Utilizing Personal Exemptions for Dependents

Divorced parents can maximize the income tax benefits of claiming dependency exemptions for their children. They may also be able to prevent the exemptions from becoming subject to phaseout rules. The parents can save income taxes by agreeing to transfer the dependency exemptions (currently $2,450 for each dependent) to the parent with the highest marginal income tax rate until that parent’s adjusted gross income exceeds the threshold triggering the phaseout of the exemption.

If either party has or expects adjusted gross income in excess of the threshold, then the agreements might be structured to transfer the dependency exemption to the other party. Tax savings derived by shifting exemptions can be anticipated in the divorce agreement and passed on (or deducted from) child support or alimony payments. The exemptions can be shifted by using IRS Form 8332 which is discussed later.

To implement the planning opportunities, we need to review the rules for claiming dependency exemptions:

1. If the parents have custody of a child for more than one-half of the year, provide over one-half of the child’s support, are legally divorced or separated under a written agreement, and live apart at all times during the last half of the year, the custodial parent (who is the parent having custody for the greater portion of the year) gets the exemption.

2. If a multiple support agreement is effective and no one person provides over half of the child’s support, then by agreement, a specified party providing at least 10% of the support may claim the exemption.

3. If a divorce decree or agreement dated before 1985 provides for the custodial parent to release claim for the exemption to the other parent, then the other parent gets the exemption as long as the other parent provides at least $600 of support to the child.

4. If the custodial parent relinquishes the exemption by completing IRS Form 8332, then the other parent may claim the exemption. Such transfers may be for a single year, or a specified number of years, or alternate years. Thus, by using Form 8332, the exemption can be shifted between parents.

5. Under the phaseout rules, a taxpayer whose adjusted gross income exceeds the following thresholds loses 2% of the exemption for each $2,500 by which his or her adjusted gross income exceeds the threshold ($1,250 for married filing separately). Thus, if a taxpayer’s adjusted gross income exceeds the threshold by $125,000 ($62,500 for married filing separately) he or she will lose the entire deduction for exemptions. The 1994 thresholds are:

Married filing jointly
$ 167,700

Head of household
$ 139,750

Married filing separately
$ 83,850

Single
$ 111,800

As a result of the phaseout rules, a single parent will lose the benefit of all dependency exemptions when his or her adjusted gross income reaches $236,800. A married parent filing a joint return will lose the benefit of all dependency exemptions when his or her adjusted gross income reaches $292,700.

The following examples illustrate the dependency exemption rules.

Example (1) F and M are divorced. M has custody of their child for the entire year. F pays 65% and M pays 35% of the child’s support. M is entitled to claim the exemption on her separate return because she had custody for more time during the year than F.

Example (2) F is in the 28% bracket and M is in the 15% bracket. F and M are divorced. If M has
custody of a child but agrees to relinquish her claim to the exemption and transfer the exemption to F by using Form 8332, then F will realize $686 of federal tax savings that could be passed to M as additional child support. Even though M would have obtained a benefit of $367 if she retained the exemption, under the above circumstances, she could have more support for her child after transferring the exemption to F.

Example (3) F and M are divorced and each contribute 35% toward support of their son who lives full time with his grandmother. Although F and M contribute in the aggregate over 50% of the son’s support, no person provides over one half of the son’s support. Therefore, the multiple support agreement rule is available and either F or M or the grandmother may be designated to claim the dependent exemption.

Example (4) F and M were divorced in 1984 and agreed that F would pay at least $600 of their daughter’s support. The divorce decree specified that F could claim the dependency exemption even though the daughter, who is currently 16 years old, lives with M eleven months of the year. Under the existing decree, F is entitled to claim the 1994 exemption of $2,450.

Example (5) F is in the 28% bracket, divorced from M, and single. M is also single and has adjusted gross income of $500,000 which places her in the 42.3% bracket after phaseout of certain deductions for high income persons. Because M’s adjusted gross income exceeds the above threshold by more than $125,000, she will not be able to claim any portion of the exemption for her daughter even though she paid 85% of her daughter’s support and her daughter lived with her eleven months of the year. If M signs a Form 8332 and transfers the exemption for her daughter to F, then F will reduce his taxes by $686 which he may use toward his 15% share of his daughter’s support.