In-Depth: Proposed Regs Update Rules for Claiming Dependency Exemption and Other Tax Benefits

(Parker Tax Publishing February 2017)

The IRS issued proposed regulations which amend the rules relating to the dependency exemption deduction, surviving spouse and head of household filing statuses, the child and dependent care credit, the earned income credit, the standard deduction, joint tax returns, and taxpayer identification numbers for children placed for adoption. In determining a taxpayer's eligibility to claim a dependency exemption, the proposed regulations change the IRS's position regarding the adjusted gross income of a taxpayer filing a joint return for purposes of the tiebreaker rules in Code Sec. 152(c)(4) and the source of support of certain payments that originated as governmental payments. REG-137604-07 (1/19/17).

Background

Under Code Secs. 151(c) and 152(a), a dependency exemption deduction is available for a qualifying child or qualifying relative. According to Code Sec. 152(c)(2), a qualifying child must be a child or a descendant of a child of the taxpayer, or a brother, sister, stepbrother, or stepsister of the taxpayer, or a descendant of any of these relatives. Under Code Sec. 152(d), a qualifying relative is an individual who bears a certain relationship to the taxpayer, including an individual who has the same principal place of abode as the taxpayer and is a member of the taxpayer's household for the tax year

(qualifying relative relationship test), has gross income less than the exemption amount for the tax year (gross income test), receives more than one-half of his or her support from the taxpayer (qualifying relative support test), and is not a qualifying child of any taxpayer (not a qualifying child test).

In 2004, the Working Families Tax Relief Act of 2004 (WFTRA) amended Code Sec. 152 to establish a uniform definition of a "qualifying child" for purposes of claiming child-related tax benefits, such as head of household filing status, the child and dependent care credit, the child tax credit, the earned income credit, and the dependency exemption deduction. The uniform definition also applies in determining whether a taxpayer qualifies for the exclusion from income for dependent care assistance under Code Sec. 129.

The Fostering Connections to Success and Increasing Adoptions Act of 2008 (FCSIAA) added to the definition of a qualifying child the requirements that the child must be younger than the taxpayer and must not file a joint return (other than as a claim for refund). The FCSIAA also amended the rules that apply if two or more taxpayers are eligible to claim an individual as a qualifying child.

The IRS has now issued proposed regulations which incorporate changes made by WFTRA and FCSIAA. The IRS also withdrew previously issued proposed regulations relating to the definition of an authorized placement agency for purposes of a dependency exemption for a child placed for adoption that were issued prior to the changes made by WFTRA.

Observation: The preamble to the proposed regulations notes that a taxpayer's treatment of the dependency exemption under Code Sec. 151 for a particular qualifying child or qualifying relative might have tax consequences under other Code provisions, such as the education tax credits under Code Sec. 25A, the premium tax credit under Code Sec. 36B, and the penalty imposed by Code Sec. 5000A for failing to maintain minimum essential coverage.

Changes Relating to the Dependency Exemption Deduction

Before WFTRA, Code Sec. 151 contained many of the rules relating to the definition of a dependent. WFTRA moved those rules to Code Sec. 152. Consistent with the Code revisions made by the WFTRA, the proposed regulations move rules relating to the definition of a dependent from the regulations under Code Sec. 151 to the regulations under Code Sec. 152. The following discussion highlights some of the more important provisions in the proposed regulations relating to the dependency exemption.

Relationship Test. The proposed regulations adopt the rule in Notice 2008-5 regarding whether an individual is a qualifying child of a taxpayer when determining whether that individual may be a qualifying relative. Thus, the proposed regulations provide that an individual is not a qualifying child of a person if that person is not required to file an income tax return under Code Sec. 6012, and either does not file an income tax return or files an income tax return solely to claim a refund of estimated or withheld taxes.

