Making Your Kids Pay Off at Tax Time

Your son is off at college. Can you still claim him as a dependent? The answer for most parents is, yes. But, as is often the case with tax questions, determining who can be claimed as a dependent is not always a clear-cut exercise.

In this tax tip:

• Tax definition of a child
• Changes reflect changing families
• Child dependent tests
• Tie-breaker guidelines
• Final exemption factors

Dependent claims aren't limited to parents. An adult relative could qualify as a taxpayer's dependent as long as he or she meets certain Internal Revenue Service conditions.

More From Bankrate.com: • Tips for Claiming Dependents • Who Has to File a Tax Return? • 10 Common Tax-Filing Mistakes to Avoid

Making sure the requirements are met is critical, because dependents can help reduce your tax bill. In many cases, you can claim certain tax-cutting deductions and credits related to a dependent.

Even if these added tax breaks don't apply to your situation, a dependent named on your return can still trim your taxes. Each dependent directly translates into an exemption, a specific dollar amount deducted from your adjusted gross income.

The exemption amount is adjusted annually for inflation and can be found on your tax return form. On 2007 returns, each exemption allows a filer to cut taxable income by $3,400. By lowering your taxable income, your tax bill usually is a little less.

Tax definition of a child
Most often, dependent claims revolve around children. Just when, for tax purposes, is a child a qualifying child? The answer to that used to vary considerably, depending upon which tax benefit you wanted to claim.

The key tax breaks associated with a child are the dependency exemption, head of household filing status, the child tax credit, the child and dependent care credit, and the earned income tax credit. Previously, each of these tax situations had different requirements for how a child could help you qualify for the separate tax breaks.

In an attempt to streamline the many rules connected to the assorted child-related tax benefits, the IRS created a uniform definition of a qualifying child. Although there are still some variations (usually concerning the age of the child), just who the IRS considers a child for tax purposes is now more consistent.

"What was considered a child for each of those benefits was a little confusing for some taxpayers," says Kathy Burlison, director of tax implementation for H&R Block in Kansas City, Mo. "For some, the changes will have some good consequences."

And, as is often the case with taxes, some will find the changes will present new problems.

Tax changes reflect changing families
The most significant change is in the area of adult support. This used to be a key determinant of who got to claim a child on a return. And it's one that posed many problems, especially when a child lived with multiple adults, several of whom provided money for the household.

"The traditional family won't see any change," says Burlison. "A single-parent family won't either. But multigenerational families will see changes, so you've got choices as to who gets to claim the child for tax purposes."

Donna LeValley-Cocovinis, tax attorney and contributing editor to J.K. Lasser's annual tax guide, agrees.

"The tax law is catching up to changes in the world," she says. "We now have single parents who've never married living with an adult parent or grandparent." In other cases, says LeValley-Cocovinis, "We have divorced parents who share custody and maybe the child lives with one person most of the time, but that parent didn't provide the majority of the child's financial support. Or sometimes the custody is split six months each so that there is not a clear-cut time of residency."

LeValley-Cocovinis says that in these cases "the IRS had to say, 'Sorry. No tax break.'"

To address these situations, tax-law writers opted to eliminate the support test. With that requirement gone, say both Burlison and LeValley-Cocovinis, taxpayers have more choice when considering child dependency issues and families are able to decide which adult filer would or should get the tax break.

"If a single mom is getting financial help from a parent or lives with a boyfriend who is providing support, it's no longer an issue that she didn't provide the majority of the child's support," says LeValley-Cocovinis. "The child lived with her and residency now trumps support."

Child dependent tests
In order to claim a child as your dependent so that you can use the $3,300 exemption, as well as gain other potential child-related tax breaks, the youngster must now meet four tests.

• Relationship test: The child must be your child, either by birth, adoption or by being placed in your home as a foster child. Even if the adoption isn't yet final, if the child is living with you and the process is under way, it counts. A dependent child can also be your brother, sister, stepbrother, stepsister or a descendent of one of these relatives.
• Residency test: The child must live with you for more than half of the year. If the youth is away temporarily for special circumstances, such as for school, vacation, medical treatment, military service or detention in a juvenile facility, these particular absences still count as time lived at home. A child who was born or died during the year is considered to have lived with you for the entire year if your home was the child's home for the entire time he or she was alive during the year.
• Age test: A child must be under a certain age, depending on the particular tax benefit. For the dependency exemption, the child must be younger than 19 at the end of the year. However, a youth who was a student at the end of the year can be claimed as long as he or she is younger than age 24. There is no age limit where the individual is permanently and totally disabled.
• Support test: This refers to the youngster's contributions, not those of adults in the family. To qualify as a dependent, the child cannot provide more than half of his or her own support during the year.

The support issue usually is not a problem, says Burlison. However, if the child is a successful model, for example, he or she could bring in substantial income and therefore might not be able to be claimed as a dependent under this test. Even then, as long as the parents provide more than the youngster is bringing in, says Burlison, then the child would still qualify.

Even after the child meets the four qualifying tests, there are two other considerations before he or she can be claimed as a dependent for exemption purposes.

The youngster generally must also be a U.S. citizen, U.S. national or a resident of the United States, Canada or Mexico. An exception applies for certain adopted children.

And if married, the child cannot file a joint return unless the return is filed only as a claim for refund and no tax liability would exist for either spouse if they had filed separate returns.

Tie-breaker guidelines
Sometimes a child can be the qualifying child of more than one person. However, because the IRS only allows one taxpayer to claim the same youngster, all eligible taxpayers must decide who will claim the child and any ensuing tax benefits.

If you can't agree and both of you list the youth on separate returns, expect the IRS to disallow one or more of the claims using tie-breaker rules.

Tie-breaker rules

• First, the agency looks at whether only one person is the child's parent. This would be the case, for example, if one credit claimant is a stepparent. The parent would get the credit.
• If both taxpayers are the child's parents, then the parent with whom the child lived the longest during the tax year would be allowed the credit. If the child lived with both separated parents for an identical amount of time, the credit would go to the parent with the highest adjusted gross income, or AGI.
• Finally, if neither person is the child's parent, the IRS would then allow the credit to the filer with the highest eligible AGI.

If several children are involved in a family situation where two taxpayers may claim them, the adults can decide to share the children for tax purposes. For example, you and your three children live with your mother. You can claim one child as a dependent and your mother can claim the other two. Again, if such a sharing agreement cannot be reached, the tiebreaker rules would come into play.

What if a person used to qualify as your dependent, but under the new definition is not your qualifying child? That person might qualify as your dependent by being a "qualifying relative." To claim this dependency exemption, the child cannot be the qualifying child of any other person and must meet the all the dependency tests detailed in IRS Publication 501, Exemptions, Standard Deduction, and Filing Information.

Final exemption factors
A spouse is never considered a dependent. However, you can claim an exemption for your husband or wife as long as you file a joint return.

You also are allowed an exemption deduction for yourself. But if you file a return while being claimed as a dependent on someone else's 1040, the IRS warns that you won't be able to claim a personal exemption on your own return.

The exemption amount also is reduced if you make a lot of money. On 2007 returns, exemptions are whittled down if you make more than $117,300 and are a married person filing a separate return; earn more than $156,400 as a single filer; make more than $195,500 as a head of household; or are married filing jointly with income of more than $234,600.

Really well-off taxpayers -- those making $122,500 more than the amounts shown for each filing status ($61,250 more for married-filing-separate taxpayers) -- get no tax exemption amount.

And remember to include the Social Security number of each person claimed as an exemption or dependent on your tax return. Without this number, the agency won't process your filing and could even disallow your claims.