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Bad News for Noncustodial Parents after Divorce or Separation

However, IRC Sec. 152(e) provides a special rule that allows the custodial parent to release to the noncustodial parent the right to claim the designated child as a dependent. This, in turn, allows the noncustodial parent to claim certain tax breaks associated with the child. Let’s call this special rule the noncustodial parent rule. In the right circumstances, it can be worth significant bucks to a noncustodial parent.

The main purpose of this article is to tell you about recent final amendments to Reg. 1.152-4 (contained in TD 9408) that allow the custodial parent to unilaterally revoke an earlier release to the noncustodial parent of the right to claim a child as a dependent. This is bad news for noncustodial parents because it can result in the loss of valuable federal income tax benefits. But before addressing that issue, let’s first cover the basics on how the noncustodial parent rule works and why it’s important. Here goes.

How the Noncustodial Parent Rule Works

Under the noncustodial parent rule, a child is the qualifying child of the noncustodial parent if all of the following five tests are passed for the calendar year in question. [See IRC Sec. 152(e).]

1.   Support Test. The child receives over half of his or her support from the parents.

2.   Divorced or Separated Test. The child’s parents are divorced or legally separated under a decree of divorce or separate maintenance, or they are separated under a written separation agreement, or they lived apart at all times during the last six months of the year.

3.   Custody Test. The child is in the custody of one or both of the parents for over half the year.

4.   Written Declaration Test. The custodial parent signs a written declaration releasing to the noncustodial parent the right to claim the child as a dependent for the year. This required written declaration is generally made by having the custodial parent sign IRS Form 8332 (or a successor form issued by the IRS) to effect a release for one or more years. Currently, Form 8332 (dated 9/07) is called Release of Claim to Exemption for Child of Divorced or Separated Parents. Alternatively, the required written declaration can be made on another document that conforms to the substance of Form 8332 (or a successor form).

Warning: Effective for tax years beginning after 7/2/08, amended final Reg. 1.152-4(e) stipulates when Form 8332 (or a successor form) is not used, the required written declaration must be made on a separate document that is executed for the sole purpose of releasing to the noncustodial parent the right to claim the child as a dependent for one or more years. This rule means that a written declaration cannot simply be included in a court order, decree, or separation agreement. [See Reg. 1.152-4(g), Example 18.] However, written declarations that were executed on or before 7/2/08 are still okay as long as they complied with the rules in effect at the time.

5.   Return Attachment Test. The noncustodial parent attaches to his or her Form 1040 for the year the signed written declaration (Form 8332 or the equivalent). Amended final Reg. 1.152-4(e)(2) clarifies that a copy (rather than the original) should be attached.

Why the Noncustodial Parent Rule Is Important

When all of the preceding five tests are passed, the noncustodial parent is eligible for the following tax breaks with respect to the child to whom the noncustodial parent rule applies (assuming all the other qualification rules for these breaks are also met):

·         Section 152 Dependency Exemption Deduction. For 2008, this deduction is $3,500 (subject to partial phaseout for higher-income parents). IRS Notice 2006-86 says the deduction for a child to whom the noncustodial parent rule applies always belongs to the noncustodial parent.

·         Section 24 Child Tax Credit. This credit is $1,000 per eligible child (subject to AGI-based phaseout rules). IRS Notice 2006-86 says the credit for a child to whom the noncustodial parent rule applies always belongs to the noncustodial parent.

·         Section 25A Education Tax Credits. A parent can claim the Hope or Lifetime higher education tax credit (subject to AGI-based phaseout rules) for qualified tuition and related expenses incurred for a child for whom that parent can claim a dependency exemption deduction. Therefore, when the noncustodial parent rule applies to a child, the noncustodial parent can claim a Section 25A credit for that child’s education expenses, and the custodial parent is out of luck. [Notice 2006-86 doesn’t address the Section 25A credits, apparently because they are not often affected by the noncustodial parent rule. Once a child reaches the age of majority (18 in most states), custodial rules no longer apply. Instead, the general rules are used to determine dependency. Still, the noncustodial rule should apply if the child had not yet reached the age of majority.]

·         Section 221 Student Loan Interest Deduction. A parent can claim a deduction for up to $2,500 of qualified education loan interest expense (subject to AGI-based phaseout rules) incurred for a child who is that parent’s qualifying child under the Section 152 rules. Therefore, when the noncustodial parent rule applies to a child, the noncustodial parent can claim the Section 221 deduction for interest paid on education loans taken out for that child, and the custodial parent cannot. (Once again, Notice 2006-86 doesn’t address the Section 221 deduction, apparently because this break is not often directly affected by the noncustodial parent rule.)

