Dependent Care Credit

The child and dependent care credit (hereafter abbreviated as dependent care credit), a nonrefundable credit that can be taken against regular and alternative tax liability, provides relief to those able to work (or look for work) only if care, at a price, is provided for their dependents. Like other tax credits, the dependent care credit provides a 100% after-tax savings for each dollar of credit a taxpayer is able subtract from income tax liability; deductions, on the other hand, deliver an after-tax savings equal to the taxpayer’s marginal tax rate (at present, the highest marginal tax rate for individual taxpayers is 35%). In short, credits are more valuable than deductions. Unfortunately, there is no carryover for any unused dependent care credit.

Eligible taxpayers can take a credit of up to 35% of employment-related (pdf file) for qualifying individuals, where the total of employment-related expenses is limited to the taxpayer’s earned income. (Note: Earned income includes wages, salaries, professional fees, tips, and other payments for personal services but not interest and dividends.) Expenses incurred during the time a taxpayer is able to secure, or search for, gainful employment only if others are paid to care for taxpayer’s dependents are classified as employment-related expenses for purposes of the dependent care credit. Gainful employment includes the obvious such as working for others part- or full-time or being self-employed but not volunteer work at nominal pay. In addition, the Internal Revenue Code is written in a way that prevents a double tax benefit, that is, payments received by a taxpayer from an employer-provided are subtracted from the total of expenses available for the dependent care credit. Click on (pdf file) for a worksheet that helps a taxpayer optimize his or her tax situation via a comparison of the dependent care credit with an employer-provided flexible spending account. (Note: IRS Form 2441–Child and Dependent Care Expenses–and related instructions, two vital documents for those investigating the dependent care credit, have been posted to my Tax Forms page on the navigation menu above.)

Dependent care expenses attributable to any part of the year in which a taxpayer is not working or looking for work are not eligible for the dependent care credit. Put differently, only dependent care expenses allocable to the time during which a taxpayer is actually employed or looking for gainful employment qualify for the credit.

Expenses do not qualify for the dependent care credit if paid to (1) a person the taxpayer can claim as a dependent, (2) taxpayer’s spouse, or (3) taxpayer’s child who is under age 19 at the end of the tax year. In addition, no credit is allowed for the cost of sending a child or other dependent to an overnight camp.

A taxpayer must file a joint return if married in order to claim the dependent care credit. (Note: A married taxpayer providing a principal place of abode for a qualifying dependent but living apart from his or her spouse for the last six months of the tax year is considered unmarried and qualifies as a head of household filer for purposes of the dependent care credit). In the case of a married couple, the total of employment-related expenses eligible for the credit can be no more than the earned income of the lower-earning spouse. More important, if one spouse is not working then the married couple cannot take the dependent care credit. However, just in case a nonworking spouse is a full-time student for at least five calendar months or disabled and the couple has one qualifying dependent, federal law, for the sole purpose of calculating the earned income of the lower-earning spouse, assigns to the nonworking spouse earned income of $250 per month each month the spouse is disabled or attends school ($500 per month if the couple has two or more qualifying dependents) thus making the couple eligible for the credit. While this exception creates earned, but not taxable, income for the unemployed spouse by statutory maneuver, it does not apply when both spouses are unemployed.

Since the credit addresses only a fraction of total dependent care costs necessary for gainful employment, the maximum amount a taxpayer can write off is $1,050 for the care of one qualifying dependent ($3,000 x 35%) and $2,100 for two or more qualifying dependents ($6,000 x 35%). The top rate of 35% is reduced by one percentage point for each $2,000 increment, or portion thereof, of adjusted gross income (AGI) above $15,000 and bottoms out at 20% for taxpayers with AGI greater than $43,000. An increment of AGI greater than $2,000 causes a two-bracket jump thereby reducing the fraction of available dependent care credit by two percentage points. For example, a taxpayer with AGI of $17,300, an AGI producing an increment $2,300 above the $15,000 threshold, jumps not one but two brackets, landing in the $17,001-to-$19,000 bracket and its smaller proportion of expenses (33% to be exact) open to the dependent care credit. But click on (pdf file) for a brief examination of why the dependent care credit may not work for married couples and other important shortcomings of the credit.

