Understanding the Dependency Deduction
By Sharan Sawhney, CPA and Matthew E. Miller, CPA, MBA
The tax filing season will shortly begin. With it will come the filing of new graduates’ income tax returns. One of the more frequent questions taxpayers face each tax year is whether or not they can or should still claim their graduate as a dependent on their tax return.
Parents and new graduates need to coordinate their tax filing so each knows who is claiming the exemption for the recent graduate since both can’t claim a deduction. Typically what happens is the new graduate receives their W-2 from their new employer, downloads a tax preparation software, enters their tax data, claims a personal exemption for themselves, and submits an electronic return. Taxes Done! Mom and Dad prepare their return and if they also list their new graduate as a dependent, when they electronically file the return, the return gets rejected because their new graduate has already claimed themselves on their tax return. But who correctly claimed the exemption?
“Can I still claim my graduate on my tax return”?
There are four tests to determine if your child is your dependent. While there are always exceptions and unique circumstances, these four tests will get most of us to the correct determination.
The four tests have a few complexities. Let’s look at each one.
Relationship – The graduate must be a child or stepchild, grandchild (whether by blood or adoption), foster child, sibling or stepsibling, or a descendant of one of the taxpayers. If they are, they may be your “Qualifying Child”.
That is an easy test which you had to meet in year one of claiming the child as your dependent. The fact that they graduated from college doesn’t change your relationship. The only thing new to us under the test is the introduction of a new defining term “Qualifying Child”.
Age – We are going to begin to tighten the requirements here. During the entirety of the year, the qualifying child must be under the age of 19, or under the age of 24 and a full-time student.
Relax, you’re fine. A full-time student is anyone enrolled in a degree program for at least 5-months during the year.
So far I think we can conclude you have met the 1st two tests.
Residency – Your qualifying child must have lived with you for at least half the year. I know what you’re thinking, ‘they lived in an off-campus apartment’. Not to worry, your child is considered living with you, even if not in your house, if the reason for their temporary absence was for education.
Example 1: Stuart participates in his college’s commencement exercises in May, 2016. Prior to graduation he accepted a position with a company located in Seattle and has an anticipated start date of June 1st. Stuart’s parents live in Charlotte, NC. After graduation Stuart returns to Charlotte for a quick family visit, then late May, he moves to Seattle.
Ok, this one is easy. Stuart will not meet the residency test to be claimed as a dependent on mom and dad’s 2016 return. Agreed? Stuart will claim his personal exemption on his own return.
Example 2: The facts are the same as above except Stuart’s start date is September 1st. Stuart still returns to Charlotte after graduation. He has the summer to burn. Mid-June, Stuart and a couple friends travel to the islands for sun and fun. He returns, packs his bags, hugs mom & dad, then heads to Seattle.
Still a dependent? Was the trip to the island a temporary absence?
Now, not every graduate moves back home after commencement. Sometimes the period of time between graduation and the start of employment is extended.
Support – Your child has their first full-time job! Again, congratulations. Does this mean they are no longer your dependent? Maybe, maybe not. This is the most complex test and the test that has the most impact on other tax areas of your return, and theirs.
Provided the above three tests are met, to claim your qualifying child as your dependent you must have provided more than half of your child’s support for the year. In the year of graduation that may be easy, it may not be. Support includes expenses related to lodging, food, transportation, education, clothing, and the dependent’s share of any household expense (while they lived with you).
This is a simple 50% test, with lots of what do I count, how do I value? Make a list! The education costs and your fair market value of housing when they were away at school are going to be amounts entered in your column.
Example: Jennifer graduated in late May 2016. She moved back home to Arlington, VA. From a prior summer internship she was offered a job in Washington, DC. She decides she will live at home for a year so she can save some money. Her job doesn’t start until mid-August, so she leaves for a couple of weeks to visit her grandparents in Illinois.
She returns from Illinois early August and starts her new job.
What your graduate earns during the year is of little matter in this test. What goes in their support “column” is what they spend to support themselves.
Example continued: Each semi-monthly paycheck Jennifer contributes to her 401(k), puts 25% of her paycheck in her savings account, gives mom and dad $100 for groceries and an extra $50 for her cell phone. Jennifer owns her own car, an old family vehicle. She pays gas and maintenance. She pays parking in her building. Pays for her personal needs of clothing and other expenses.
By year end Jennifer has earned $28,000. Her W-2 taxable income reports $21,000 because Jennifer contributed $7,000 to her 401(k). Is the amount of her taxable income the test for her support? “No”, the amount used in the test for her support is what she actually pays for her support.
Clearly, this is the most time consuming measure to see if you pass the dependency tests. Please be careful not to just “punt’ and decide to allow your child to claim the deduction. Review the qualifying test with your child, tally some support amounts, and conclude who can claim the dependency deduction. Each year thousands of e-filed parent returns are rejected by the IRS because both the parent and the child have claimed the same dependency deduction.
Who Is Entitled to the Deduction? IRC section 151 states that an individual who is eligible to be claimed as a dependent on another taxpayer’s return cannot claim an exemption for himself.
Only the taxpayer who is eligible to claim the dependency deduction can elect to claim the deduction. This is true even when the tax benefit of the dependency exemption claimed on the parents’ return is eliminated or reduced by the phase-out rules or through alternative minimum tax.
Here is a practical example:
Example: Its mid-March 2016, Judy is sitting down at her computer to prepare her joint tax return with her husband, Larry. They’ve had a good income year. Judy and Larry have three children, the oldest of which, Charles, graduated from college after the summer session 2015. All three children are claimed as dependents on Judy and Larry’s return as they meet the dependency tests. As she reviews a draft of the return, Judy notices line 42 Exemptions is showing zero. She is expecting the amount to show $20,000. Quickly, she goes to IRS website to get an understanding of why she doesn’t get any of her personal exemptions. She reads the 1040 instructions and then recalls one of the funding mechanisms of the ACA was to eliminate the personal exemption deduction for higher earning Americans. She expels a sigh!
Like all of us, Judy wants to figure out any way to claim a deduction.
Example continued: She thinks ‘I haven’t done Charlie’s return yet. He gave me his W-2 a couple of weeks ago.’ She opens the tax software and loads Charlie’s return information from last year, eliminates the input on the box “Dependent of another”. She enters the W-2 information, some interest and dividend income earned on money gifted from his grandparents. She looks at a draft of the return to make sure $4,000 showed up on line 42; it did! Happy, she relaxes in her chair, looking at the screen. A small victory! Even though Charlie is in a lower tax bracket, she saved a couple bucks in tax.
Was Judy’s preparation correct? Most probably not.
With increased scrutiny from the IRS, it is important for you and your child to understand the dependency rules and discuss who is entitled to and who is claiming the dependency exemption on their tax return. As you can see, making this determination involves extensive planning and evaluation. If you need us to help guide you through this process, we are happy to help.