After the historic June 26, 2013, Supreme Court ruling that Section 3 of the Defense of Marriage Act (aka DOMA) was unconstitutional, many LGBT couples happily committed to legal marriage in 2013 and even more are considering nuptials in the near future. However, many couples, for a variety of reasons, have not yet taken the plunge. Our LGBT tax consulting experts have identified several economic and tax considerations LGBT couples may want to quantify when assessing the financial impact of marriage. This is the first in a series of blogs that will address these issues.
No individual blog in this series should be viewed singularly since there are many variables that would impact a couple’s decision to get married. To discuss your specific situation, contact us and someone from our dedicated LGBT services team will contact you.
Today, we address a tax planning and/or refund opportunity for current or previously unmarried LGBT parents.
Who Should Claim the Kids?
Often, the misconception is that the higher-wage earner in a family with unmarried cohabitating parents should take “all the tax deductions,” including dependency exemptions for the couple’s children. There are several reasons this presumption may cause a larger combined tax bill for families; these include the Alternative Minimum Tax (AMT), Child Tax, Earned Income, Education and Dependent Care Credits. When couples prepare their own tax returns or employ separate tax advisors to prepare their tax returns, this issue can be easily overlooked, potentially costing families thousands of tax dollars annually.
Alternative Minimum Tax
AMT is a required alternative computation of tax that denies certain deductions in an effort to assure all taxpayers pay a minimum level of tax. These denied deductions are referred to as tax preferences or adjustments. Common examples of AMT adjustments are the disallowance of deductions for personal and dependency exemptions, and for state and local income taxes paid. If you have several dependents and live in a high-tax state or locality such as California, New York City, New Jersey or Philadelphia, the elimination of your personal and dependency exemptions and your state and local income tax deductions may cause you to be subjected to AMT.
If the higher-earning parent is subject to AMT, they are receiving no tax benefit for their children’s dependency exemptions. If the lower-income parent is not subject to AMT and has taxable income, they will likely receive a tax benefit by claiming the children.
Each parent may qualify for the dependency exemption of their children if that child is their “qualifying child.”
A qualifying child is someone who (1) lives in your home for over half the year, (2) is your child, stepchild, adopted child, or foster child, or your brother or sister or stepsibling (or a descendant of any of these), (3) is under 19-years old (or a student under 24), and (4) does not provide over half of his or her own support for the year. The qualifying child must also be younger than you. To be your dependent, the qualifying child must be a U.S. citizen or a resident of the U.S., Canada, or Mexico and must not file a joint return for the year.
If your child can be claimed as a qualifying child by both parents special “tie-breaking” rules may apply. However, Q3 in the IRS FAQs for Registered Domestic Partners and Individuals in Civil Unions seems to indicate that the tie-breaking rule would only apply if both cohabitating same-gender parents claimed the children simultaneously (e.g., in error). See Tax Warrior Perspective below, for tips on how to avoid this issue.
Dependent Care & Education Credits
If you paid someone to care for your qualifying child so you could work, you may be eligible for the child and dependent care credit. This credit is available if, to work or to look for work, you paid for child care services for dependents under age 13. Income thresholds affect the credit you may receive. If you earn less than $15,000 you may qualify for a credit of up to 35% of what you paid for childcare and if you earn over $43,000 you may qualify for a credit of up to 20%. A higher percentage of your childcare expenses may be available for credit if the lower-income parent claims the children.
You may be able to take a credit for some of your children’s higher education tuition expenses. There are two tuition tax credits available and both phase out for higher-income taxpayers at different income levels. It is likely that the lower-income parent will qualify and benefit from any applicable tuition tax credits that may apply to your children, while the higher-income parent may receive no benefit.
Child Tax Credit
The Child Tax Credit (CTC) allows you to claim a credit of up to $1,000 for each qualifying child. The allowable credit is reduced by $50 for each $1,000 (or part of $1,000) of modified adjusted gross income (MAGI) above the $75,000 threshold for single filers and heads of household.
The higher-wage-earning parent would receive no CTC if their MAGI is over $95,000. Alternatively, the lower-earning parent may qualify for the CTC. The beauty of this credit is that it can be a ‘refundable credit,’ that is, the government sends you a check even if you don’t have a tax liability.
Earned Income Credit (EIC)
In general, you qualify for the EIC if your income doesn't exceed certain amounts. However, even if the lower-income-earning parent falls within the earned income and AGI limits, their investment income must be $3,300 or less (in 2013) to qualify for the EIC.
Since the EIC earned income and AGI limits are modest (ranging from $14,340 with no qualifying children - $46,227 if you have three or more qualifying children in 2013), your family probably would receive the greatest benefit (if any at all) from the EIC, if the lower-earning parent claims your children.
In 2013, the maximum EIC ranges from $487 if you have no qualifying children, to $6,044 if you have three or more qualifying children. Similar to the CTC, even if the allowable EIC is more than your income tax liability, the excess may be refundable.
Usually, the higher-earning parent will qualify for head of household (HOH) status even if the lower-earning parent claims the dependency exemptions for the children. Both parents may not claim HOH status if they cohabitate, since only one can mathematically pay over half of the cost of running the household, the main qualification for the HOH filing status.
To take advantage of the potential tax savings summarized above, amended tax returns will be required for both parents. The higher-income-earning parent will need to amend to remove the children as dependents from their returns. Amending may cause a tax due. However, often the higher-income parent’s amended return will be tax neutral if they were subject to AMT, creating no additional tax liability. A corresponding amended return would be filed for the lower-income-earning parent to add the children as dependents, reaping some or all of the many tax benefits noted above. Please consult a tax advisor.
Tax Warrior Perspective
In certain extreme cases, a family could reduce their tax bill by over $6,000 per year; however, it has been our experience that most families will benefit by reducing their combined tax liabilities by $2,000-$4,000 per year if they employ this tax strategy or amend their prior-year tax returns.
The amended return removing the dependency exemptions should be filed at least a week before the corresponding amended return adding the dependency exemptions to avoid processing errors by the IRS. We also recommend attaching a statement to each return stating the parents are the same gender and cross reference both parents’ names and social security numbers.
IMPORTANT: All amended returns should be filed by the expiration of statute of limitations for the applicable tax year.
Time is running out for families to file amended returns for the 2010 tax year if they filed their original 2010 returns by April 15, 2011. Contact us now and someone from our dedicated LGBT services team will discuss your specific situation and determine if filing amended returns may be beneficial for your family.