An individual qualifies for the dependent care credit under the following circumstances:

The non-exhaustive list below identifies several employment-related expenses (to repeat: expenses necessary for gainful employment, or job search activities, of a taxpayer) that qualify for the dependent care credit:

  1. Wages and taxes paid in connection with household services performed by a full-time, live-in employee for the benefit of taxpayer’s qualifying dependent; in this type of arrangement, the taxpayer, as employer, may be required to pay employer’s, and withhold employee’s, share of FICA and federal and state unemployment taxes;
  2. Services for taxpayer’s qualifying dependent or disabled spouse at a properly licensed outside dependent care center provided the individual in question regularly spends at least eight hours a day in the taxpayer’s home;
  3. Payments to a babysitter, cook, housekeeper, maid, etc. for household services that benefit taxpayer’s qualifying dependent, including the cost of providing meals and lodging for any in-home provider;
  4. Nursery school and kindergarten costs, but any separable educational benefits must be subtracted from the total of qualifying expenses; and
  5. The cost of a special school program.

Refer to the list of relevant articles below for more information about the dependent care credit:

Many happy returns, Roger

Child Tax Credit

Taxpayers can take a $1,000 tax credit through 2010 for each qualifying child under age 17. Except for taxpayers who qualify for the Additional Child Tax Credit (see below), the is nonrefundable and taken against the sum of regular and alternative minimum tax (AMT) liability. The difference between refundable and nonrefundable tax credits is important as refundable credits, unlike their nonrefundable cousins, can be used to offset taxes other than the income tax and reduce or eliminate the recapture of other tax credits.

The order of personal tax credits is important in the case of the child tax credit. Specifically, nonrefundable personal credits must be taken in the following order:

  1. Credit for child and dependent care expenses;
  2. Credit for the elderly or the disabled;
  3. Education credits, that is, Hope and Lifetime Learning Credits;
  4. Residential energy credits;
  5. Foreign tax credit;
  6. Child tax credit;
  7. Retirement savings contributions credit;
  8. Home mortgage interest credit;
  9. District of Columbia first-time homebuyer credit;
  10. Qualified adoption expenses credit;
  11. Alternative motor vehicle credit; and
  12. General business credit.

The child tax credit is subject to phase out when modified adjusted gross income (AGI) is over $75,000 for head of household filers, single taxpayers, and surviving spouses; $110,000 for taxpayers married and filing jointly; and $55,000 for taxpayers married and filing separately. (Note: Modified AGI is AGI increased by the following items: student loan interest deduction, tuition and fees deduction, foreign earned income exclusion, foreign housing deduction or exclusion, deduction for domestic producers, and several other items not relevant to the discussion in this article.) The $1,000 credit is reduced or phased out by 5% for each $1,000 increment of AGI above the threshold.

Example 1: Assuming only the existence of the child tax credit and sufficient tax liability to extinguish it, a single taxpayer with two qualifying children under age 17 and AGI of $80,400 would be able to take a credit of $700 for each child, or $1,400 total, calculated as follows: $80,400 AGI - $75,000 threshold level = $5,400/$1,000 per increment = 5.4 increments above the threshold level but any fraction of an increment is rounded up making 6 increments in this case; 6 increments x 5% = 30%; $1,000 - (30% x $1,000) = $1,000 - $300 = $700 credit per child x 2 children = $1,400.

A child qualifies for the child tax credit if he or she meets all the following requirements:

For a more comprehensive definition of qualifying child, click on .

In cases where the child tax credit is refundable, it is labeled as (pdf file) and available to taxpayers with at least one qualifying child but without sufficient tax liability to extinguish the regular child tax credit. The refundable portion of the child tax credit is 15% of earned income (plus tax-free combat pay, if any) in excess of $11,750 reduced by the amount of regular child credit. Click on for instructions on how to calculate and claim the regular and additional child tax credits.