Adoption by Individual Other than Taxpayer. WFTRA revised the definition of an adopted child in Code Sec. 152(f)(1)(B) from a child placed by an authorized placement agency for adoption to a child who is lawfully placed for legal adoption. In making that change, however, WFTRA also changed the reference to the adopting person from "an individual" to "the taxpayer," so that Code Sec. 152(f)(1)(b) currently provides that a legally adopted individual of the taxpayer is treated as a child by blood of the taxpayer. The use of the word "taxpayer" rather than "individual" arguably limits the recognition of a relationship through adoption only to those situations where the taxpayer claiming a dependency exemption for the child is the person who adopts the child. According to the IRS, this interpretation of the amended statutory language would diverge from the results of a legal adoption under property, inheritance, and other nontax law, and from the prior tax treatment of adoptions - a significant change in the applicable law. The IRS noted that there is nothing in the legislative history indicating that Congress intended to limit the treatment of an adopted child as a child by blood in this manner or that otherwise suggests this change in language was intended to effect a change in existing law. To fill this apparent gap in the statute, the proposed regulations provide that any child legally adopted by a "person," or any child who is placed with a "person" for legal adoption by that "person," is treated as a child by blood of that person for purposes of the relationship tests under Code Secs. 152(c)(2) and 152(d)(2). Similarly, the proposed regulations provide that an eligible foster child is a child who is placed with a "person" rather than with a taxpayer.

Child Placement. As amended by WFTRA, Code Sec. 152 treats a child placed for adoption as a child by blood if the child is "lawfully placed with the taxpayer for legal adoption by the taxpayer" - which can be done not only by an authorized placement agency but also by the child's parents or other persons authorized by state law to place children for legal adoption. The proposed regulations revise the regulations under Code Sec. 6109 to provide that the IRS will assign an adoption taxpayer identification number (ATIN) to a child who has been lawfully placed for legal adoption and not just a child who was placed for adoption by an authorized placement agency. For this purpose, "child" includes a child placed with the taxpayer by an authorized placement agency or by the judgment, decree, or other order of a court of competent jurisdiction.

Authorized Placement Agency. The proposed regulations clarify that an authorized placement agency can be an Indian Tribal Government, or an agency or organization authorized by or a political subdivision of an Indian Tribal Government that places children in foster care or for adoption.

Residency Test. Principal Place of Abode. In determining whether an individual has the same principal place of abode as the taxpayer in applying the residency test for a qualifying child and the relationship test for a qualifying relative, the proposed regulations define "principal place of abode" as a person's main home or dwelling where the person resides. This need not be the same physical location throughout the year and may be temporary lodging such as a homeless shelter or relief housing following a natural disaster. The proposed regulations further provide that a taxpayer and an individual have the same principal place of abode despite a temporary absence by either person. A person is temporarily absent if, based on the facts and circumstances, the person would have resided with the taxpayer but for the temporary absence and it is reasonable to assume the person will return to reside at the place of abode. Thus, the proposed regulations adopt the "reasonable to assume" language from the existing regulations under Code Sec. 2. The proposed regulations indicate that a nonpermanent failure to occupy the abode by reason of illness, education, business, vacation, military service, institutionalized care for a child who is permanently and totally disabled (as defined in Code Sec. 22(e)(3)), or incarceration may be treated as a temporary absence due to special circumstances. This definition of temporary absence applies to the residency test for a qualifying child, to the relationship test for a qualifying relative who does not have a listed relationship to the taxpayer, and to the requirements to maintain a household for surviving spouse and head of household.

The proposed regulations also provide that, for residency test purposes, an individual has the same principal place of abode as the taxpayer for more than one-half of the tax year if the individual resides with the taxpayer for at least 183 nights during the year (or 184 nights in leap years). An individual resides with the taxpayer for a night if sleeping at the taxpayer's residence or in the company of the taxpayer while away from the residence (e.g., while on vacation).

Age Test. The age test for a qualifying child requires in part that the individual must not have attained the age of 19 (or age 24 if the individual is a student) by the close of the calendar year. The proposed regulations define a "student" for purposes of the age test as an individual who, during some part of each of five calendar months during the calendar year in which the tax year of the taxpayer begins, is a full-time student at an educational organization described in Code Sec. 170(b)(1)(A)(ii) or is pursuing a full-time course of institutional on-farm training under the supervision of an accredited agent of an educational institution or of a state or political subdivision of a state. Code Sec. 170(b)(1)(A)(ii) provides that an educational organization is a school normally maintaining a regular faculty and curriculum and having a regularly enrolled body of students in attendance at the place where its educational activities are regularly carried on.

