Tip of the Month:
Claiming the Kids – 2003 Update

The first tax tip in October 2002, concerned “Who Should Claim the Kids”. The tax law changes of 2003 have increased the Under Age 17 Child Tax Credit to $1,000 (was $600) and this has increased the importance of maximizing the tax savings from the child dependency exemption and under age 17 child tax credit (they are linked and cannot be split between the parties).

You may want to review the Tax Tip from October, 2002, before you read this new one.

The new tax tip is simply – Do Not Ignore Who is Claiming the Child Dependency Exemption. In some cases, the lost tax savings from not looking at who is claiming the children for taxes is so substantial as to raise a question of malpractice when considering the impact over a period of years.

If you are the typical family lawyer who is pressed for time and practicing in a Court System that never even asks about who should claim the child dependency exemption, you are probably inclined to stop reading this Tax Tip and move on to other things. So rather than prepare an article showing the importance in words, this tax tip will simply be a review of the numbers and you can make your own decision on the importance. The case shown is a typical middle income case which is taught in all training classes for FinPlan’s Divorce Planner® software (www.divorceplanner.com). This article is a little longer than the usual Tax Tip but the importance of “Claiming the Kids” in divorce planning warrants a full example.

Facts
Assume John and Mary are getting divorced and they have 3 children under the age of 17. John makes $50,000 and Mary makes $25,000. Mary spends $3,000 per year on child care for the children. The children will reside with Mary and guideline child support is $1,200 per month or $14,400 annually. Assume these individuals live in a state with no state income tax (numbers shown will usually be greater if state taxes are considered).

Since Mary is the custodial parent, she is entitled to claim the child dependency exemption and under age 17 child tax credit but she could relinquish these to John as part of a settlement agreement. While some Courts have the right to allocate child dependency exemptions, we will assume that the parties must agree for this example.

After-Tax Cash When Mary Claims Child Dependency Exemptions
If you apply taxes to this case, the after-tax cash available to meet living expenses is shown below:

After-Tax Cash – Mary Claims Children

Note that Mary is receiving a payment from Uncle Sam of $3,281 which is the refundable Earned Income Credit and the Under Age 17 Child Tax Credit which is partially refundable. She has more cash before support than her salary since these refundable credits from the tax system are a real source of cash for lower income individuals.

Taxes
Child dependency exemptions are worth more to individuals in higher tax brackets. The under age 17 child tax credit is worth $1,000 to either party if it can be used. Mary will be receiving a very substantial tax refund because as a Head of Household post-divorce tax filer, she will be eligible for the Earned Income Credit. (Remember, in a case like this, these parties did not even know the Earned Income Credit existed because they had joint income of $75,000). The taxes when Mary claims the child dependency exemptions are shown below:

Federal Income Tax

If Mary claims the children for taxes, her tax is reduced by $2,293 ($1,450 for under age 17 credit plus $843 for dependency exemption for 3 children). Taxes are being wasted when Mary claims the children for taxes.

What would this case look like if John claimed the child dependency exemptions for taxes? Let’s look first at how taxes would change.

Taxes When John Claims Child Dependency Exemptions

When John claims the children for taxes, his taxes are reduced by $5,288 ($3,000 for under age 17 tax cr plus $2,288 for claiming 3 child dependency exemptions). Total taxes of both are reduced by about $3,000 ($4,079 vs $1,085). This means that these individuals could increase their combined after tax cash by $3,000 per year if they understood the financial implications of switching the child dependency exemption for taxes. Over a 10 year period, the present value of these tax savings would be $23,000 (5% interest rate). Where I come from, this is a lot of money to leave on the table.

Problems – Complicated Calculations & Parties Not Impacted Similarly
There are two problems which make assessing this kind of situation difficult:

1 - Getting to the numbers is complicated. A full tax calculation needs to be performed because some credits are non-refundable (child care credit) and the under age 17 child tax credit is partially refundable. Tax savings from the child dependency exemption must reflect both the actual tax rates being used and the fact that switching the children to the non-custodial parent may allow the custodial parent to make use of the nonrefundable child care credit.

2 - The parties are not impacted similarly. John realizes all the tax savings and Mary would not consent to do this unless she is compensated. Mary has the right under the tax law to claim the child dependency exemptions so to get her to relinquish those to John will require John to give a portion of those tax savings to Mary. This is where child support enters into this situation. Let’s look at the after-tax cash when John claims the children for taxes.

After-Tax Cash – John Claims Children

When John claims the child dependency exemptions, total cash of the parties increases by about $3,000 and this is from the tax savings. From Mary’s perspective, she would not agree to giving the dependency exemptions to John without compensation because her after-tax cash would be $38,475 compared to $40,768 when she claimed the kids for taxes. It’s a great idea to reduce taxes but only if both parties can participate in those tax savings.

