The Tax Benefit of Having Children:
After a Divorce, Who Claims the Tax Exemption?
By: JOHN L. NELSON, Client Financial Services Manager
Winter 1995
In a divorce involving minor children, custody is an important issue to resolve. Once that decision is reached, a related issue that needs to be resolved is which parent will claim the children as dependents for tax purposes.
The parent who has custody may not be the best parent to take the exemption. Both parents can benefit if the decision regarding allocation of the exemption is a purely economic one, with allocation to the parent who will derive the greatest tax benefit from the exemption. An adjustment to the amount of child support or maintenance paid will, in turn, benefit the other parent.
The first part of this article will analyze which parent should receive the exemption from an economic standpoint. The second part of the article will examine the appropriate steps to take to allocate an exemption to a particular parent.
Which Parent Should Receive the Exemption?
From a purely economic standpoint, the parent who derives the greatest tax benefit from the exemption should claim the exemption on his or her tax return. In general, this tax benefit is determined by multiplying the amount of the exemption by the parent's marginal tax bracket. For example, in 1995, each exemption reduces taxable income by $2,500 (this amount adjusts annually for inflation). For individuals in the 15 percent and 28 percent tax brackets, the exemption is worth $375 and $700, calculated as follows:
$2,500 x 15% = $375
$2,500 x 28% = $700
Similar calculations are made for the other tax brackets. However, this calculation is complicated by the fact that as income increases above a certain level, tax law limits the amount of the exemption you may take. In 1995, since individuals start to lose the benefit of the exemption when adjusted gross income exceeds $114,700. The benefit of the exemption is completely lost when adjusted gross income exceeds $237,200.
As illustration will show how the proper allocation of the exemption can increase total after-tax income for both spouses. Assume the following facts:
Two dependent children;
Custodial parent in the 15 percent tax bracket;
Noncustodial parent in the 28 percent tax bracket; and
The amount of the dependency exemption is $2,500.
For the custodial parent, the two exemptions reduce taxes by $750. For the noncustodial parent, the two exemptions will reduce taxes by $1,400. If the custodial parent gives up the exemptions in exchange for additional child support of $1,075 per year, that parent would have additional after-tax income of $325 ($1,075 payment less the $750 in lost tax savings). The noncustodial parent would take the exemptions, and also have an additional $325 of after-tax income ($1,400 tax savings less the $1,075 payment).
Who is Entitled to The Exemption?
Unless specific steps are taken, tax law grants the dependency exemption to the custodial parent, regardless of the actual amount of support provided by that parent. This is true even if the custodial parent provides no support to the dependent.
To overcome this general rule, tax law requires the custodial parent to release the exemption to the noncustodial parent. To do this, the custodial parent signs a written declaration that he or she will not claim the child as a dependent, and the noncustodial parent attaches the declaration to his or her tax return. The IRS provides Form 8332 to use as the declaration by the custodial parent. However, any similar statements may be used as long as it contains the necessary information.
An alternative way to allocate the exemption to the noncustodial parent is described in the instructions to Form 1040. A divorce decree or separation agreement can be attached in lieu of Form 8332 if the decree or separation agreement unconditionally states that the noncustodial parent can claim the child as a dependent. Note that a requirement that child support payments be current to claim the exemption is not an unconditional right to claim the exemption.
The allocation of the exemption can be for one year or for several years. The allocation also can change between parents from year to year.
Summary
When a divorce is being negotiated, the allocation of the exemption should be determined based on maximizing the tax benefit of the exemption. This can be done annually, and any changes in the exemption can be offset by a corresponding change in child support or maintenance.
Unless IRS rules are complied with, the dependency exemption goes to the custodial parent, regardless of the amount of support provided. Form 8332 is the IRS' provided mechanism for the noncustodial parent to claim the exemption. Alternatively, a divorce decree unconditionally granting the noncustodial parent the exemption can be submitted to the IRS.