Support Tests. In determining whether an individual provided more than one-half of the individual's own support (qualifying child support test), or whether a taxpayer provided more than one-half of an individual's support (qualifying relative support test), the proposed regulations compare the amount of support provided by the individual or the taxpayer to the total amount of the individual's. In general, the amount of an individual's support from all sources includes support the individual provides and income that is excludable from gross income. The proposed regulations further provide that the amount of an item of support is the amount of expenses paid or incurred to furnish the item of support. If support is furnished in the form of property or a benefit (such as lodging), the amount of that support is the fair market value of the item furnished. The proposed regulations provide that the term "support" includes food, shelter, clothing, medical and dental care, education, and similar items for the benefit of the supported individual. Support does not include federal, state, and local income taxes, or social security and Medicare taxes, of an individual paid from the individual's own income, funeral expenses, life insurance premiums, or scholarships received by a taxpayer's child who is a student as defined in Code Sec. 152(f)(2).

The proposed regulations provide that medical insurance premiums are treated as support. These premiums include Part A Basic Medicare premiums, Part B Supplemental Medicare premiums, Part C Medicare + Choice Program premiums, and Part D Voluntary Prescription Drug Benefit Medicare premiums. However, medical insurance proceeds, including benefits received under Medicare Part A, Part B, Part C, and Part D, are not treated as support and are disregarded in determining the amount of the individual's support. Thus, only the premiums paid and the unreimbursed portion of the expenses for the individual's medical care are support.

Finally, payments from a third party (including a third party's insurance company) for the medical care of an injured individual in satisfaction of a legal claim for the personal injury of the individual are not items of support and are disregarded in determining the amount of the individual's support.

The proposed regulations distinguish, for meeting the support test, between government payments that are intended to benefit a named individual (whether the recipient or another individual for whom the recipient acts as payee), and payments that are intended to support the recipient and other individuals. If the intended beneficiary in the first scenario uses the payments to support another individual, the amount used constitutes support of the other individual provided by the intended beneficiary. Use of the payments in the latter scenario by the recipient to support another individual constitutes support of the other individual provided by the recipient, although any part used for the support of the recipient constitutes support of the recipient by a third party.

Citizenship. Under Code Sec. 152(b)(3)(A), an individual who is not a citizen or national of the United States is not a dependent unless the individual is a resident of the United States, Canada, or Mexico. Nevertheless, consistent with the exception for certain adopted children in Code Sec. 152(b)(3)(B), the proposed regulations provide that an adopted child of a taxpayer who is a U.S. citizen or national may qualify as a dependent if, for the taxpayer's tax year, the child has the same principal place of abode as the taxpayer and is a member of the taxpayer's household, and otherwise qualifies as the taxpayer's dependent.

Tiebreaker Rules. The proposed regulations change the interpretation in Publication 501, Exemptions, Standard Deduction, and Filing, regarding a taxpayer's adjusted gross income on a joint return and provide that, in applying the tiebreaker rules that treat an individual as the qualifying child of the eligible taxpayer with the higher or highest adjusted gross income, the adjusted gross income of a taxpayer who files a joint tax return is the total adjusted gross income shown on the return. According to the IRS, the prior interpretation was changed to be consistent with other Code sections that require the filing of a joint return to claim a benefit and therefore calculate income based on the entire amount shown on the joint return. The proposed regulations also expand the tiebreaker rule in Code Sec. 152(c)(4)(C) to address the situation in which an eligible parent does not claim an individual as a qualifying child and two or more taxpayers, none of whom is a parent, are eligible to claim the individual as a qualifying child and each has adjusted gross income higher than any eligible parent. In this situation, the proposed regulations provide that the individual is treated as the qualifying child of the eligible taxpayer with the highest adjusted gross income.

