Article: Cashing in on the “Dependency Loophole”


	Gerry Henderson

June 2006

Cashing in on the “dependency loophole”

In coordinating various deductions and credits, Congress created a tax windfall for qualifying families, rich and poor

You may not have noticed it, but, effective with the 2005 Form 1040s, Congress rewrote the definitions of “dependent.” The new definitions are part of an effort to coordinate how a child is defined for the exemption deduction, the $1,000 child tax credit, and the earned income credit. While these changes are generally of little consequence, for some families the new definitions represent a significant financial windfall.

The first change is that a qualifying child, for dependency and tax credit purposes, can be a child or sibling of the taxpayer, or a descendant of either. Also, the new law allows multiple adults living within a household to make the choice as to who will claim a child as a dependent. The definition no longer focuses on which adult provided more than 50% of the child’s support.

Middle and upper income families often gain little advantage from having a dependent child within their return. The $3,200 dependency exemption (2005 amount) allows, at best, about $1,000 of federal tax savings. But that phases out in higher-income returns (joint income above $219,000 for 2005). Further, the $1,000 tax credit for each child under age 17 phases out as joint income exceeds $110,000.

On the other hand, a young adult living in the household, such as an older sibling of the dependent, may gain a significantly greater advantage from claiming the younger sibling as a “qualifying child” under the new law.

Example. Dick and Ruth are high-income professionals with a 16-year-old daughter, Jennifer, and a 23-year-old son, Brandon. Both children live with their parents. Brandon is not a full-time student, and during the year he earned $16,000 in wages. Dick and Ruth are eligible to claim Jennifer as a dependent, but they receive no tax benefit for doing so. However, believe it or not, Brandon can claim his sister as a “qualifying child.” In Brandon’s return:

the dependency exemption for Jennifer is allowable,
Brandon qualifies for a $1,000 child tax credit (since Jennifer is younger than 17),
he also qualifies for a $2,400 refundable earned income credit, and
the portion of the $1,000 child tax credit that is not needed to eliminate Brandon’s tax also becomes refundable.

By allowing Brandon, instead of his parents, to claim Jennifer’s dependency exemption, the family saves almost $4,000 in income taxes!

A key to the preceding illustration is that the older child (Brandon) who claims the younger child (Jennifer) as a dependent must be residing in the same household (either child’s temporary absence for school or military is not an impediment). Also, the older child cannot be eligible to be a “qualifying child” of the parent. Effectively, this strategy only works if the older child is age 19 and above and not a full-time student, or is age 24 or older, or is providing over half of his or her own support.

Another aspect of eligibility is that the person who claims the dependency exemption:

must have wages or other earned income to qualify for the lucrative earned income tax credit, but
cannot have investment income, such as interest, dividends, or capital gains, over $2,700 (2005 amount).

Loophole closing. The tax law is likely to be changed in order to tighten up this rule, but opportunities clearly remain for 2005 amendments.

If your family circumstances might fit the profile illustrated here, please contact your Schmidt Westergard & Company professional, and we will help you determine if a refund opportunity is available to you.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.