Example 2: Modifying Example 1 above, assume the single taxpayer doesn’t have sufficient tax liability to consume the regular child tax credit, say, a regular tax liability of $1,000 (but no AMT liability). He would be eligible for a refundable credit or additional child tax credit calculated as follows: (1) after reducing regular tax liability to zero, the taxpayer is left with a $400 child tax credit ($1,400 regular child tax credit - $1,000 tax liability); (2) comparing the 15%-of-earned income-over-$11,750 test amount or $10,298 ([$80,400 - $11,750] x 0.15) with $400 in step one and choosing the smaller, we discover the taxpayer is eligible for a refundable credit of $400 (remember our taxpayer is subject to phase out of the child tax credit since his AGI exceeds $75,000 thereby reducing the maximum credit per child from $1,000 to $700). Final tally for our single taxpayer: $1,000 regular child tax credit + $400 additional (refundable) child tax credit = $1,400. This example also illustrates the rule that any portion of the child tax credit that is phased out is lost and not recoverable by means of the additional child tax credit.

For taxpayers with three or more qualifying children, the additional child tax credit is the greater of (1) the result of the process outlined in Example 2 above for one or more qualifying children, that is, the smaller of the remaining child tax credit or 15% of earned income over $11,750 or (2) the excess of the taxpayer’s employee share of Social Security (FICA) taxes paid (including, if applicable, one-half of self-employed tax liability) over the , where this excess amount is limited to the child tax credit remaining after reducing regular and alternative tax liability to zero. In effect, the test for three or more children brings the difference between Social Security taxes paid and the earned income credit into the equation.

More information on the child tax credit is contained in the relevant articles listed below:

Many happy returns, Roger

Alimony

For purposes of the federal income tax, alimony refers to the written obligation of one spouse to make periodic cash or cash equivalent payments to the other spouse for maintenance and support during the time the couple is (1) separated, (2) involved in a matrimonial lawsuit, or (3) divorced. Alimony is also correctly described as maintenance, support, maintenance and support, or spousal support.

In determining the alimony deduction, checks and money orders are considered to be cash equivalents. However, attempts to satisfy an alimonial obligation by (1) transferring property or services, (2) making provision for the free use of property, or (3) executing a debt instrument are not considered alimony under federal tax law and therefore not deductible.

is deductible by the payor spouse and taxable income to the recipient spouse. In the lexicon of tax law, alimony is a deduction from gross income or what is otherwise known as an above the line deduction; in short, a taxpayer doesn’t have to itemize in order to write off alimony payments.

Alimony may be treated as child support if payments change in response to the happening of an event or contingency relating to a child. Specifically, payments designated as alimony may be reclassified as nondeductible child support if they are reduced (1) within six months before or after a child reaches age 18, 21, or the local age of majority; (2) on two or more occasions within a year after a child reaches a certain age between 18 and 24; or (3) at the time a child marries or dies. And if the payor spouse is obligated to make both child support and alimony payments but comes up short, proceeds received by the recipient spouse are first applied to child support. In other words, alimony is deductible only after child support has been paid in full. For a lucid summary of alimony versus child support click on (pdf file).

In deciding whether a payment qualifies as deductible alimony, the Internal Revenue Code trumps state and domestic relations laws, including divorce agreements and court orders. What may be considered as alimony under state law may not be considered as such under the Code and vice versa.

To be deductible, alimony must be governed by a written divorce or separation instrument. Divorce or separation instruments include “(A) a decree of divorce or separate maintenance or a written instrument incident to such a decree, (B) a written separation agreement, or (C) a decree…requiring a spouse to make payments for the support or maintenance of the other spouse” [Code Section 71(b)(2)]. The instrument does not have to be binding under state law but it must clearly outline the terms of support for the separated parties. Payments made before the execution of such instrument or prior to the effective date of a decree or order of support are not deductible as alimony even if the divorce or separation instrument is made to retroactively account for these payments. And voluntary payments or payments that exceed what a written divorce or separation instrument requires are not alimony and hence not deductible.

Payments qualify as alimony under the Code only if all the requirements listed below are satisfied:

  1. Payments must be made in cash or cash equivalents;
  2. Payments must be made to, or on behalf of, a spouse or former spouse;
  3. The divorce or separation instrument cannot explicitly state the payments are not alimony;
  4. Payments are not characterized in the divorce or separation instrument as being nondeductible by the payor spouse and tax-free to the recipient spouse;
  5. Payments cannot be designated as, or considered to be, child support;
  6. Payor and recipient spouses cannot be members of the same household at time of payment;
  7. Payor and recipient spouses cannot file a joint income tax return; and
  8. The obligation to make payments must end at the time of the recipient spouse’s death.