·         Section 222 Tuition Deduction. Assuming Section 222 is reinstated without any changes (it expired at the end of 2007), a parent can claim a deduction for up to $2,000 or $4,000 of qualified tuition and related fees (subject to AGI-based disallowance rules) for a child for whom that parent can claim a dependency exemption deduction. Therefore, when the noncustodial parent rule applies to a child, the noncustodial parent can claim the Section 222 deduction for qualified tuition and fees paid for that child, and the custodial parent cannot. (Again, Notice 2006-86 doesn’t address the Section 222 deduction, apparently because this break is not often directly affected by the noncustodial parent rule.)

·         Other Tax Breaks. Amended final Reg. 1.152-4(f) stipulates that when the noncustodial parent rule applies to a child, both parents can claim the following three tax breaks: (1) itemized deductions for that child’s medical expenses under IRC Sec. 213(d)(5), (2) tax-free reimbursements for that child’s medical expenses under IRC Sec. 105(b), and (3) tax-free treatment for employee discounts and no-additional-cost services provided to that child under IRC Sec. 132(h)(2)(B).

On the other side of the coin, Notice 2006-86 says a noncustodial parent cannot claim the following four tax breaks when the noncustodial parent rule applies to the child in question.

·         Head of Household Filing Status. This advantageous federal income tax filing category, under IRC Sec. 1(b), cannot be used by the noncustodial parent based on a child to whom the noncustodial parent rule applies.

·         Child and Dependent Care Tax Credit. This break, under IRC Sec. 21, cannot be claimed by the noncustodial parent based on a child to whom the noncustodial parent rule applies.

·         Earned Income Tax Credit. This break, under IRC Sec. 32, cannot be claimed by the noncustodial parent based on a child to whom the noncustodial parent rule applies.

·         Tax-free Dependent Care Assistance Benefits. This break, under IRC Sec. 129, for assistance provided by an employer plan cannot be claimed by the noncustodial parent based on a child to whom the noncustodial parent rule applies.

The preceding four breaks generally belong to the custodial parent. In any case, the noncustodial parent cannot claim them based on a child to whom the noncustodial parent rule applies.

Custodial Parent Can Unilaterally Negate Noncustodial Parent Rule

The really big news in amended final Reg. 1.152-4 is potentially bad news for noncustodial parents for tax years beginning after 7/2/08. According to Reg. 1.152-4(e)(3), the custodial parent can unilaterally revoke an earlier release (including a release executed in a tax year beginning on or before 7/2/08) to the noncustodial parent of the right to claim the designated child as a dependent. This new unilateral revocation rule effectively allows the custodial parent to yank from the noncustodial parent all of the federal income tax benefits associated with the noncustodial parent rule—with or without cause!

The amended regulation says such a unilateral revocation is allowed even when the divorce papers clearly stipulate that the custodial parent must release to the noncustodial parent the right to claim the designated child as a dependent. Yikes! This certainly doesn’t seem very fair to all the noncustodial parents of the world, but it’s a great weapon for all the ticked-off custodial parents of the world—whether or not they have good reason to be ticked off! [See Reg. 1.152-4(e)(3) and 1.152-4(g), Example 20.]

How to Make Revocation. A revocation is accomplished by attaching to the custodial parent’s Form 1040 a copy of the yet-to-be-released new version of Form 8332 (or a successor form issued by the IRS). Alternatively, a revocation can be made with a separate document that conforms to the substance of new Form 8332 (or a successor form) and that is executed for the sole purpose of revoking an earlier release to the noncustodial parent of the right to claim the designated child as a dependent. The new version of Form 8332 will be called Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent.

Tax Years Affected by Revocation. A revocation must specify the year or years for which the revocation applies, and a copy must be attached to the custodial parent’s Form 1040 for each year that the revocation applies. A revocation for all future years is treated as taking effect starting with the first year after the year during which the revocation is executed.

Noncustodial Parent Must Be Notified. The custodial parent must provide the noncustodial parent with written notice of the revocation or make reasonable efforts to provide such notice. The revocation cannot take effect any earlier than the year after the year in which the custodial parent provides notice to the noncustodial parent (or makes reasonable efforts to provide such notice). The custodial parent must keep a copy of the revocation and evidence of delivery of the required notice to the noncustodial parent (or attempts to deliver such notice).

Observation: The only ray of sunshine for noncustodial parents is the fact that the new unilateral revocation rule doesn’t become effective until tax years beginning after 7/2/08. In other words, it could bite noncustodial parents for 2009 and later years, but at least it can’t bite for 2008. Another small consolation is the fact that attempted revocations that fail to meet all the requirements just explained will have no effect.

Conclusion

As stated earlier, we think the unilateral revocation rule is the really big news in the amendments to final Reg. 1.152-4. If this provision was really intended by our beloved Congress, what in the heck were they thinking? The amendments also include some other relatively important changes, which we have summarized in this article, as well as some painfully detailed guidance on determining when a parent has custody of a child for a particular day and so forth, which we have completely ignored (as will taxpayers). If you’re the curious type, please feel free to read Reg. 1.152-4 in its entirety to get the full picture.


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Published by Reed Tinsley CPA
Copyright 2008 Reed Tinsley CPA. All rights reserved.
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