Parents who are Divorced, Separated, or Living Apart. Code Sec. 152(e) provides, in general, that a child is treated as the qualifying child or qualifying relative of a noncustodial parent for a calendar year if, among other things, the custodial parent provides to the noncustodial parent a written declaration that the custodial parent will not claim the child as a dependent for any tax year beginning in that calendar year. Under Code Sec. 152(e)(2)(B), the noncustodial parent must attach the written declaration to his or her return. The proposed regulations provide that the noncustodial parent must attach a copy of the written declaration to an original or amended return. A taxpayer may submit a copy of the written declaration to the IRS during an examination of that parent's return. However, to provide certainty for both taxpayers and the IRS, the proposed regulations provide that a copy of a written declaration attached to an amended return or provided during an examination will not meet the requirements of Code Sec. 152(e) and Reg. Sec. 1.152-5(e) if the custodial parent signed the written declaration after the custodial parent filed a return claiming a dependency exemption for the child for the year at issue, and the custodial parent has not filed an amended return to remove that claim to a dependency exemption. The proposed regulations provide similar rules for a parent revoking a written declaration.

Filing a Return to Claim a Tax Refund. The proposed regulations provide an exception to the rule in Code Sec. 152(b)(1) that a taxpayer cannot have a dependent if the taxpayer himself or herself is a dependent of another taxpayer. Under the proposed regulations, an individual is not a dependent of a person if that person is not required to file an income tax return under Code Sec. 6012, and either does not file an income tax return or files an income tax return solely to claim a refund of estimated or withheld taxes.

Other Tax Benefit Changes in the Proposed Regulations

In addition to the changes to the dependency exemption rules discussed above, the proposed regulations also make the following changes.

Head of Household: Proposed regulations under Code Sec. 2(b) update and simplify the existing regulations defining head of household. The proposed regulations provide rules on qualifying as a head of household by maintaining a household that is the principal place of abode of a qualifying child or a dependent. The proposed regulations on head of household apply the rules in the proposed regulations under Code Sec. 152 for determining principal place of abode, including whether an absence is temporary.

Maintaining a Household: The proposed regulations provide rules that, in certain circumstances, prorate on a monthly basis the annual cost of maintaining a household when a qualifying child or dependent resides in the household for less than the entire tax year. The proposed regulations also, in certain circumstances, recognize the creation of a new household during a year and treat shared living quarters as separate households.

Dependent Care Credit: Prior to WFTRA, Code Sec. 21 required that a taxpayer maintain a household to claim the credit for dependent care expenses, and regulations on maintaining a household were published under that section. WFTRA removed that requirement from the dependent care credit and the proposed regulations reflect this change.

Additional Standard Deduction for the Aged and Blind: The proposed regulations remove the provisions on additional exemptions for age and blindness from the regulations under Code Sec. 151 and add regulations under Code Sec. 63 on the additional standard deduction for the aged and the blind to reflect the changes made by the Tax Reform Act of 1986. In addition, to limit impediments to electronic filing, the proposed regulations also delete the requirement that a taxpayer claiming a tax benefit for blindness must attach a certificate or statement to the taxpayer's tax return. Instead, a taxpayer must maintain the certificate or statement in the taxpayer's records.

Taxpayer Identification Numbers for Children Placed for Adoption: The proposed regulations reflect changes made by WFTRA relating to taxpayer identification numbers for children placed for adoption. The proposed regulations amend the regulations under Code Sec. 6109 to provide that the IRS will assign an adoption taxpayer identification number to a child who has been lawfully placed with a person for legal adoption.

Earned Income Credit: For a discussion of the proposed regulations relating to the earned income credit, see "IRS Changes Position on Claiming Childless EIC; Amended Returns May be in Order" in this Bulletin.

Effective Date

The proposed regulations will be effective when finalized. However, the proposed regulations provide that taxpayers can apply these rules to any open tax years. To the extent the proposed rules would favorably impact a taxpayer with respect to returns that have been filed, amended returns should be considered for open tax years.

Caution: Subsequent to the issuance of these proposed regulations, the White House issued a moratorium on the implementation of regulations with effective dates after January 20. As a result, it is unclear whether these regulations may be immediately applied to request refunds relating to previously filed returns.

For additional discussion of claiming dependency exemptions, see Parker Tax ¶10,720.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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