Although listed as constraints, items (3), (4), and (5) above also create financial planning options for the divorcing or separating couple, even if the primary purpose of any given allocation of alimony and child support payments is to avoid tax. But the recipient spouse should be aware that alimony ends upon the death of the payor spouse.

The reason for requiring alimony payments to be made in cash or cash equivalents is to ensure that noncash property transfers between spouses incident to divorce conform to Section 1041 of the Code. In effect, for Section 1041 property transfers incident to divorce (i.e., transfers made within one year of the divorce or related to the dissolution of the marriage), the transferee spouse takes a carryover basis, that is, a basis and holding period equal to that of the transferor spouse. Section 1041 transfers are not deductible by the transferor spouse and not income to the transferee spouse.

Cash payments to third parties by the payor spouse to satisfy a spouse’s or former spouse’s obligations (e.g., automobile insurance, credit card bills, rent, tuition, etc.) qualify as alimony. But if a spouse or former spouse resides in a house owned by the payor spouse (that is, payor spouse is the principal obligor on the mortgage debt), payments on behalf of the spouse or former spouse are not considered alimony. A similar restriction is placed on life insurance: the recipient spouse must be the irrevocable beneficiary and owner of the policy for payments to qualify as alimony.

The IRS considers the substance of a live-in divorce or separation to be tax avoidance despite the existence of a formal, written instrument. In other words, because of the income-shifting potential of a live-in divorce or separation and the negative effects on federal revenue intake that could result from such arrangements, payor and recipient spouses cannot live together.

An essential element in the legal definition of alimony is the existence of a living person for a payor spouse to maintain or support. Therefore, payments made after the death of a spouse or ex-spouse cannot, by definition, be designated as alimony.

Payments must be periodic in nature, and the consider uneven cash or cash equivalent payments posing as alimony to be in substance nondeductible lump sum property settlements unless the lump sum payment represents past-due alimony. If alimony payments decrease significantly after the first or second year of scheduled payments, where a decrease of more than $15,000 is considered significant, the payor spouse may be subject to Section 71(f) recapture.

The first component of possible recapture is based on a comparison between alimony payments in the second and third years. If the second year payment is more than $15,000 higher than the third, the excess is subject to recapture. The second component of recapture examines the difference between the first year payment and the average of the second and third year payments. Again, if the first year payment is more than $15,000 higher than the average of the second and third year payments, then the excess must be recaptured.

For example, if alimony payments are $40,000 in the first and second years and $20,000 in the third, the payor spouse will have to recapture a total of $5,000 in the third year. In this calculation, the first comparison between the second and third years shows a difference of $20,000 ($40,000 second year payment minus $20,000 third year payment), with $5,000 being subject to recapture ($20,000 difference minus $15,000, the amount earmarked in the Code as representing a significant difference between alimony payments). The second comparison between the first year payment of $40,000 and the average of the second and third year payments ([$40,000 + $20,000]/2 or $30,000) yields a difference that is less than $15,000 and therefore not subject to recapture. Click on for a quick and dirty application for those with math anxiety.

However, alimony payments made after the third year are not subject to the recapture provisions of Section 71(f). Furthermore, Section 71(f) recapture does not apply to significant decreases in alimony payments brought about by (1) recipient spouse’s remarriage or death or (2) changes in payments lasting for at least three years and fixed as a percentage of income from the payor spouse’s business, employment, or property.

In the case of recapture, excess alimony deductions taken by the payor spouse are reversed in year three of the payment schedule by including these amounts in income. A similar process holds for the recipient spouse: amounts previously booked to income are reversed by means of a deduction reported on the third-year tax return.

Alimony trusts are governed by Section 682(a) of the Code and, in terms of deduction and inclusion, produce results similar to those under regular alimony arrangements: trust income from a properly crafted alimony trust is excluded from payor’s gross income but is taxable to the recipient spouse.

Additional relevant articles on the federal income tax consequences of alimony are listed below:

Many happy returns, Roger

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