DANTE’S DEDUCTION: Or Did You Mean A Credit?

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There is hope that the plague is behind us.  Pestilence is on its way either in the form of a lantern fly or the return of the cicada after 17 years of peace.  For the divorce lawyer and his friend in crime, the accountant, there is another crisis emerging.  It’s the war over who gets the tax credits for the children.  Chances are the true winners will be the lawyers and the accountants, because in many instances the fight will consume the dollars in controversy.

Once upon a time, in fact for most of time, if you had primary physical custody of a child under 19 or under 24 if a student, you could deduct what was essentially $2,000 for yourself, your spouse and those dependent kids who qualified.  The statute was and remains Section 152 of the Internal Revenue Code.  In 1984 Congress allowed parties to agree upon an allocation of the deduction so long as that agreement was embodied in IRS Form 8332.  Life was simple but for the fact that the Congress decided to inflation adjust the dependence exemption amount.

In 1997 Congress decided to fiddle some more.  They passed a small ($400) child tax credit.  A credit is a different animal than a deduction.  If you are in a 22% tax bracket a $2,000 tax deduction is subtracted from income.  It thus saves you $440.  A tax credit is a dollar for dollar reduction of your tax liability.

Fast forward to 2017.  We had a late year tax reform bill that changed everything.  Dependency exemption; gone; at least until 2025.  Tax rates completely revised for all tax classifications from single to married joint.  And the tax credit got juiced.  Before 2018 for households with more than $110,000 the tax credit was beyond the pale.  The 2018 bill did not phase out the tax credit until $200,000 for single households and $400,000 for married/joint returns.  And the credit itself was increased to $2,000 per child.  The other big news was that in some circumstances you could get a payment for the tax credit even if you owed no income tax.  So effectively it was a negative income tax, subsidizing families with tax dollars.

In 2020 we saw the economy stagger when the pandemic of influenza began to lay grip to the economy.  Congress decided it needed to pump money into the economy via loans to business and money to households.  The latter was done, in part, through the American Rescue Plan Act of 2021.  The tax credit is now $3,000 per child under 17 and $3,600 per child under age 6.  Half of the benefit is payable in the second half of 2021 by deposit from the Treasury Department.  Read any news collection source out there and articles are appearing daily about who qualifies and how to get the money.

So, the sharks are in the water and they can smell stimulus.  Meanwhile, the problem with all new law is that the devil in the details and the Treasury Department is stuck administering those details.

In this vein, we report on two cases.  The first is Donnelly v. Donnelly, a May 17,2021 non precedential decision by the Superior Court.  In quieter times, the Donnelly’s separated and reached a sensible agreement not uncommon to all of us.  They would alternate taking the dependency exemption for their children from year to year.  This actually worked until Congress decided to meddle by eliminating the exemption effective in 2018.  Tax Year 2019 was dad’s year, so he wandered into his local H&R Block and had them cook up his return.  When they fed it into the computer, it choked first because there was no exemption to claim.  Not to worry, he would be content with the newly re-written tax credit.  But the computer at the IRS choked a second time because mother had already filed a return claiming the child tax credit for the children.

Dad was not a happy taxpayer.  So, he went to see his local judge in Bucks County and demanded that his ex be held in contempt for appropriating his dependency exemption.  Alas, the court noted that there was no exemption because Congress took it away.  But, not to worry, the Court “interpreted” the tax law change as one justifying modification of the support so that dad got a $1,200 reduction in support that mirrored the tax credit that mom had purloined.  No contempt was found because what mom did was not willful, and a tax credit is a different thing than a dependency exemption.

Mom appealed.  She didn’t change the tax scheme, Congress did, and it gave the tax credit to a person who qualified by having primary physical custody.  The revised childcare credit was a matter between her and the government.  And this was not money being taken from dad’s pocket to line hers.  After all, the whole tax scheme had changed, and rates were generally lowered.  The agreement in 2014 related to dependency exemptions under Section 152.  What she claimed and got was a tax credit under Section 24 of the Code.

The Superior Court came down on dad’s side and said this needed to be treated as a petition for modification and that the law had changed circumstances.  The order was not modified itself.  Instead, mom was ordered to repay dad the tax credit he couldn’t process because she had already filed a return and claimed it.  The Superior Court saw no harm in this result even though no modification appears to have been requested and it appears the only issue addressed was dad’s “lost” tax credit money.

The opinion cites Pa.R.C.P. 1910.16(f) a rule stating that it is within the power of a trial court to award the child tax credit.  The same provision then goes on to talk about the dependency exemption even though they are two statutorily different animals.  Meanwhile IRS Form 8332, which is the definitive document involving “exemptions” for dependents says the release when signed includes all forms of child tax credits when it is properly signed and submitted.

In Donnelly, the trial court fixed the problem by amending the order so that dad got the tax credit for 2019.  But a recent tax court case reminds us that the IRS is rather finicky about how dependent children are to be claimed for purposes of head of household or child tax credits where the non-primary custodian is doing the claiming. In DeMar v. Commissioner, the Tax Court upheld a longstanding policy that Form 8332 is the exclusive means by which the non-custodial parent can claim head of household or tax credits.  In other words, the IRS doesn’t want to see agreements, court orders or any other form of indicia of an agreement.  You either produce a signed Form 8332 or lose the battle. T.C. Memo 2019-91.  You can get a court to force the custodial parent to sign.  You can get the court to modify the order to get your money back.  But it appears that even a court order allocating the dependency or tax credit does not move the IRS computer in West Virginia to accept the claim.  It’s pretty much a signed Form 8332 or bust.  In DeMar, the father even got the form signed.  But because the custodial parent did not amend her return to allow dad to claim the kid, the IRS said no to the amended return.

The IRS regulations governing this aspect of the law are found at 26 C.F.R. Sec. 1.152-4(e)(1)(ii).  It is a labyrinth of rules which reflect a real effort to get things right.  But as many taxpayers know all too well, he or she who files first may get the last laugh unless you join Mr. Donnelly and take the matter to court.  Indeed, Mr. Donnelly did get his $1,297 back but one must wonder at what price?  With the tax credit now greater and more accessible we may be destined for more of these fights.  It is not clear once the dust settles who will be the winner.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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