What can be done to get the parties to agree to switching the child dependency exemptions to John and still leave Mary with more cash? Your initial consideration may be to use spousal support (alimony) to give Mary more cash but that would be a mistake in this kind of case. While spousal support is generally a good thing from a tax perspective when individuals are in different tax brackets, this is not always true in lower income cases when one individual (Mary) is getting the Earned Income Credit. A small amount of alimony will actually increase the joint taxes of the parties (hurt them) because the tax savings from any tax bracket differences are not sufficient to offset the decrease in the Earned Income Credit. This point is easily overlooked and is counter intuitive. However, it is correct and you should be very cautious on using small amounts of alimony in a divorce when the support receiver is low income and is receiving the Earned Income Credit.

Use Child Support to Share the Tax Savings
In this kind of case, child support could be increased to share the tax savings. Child support calculation methods are not the same in each state with some states basing child support on gross income of one or both parties and other states basing child support on net after-tax income of one or both parties.

How guideline child support is calculated is very important. In states where guideline child support is based on net after-tax income of the parties, Mary will usually have more after-tax cash in the second case than in the first case. When the 3 child dependency exemptions are moved to John, the amount of child support that John will pay would increase significantly over the assumed level of $14,400 because John’s taxes would be decreased by about $5,300. This would increase the income level on which child support is based. Higher child support would not only offset the tax loss to Mary of relinquishing the dependency exemptions to John but would actually be sufficient to increase her total after-tax cash from the initial case in which she claimed the dependency exemptions. If you are from CT, FL, IL, MN, or PA (states where child support calculations are based on after-tax cash and states in which FinPlan offers tax and child support software so the actual numbers are available to the author), switching child dependency exemptions with this fact pattern will be beneficial to both parties without any other changes being made.

In states where child support is based on gross income, child support will not change when child dependency exemptions are switched from the custodial to the non-custodial parent. In those states, you have to increase the amount of child support so that each of the parties can share in these tax savings in a manner considered appropriate (does not have to be 50/50).

When to Look at Switching the Kids for Taxes
The example used to illustrate these concepts had 3 children and the custodial parent’s income was $25,000. Tax savings will be even greater when the custodial parent has lower income and will be less as the income of the custodial parent increases. If Mary made $20,000, the annual tax savings would be $4,300. If there were 2 children and Mary made $20,000, the tax savings would be about $2,500 per year. Savings in the case of a single child are less and may not warrant this kind of detailed analysis. The rule should be to look closely at who is claiming the children for taxes when the income of the custodial parent is less then $30,000 and there are two or more children.

Crunching the Numbers
I won’t deny that this analysis is a little complicated and requires some knowledge of taxes (the author feels that divorce attorneys need some understanding of those tax issues which are very important in divorce). If you are not now doing this kind of analysis, you are faced with several choices:

1 - Do nothing if you do not feel it’s the attorneys responsibility to assist with financial issues that involve taxes and continue to tell clients to go to a CPA (lower & middle income clients will not do this and it is these clients where this issue is most important). The result of this may be to continue to leave significant tax savings on the table and will foster what the author calls “DOS – the Divorce Ostrich Syndrome or keep my head in the sand syndrome”. If you are reading this article, you are not contributing to this syndrome – it is the many thousands of family lawyers who continue to shortcut financial issues in divorce that form the base of DOS.

2 - Try to integrate this analysis into your practice (I would not recommend you do this manually since it is difficult to compute how much of the under age 17 child tax credit can actually be used by a lower income person)

3 - Learn to use software (FinPlan or other systems) which is specifically designed to assist in this kind of analysis (with a good software program, this kind of case analysis can be completed in 15 minutes and you then know if switching child dependency exemptions is worth pursuing). Regular tax preparation software programs do not show the specific tax savings from the child dependency exemption which need to be added to the taxes saved from the under age 17 child tax credit to translate the tax savings into a divorce specific context. What is needed is to show how much total tax is saved by either parent as a result of claiming the children for taxes.

Real Tragedy
The real tragedy is that not many family lawyers and/or Courts consider this as a matter of course in their cases. I am aware that OH child support guidelines specifically require a review of the tax consequences of claiming the child dependency exemption but the author feels that OH is not the national norm. From teaching FinPlan software all across the country and interacting with thousands of attorneys and Judges for many years, it is all too apparent that many divorces are being settled each year without anyone even giving this issue a second thought. As professionals in divorce, we all need to keep up with how changes in tax laws impact divorce and the recent tax changes from the Under Age 17 Child Tax Credit are very important.

Improved financial awareness needs to be moved up the ladder of things done by divorce professionals and the author hopes this article may open a few more eyes. To keep our eyes closed, costs divorcing individuals money and hurts the image of divorce professionals in the eye of the public.