Tax Guru – Ker$tetter Letter

Q:

Mr Guru – hope you don’t mind my picking your brains on this matter.  I have a couple who divorced early in the decade with a dependent child  Father was to claim child in odd years and Mother in even years.  In 2006, I prepped Mother’s 2005 return, who instructed me to claim the child regardless that this was an odd year.  Now, Father (who had some long-standing tax problems) wants to finally file his 2005 1040 & claim child.  Ethically, do I need to notify Mother that I’m filing Father’s 1040 claiming child?  Should I automatically file a 2005 1040X for Mother taking off the child?  Or just let me IRS notify them both?  Any ideas?

A:

That kind of every other year arrangement is increasingly common with divorced parents, so this kind of thing does pop up frequently.

As you most likely already have experienced, IRS is very efficient at catching attempts to claim the same child more than once and they will generally allow the first parent’s return to have the exemption and deny the second parent’s.

This brings you to your point; how to remedy the problem.  While there may be a number of ways to correct the situation, here are some ideas. 

Technically, in the IRS’s eyes, they don’t have to honor the agreement between the parents and will leave it up to them to hash it out between themselves to equalize the situation.  While the short-changed parent could notify IRS of the inappropriate dependent claim and try to trigger some IRS pressure on his ex, I have found that IRS really isn’t very concerned about this kind of thing and will most likely do nothing.  This leaves a civil lawsuit as the remedy for the short-changed parent to enforce his rights under the divorce agreement, most likely in Small Claims Court. 

I wouldn’t just go ahead and prepare the 1040X without getting an agreement from the mother that she will indeed file it with IRS and pay you for doing that work.  Otherwise, you have wasted your time for nothing.

If the mother agrees to filing a 1040X to remove the child, that’s fine and sets the stage for the father to later file his proper 1040.

However, I have seen a number of occasions where the first parent didn’t want to rock the boat with IRS by filing a 1040X and instead agreed to reimburse the other parent directly for the difference in the taxes with and without the child.  In those kinds of cases, you can prepare draft returns both ways to document the difference in Federal and State taxes, and the mother would then write a check for that amount to the father, plus the additional costs for you to do those calculations, since it was her fault in improperly claiming the child. 

Obviously, who bears these additional costs is negotiable between the three of you.  If you want to accept some responsibility for the screw-up on the mother’s 1040, and do the extra work for free, that’s your call to make.

Obviously, there’s no cut and dried answer; but I hope this gives you some ideas to work with.

Good luck.

Kerry

Follow-Up:

Mr Guru – thanx for your input, as always.  I’ll take it from here.

Q:

Subject: Lifetime Learning Credit intertwined with a Gift

Hi Kerry,

Longtime reader, first-time e-mailer. For starters, great blog! On to my question…

I am about to begin my second year of law school. For 2006, I took the lifetime learning credit because I had income from the job I held for the first seven months of the year. In 2007, I will have negligible income and the lifetime learning credit will do nothing for ME. My parents will not pay for any of my education.

Are there any roadblocks to the following scenario?:
1) Mom pays for $10,000 of my education expenses
2) I gift Mom $8,000
3) Mom takes the lifetime learning credit for a $2000 deduction
Net results: Mom = even, Me = +$2000

Lastly, would my Mom need to pay the $10,000 directly to the institution or could she simply pay me.

Thanks in advance for your response (and the great service your blog serves)!

A:

After the first reading of your email, my gut reaction was that there were several flaws to your plan.  However, after checking my reference materials on the lifetime education credit, it appears that many of the steps are possible. 

One key point that you forgot to mention was whether or not you are being claimed as a dependent on your mom’s 1040.  If not, she can’t claim any credit for your education costs. 

If you are a qualified dependent on your mom’s 1040, she can use gift money to pay the education costs.  However, that step may not even be necessary.  She also has the option to count payments made directly by her dependent (you) when computing the credit. 

Just to clear up terminology, the lifetime education credit is 20% of the qualified costs, up to $10,000 per taxpayer.  This would result in a $2,000 credit, which is a potential dollar for dollar reduction of her income tax.  This is much more valuable than a $2,000 deduction, which has a savings based on her tax bracket.

You also didn’t say how high your mom’s income is.  There are phase-outs of the credit in order to prevent the people our rules consider to be evil rich from receiving any of this tax break.  If her AGI is over those limits, this is all a moot point.

As always, these are general comments and any specific plans related to this kind of strategy should be developed with the assistance of your and your mom’s personal professional tax advisors.

Good luck.

Kerry Kerstetter

Follow-Up:

Ok thanks. I guess as a law student I should’ve read the lifetime learning credit materials a little closer as I am NOT a dependent anymore.

Thanks for your help!