Do you qualify for child or dependent tax breaks?

The Internal Revenue Code contains a variety of exemptions, deductions and credits designed to ease the federal tax burden on people with children or other dependents. For many years, these provisions had different definitions of “qualifying child.” This inconsistency caused a great deal of confusion among taxpayers and led to a lot of tax return errors.

The Working Families Tax Relief Act of 2004 (WFTRA) sought to simplify this aspect of the tax code by creating a uniform definition of qualifying child. For the most part, it appears that the act has succeeded. Determining whether someone is a qualifying child for purposes of several of the most common tax breaks is a matter of applying four simple tests. In some cases, the new definition leads to surprising — and arguably unintended — results.

Take the qualifying child test

WFTRA’s uniform definition of a qualifying child applies to the dependency exemption, the child credit, the child and dependent care credit, the earned income credit (EIC) and head-of-household filing status. You can claim a person as your child for purposes of these tax breaks if you meet all four of these tests:

1. Relationship. The person is your child, stepchild, eligible foster child, sibling (including a stepsibling or half-sibling) or one of their descendants.

2. Residency. The person lives with you for more than half the year. Temporary absences — due to illness, military service, or school, for example — count as time living at home.

3. Age. The person is under a certain age, but this is one area where the uniform definition isn’t uniform. Age limits vary depending on the tax break involved. (See “Not for all ages” on sidebar.)

4. Support. Unlike under the definition of a dependent, you need not provide more than half of a qualifying child’s support, so long as the child doesn’t provide more than half of his or her own support. One exception is the EIC, which allows you to claim that credit even if your child provides more than half of his or her own support.

There are special rules for divorced or separated parents, as well as tie-breaking rules in the event that more than one taxpayer claims the same qualifying child. And, as before, a qualifying child can’t file a joint return with his or her spouse and generally must be a citizen or resident of the United States, Canada or Mexico.

Determine if the dependency exemption applies

You can claim a dependency exemption for a qualifying child or for a “qualifying relative.” A qualifying relative is someone who doesn’t meet the definition of qualifying child because of the age requirements but does meet these pre-WFTRA tests:

Relationship. The person is a relative (including any of the qualifying-child relationships, plus your parents, stepparents, grandparents and other direct ancestors, nieces, nephews, aunts, uncles and certain in-laws) or is a member of your household for the entire year.

Joint return. The person doesn’t file a joint tax return with someone else.

Citizenship. The person is a citizen or resident of the United States, Canada or Mexico.

Gross income. The person’s gross income is less than the personal exemption amount (currently $3,400).

Support. You provide more than half of the person’s support during the year.

Keep in mind that you can’t claim someone as a dependent if you’re claimed as a dependent on another person’s return.

Watch for odd results

WFTRA creates some peculiar results involving the dependency exemption. The reason for this is the rule that a person who is a qualifying child of one taxpayer can’t be a qualifying relative of another taxpayer.

Let’s see how this rule can work. Michelle, age nine, and Jennifer, age seven, are sisters. Their parents died a few years ago and now they live with their adult cousin, Amy. Even though Amy fully supports Michelle and Jennifer, she doesn’t qualify for the dependency exemption. Amy can’t claim Michelle and Jennifer as qualifying children, because the relationship requirement doesn’t include cousins. And she can’t claim the sisters as qualifying relatives, even though they live with her year-round, because Michelle and Jennifer meet the definition of qualifying child with respect to each other.

This is just one example of several inequitable results caused by the new rules. There are bills pending that would eliminate many of these issues.

Shift tax breaks

Dependency exemptions and certain other child-related tax breaks are phased out for higher-income taxpayers. In 2007, for instance, the dependency exemption is eliminated for joint filers whose adjusted gross income (AGI) exceeds $357,100 and single filers with an AGI greater than $278,900. And the child credit is eliminated for joint filers with AGIs above $130,000 and single filers with AGIs above $95,000.

By eliminating the requirement that taxpayers provide more than half of their qualifying child’s support, WFTRA creates an opportunity for high-income parents to shift tax breaks to their offspring. To take advantage of this strategy, you must meet other requirements.

Keep an eye out

Congress is considering modifications to the uniform definition of qualifying child. So be sure to keep an eye on legislative developments and consult your tax advisor to see how they, or other changes, may affect your tax planning strategies. •