfying child" for child credit purposes.

My faithful TurboTax program gives some fairly sketchy guidance on this point, and it doesn't even support Form 8901. The legislative history of the "qualfying child" provisions, which took effect in 2005, doesn't contain a conclusive answer -- at least, not one that I'm seeing.

As we say on the final exams, discuss.

Comments (10)

Only if the kid was born in the Cayman Islands.


This issue was discussed pretty widely in the NYTimes a few weeks ago. Apparently it is one of those unintended consequences of the changes made during the '02 Bush Tax cuts. It is legal and apparently being used. Congress has supposedly vowed to close that loophole sometime. I'm not a tax professional, nor have I used this provision. But I'm an avid follower of stuff like this and a strong believer in the law of unintended consequences.

This federal taxation conundrum that you've posed is certainly an example of unintended consequences, and the natural result of a system that benefits those who must grapple with this particular issue of whether one trust-fund baby can claim their sibling trust-fund baby on their tax filing, thus shifting more of the federal tax burden where it belongs - onto the working class. Steve Forbes is right - burn the federal tax code, and start over with something real simple, like everyone pays the same % of gross income as tax, period.

"burn the federal tax code, and start over with something real simple, like everyone pays the same % of gross income as tax, period."

Which, of course, would have no unintended consequences, would it?

Actually, this particular issue appears to date back only to 2004.

The change resulted from the revision of the definition of a 'dependent' for income tax purposes under WFTRA (the Working Families Tax Relief Act of 2004), which was pretty sloppy legislation and inadvertently created several technical problems under various Code sections, some of which were fixed by the Gulf Opportunity Zone Act of 2005 (GOZA) back in late 2005, and others of which have been addressed via regulatory guidance.

Query: Assuming Dave can claim Ricky for purposes of the REFUNDABLE tax credit under Code section 24(a), can Ricky then turn around and claim Dave on his return? It seems that each may be a 'qualifying child' as to the other.

Travis - you're right, it will put a lot of lawyers, CPAs and tax preparers out of work. Would that really be such a bad thing? :o)

To me it's a little surprising that Ricky could be his parents' "qualifying child" for purposes of the deduction, and his brother's "qualifying child" for purposes of the credit. Nothing in the statute seems to compel the conclusion that that should be a possibility. I would have thought that the family here would have to pick one claimant of Ricky for all purposes.

The parents can claim Ricky as their dependent only if Ricky is either (a) a qualifying child or (b) a qualifying relative. Code section 152(a).

A child cannot be a qualifying relative if the child is (not simply may be claimed as) a qualifying child of the taxpayer or of any other taxpayer. Code section 152(d)(1)(D).

So, the only way for Ricky to be claimed as a dependent by his parents would be for his parents to claim him as a 'qualifying child.'

If his parents claim him as a qualifying child, and someone else (e.g., Dave) also tries to claim him as a qualifying child (e.g., for Code sec. 24 purposes), then doesn't Code § 152(c)(4)(A) pretty much preclude Ricky from being Dave's qualifying child?

doesn't Code § 152(c)(4)(A) pretty much preclude Ricky from being Dave's qualifying child?

Apparently not. The "tiebreaker" rule of 152(c)(4)(A) applies only if an individual "may be and is claimed as a qualifying child by 2 or more taxpayers." From Form 8901 and the box on the 1040, I take it that the IRS has decided that one taxpayer can "claim" the qualifying child for one purpose (the deduction), while another can "claim" the same child for another (the credit), without triggering 152(c)(4)(A).

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