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The Family & Deductions
- The dependency exemption for supporting older
relatives or unrelated taxpayers is more important
every year. This write-off is not new, but it was
worth only $1,000 or so in the past. Under tax reform
it was worth up to $2,000 in 1986, and that figure is
indexed annually for inflation. (It is worth $2,450
for 1994.) To claim an exemption for a relative, you
don't have to live with that relative. But you do have
to pay over half that person's support for the year.
Someone who isn't related to you can be your dependent
if he or she lives with you for the entire year and you
furnish over half the support. In addition, the person
cannot file a joint return with a spouse and must not
earn more than the personal exemption amount during the
year.
Payments to a nursing home qualify as support, as
do payments directly to the dependent or to someone
providing goods or services to the dependent. Money
earned by the dependent does not count as support
unless he or she actually spends it on necessities such
as food, clothing, shelter, and medical care. If the
income is put in a bank or other investments, it
doesn't count as support. In addition, tax exempt
income such as Social Security income does not count
towards the income limit of the personal exemption
amount.
Suppose you and your brothers and sisters support
a parent jointly, but nobody provides more than 50% of
the support. In that case you can sign a multiple
support agreement in which you all decide who gets the
dependency exemption. Anyone giving more than 10% of
the year's support can be assigned the exemption.
Everyone who gives more than 10% must join in filing
Form 2120 to assign the exemption. You must requalify
for and refile the multiple support agreement each
year, and the person who is assigned the exemption can
change each year.
- A dependent can earn over $2,450 tax free and still
be claimed on your return. When a child is under age
19 or a college student, the gross income limit does
not apply. That means the child can earn an unlimited
amount of money and still be claimed as your dependent
if you provide over one half the child's support. The
child is not allowed to claim the personal exemption,
if you claim it. But the child can take the standard
deduction. The deduction can offset up to $600 of
unearned (investment) income, and all of the deduction
can offset earned income, such as salaries and wages,
up to the standard deduction amount. These dollar
amounts are indexed annually for inflation.
- It is still easy for a self-employed person to
deduct a child's allowance. Tax reform puts
restrictions on giving income to children under age 14,
but the limits don't apply if the child earns the
money. You can employ your child in the business and
deduct the wages you pay as long as the wages are
reasonable payment for the work actually done by the
child. The courts have upheld the right of family
businesses to employ children as young as six years of
age as long as the children do work within their
capacities and are paid no more than they would be in
an arm's length transaction. The pay is taxable to
them. But they will have a lower tax rate than you and
can earn over $3,800 annually without paying any taxes.
Be certain to keep excellent records of their working
hours and the tasks they perform.
- Income splitting -- the most underused tax angle of
all -- gets new life after the 1993 tax changes.
Income splitting is when someone in a high tax bracket
transfers income-producing property to someone in a
lower tax bracket, usually a child or grandchild. That
reduces the family's total tax burden.
Income splitting's attractiveness declined after
the Tax Reform Act of 1986, when there were only two
tax brackets of 15% and 28%. But the 1990 tax law
added a 31% bracket, and the 1993 law added 36% and
39.6% brackets. The large difference in tax rates
makes income splitting more attractive to higher income
taxpayers than it has been in years.
But you must work around the Kiddie Tax to get the
benefits of income splitting. When a child under the
age of 14 earns investment income, the first $600 is
tax-free, protected by the standard deduction. The
next $600 (indexed for inflation) is taxed at the 15%
rate. But investment income above that amount is taxed
at the parent's top marginal tax rate. Or the parent
can elect to add the income to his or her own gross
income.
Therefore, to get the benefits of income
splitting, you should give a child under age 14
property that will produce little or no income until
the child turns age 14. This could include real
estate, tax-exempt bonds, growth stocks, precious
metals, and collectibles. U.S. savings bonds also will
defer income. Another option if you have real estate
is to put the property in a corporation, then give the
child the corporate stock. When the child turns age
14, the corporation can begin to pay dividends or it
can elect S corporation status. In those cases, the
income will be taxed at the child's tax rate.
With each of these methods you do not have to
give the property directly to a young child. The
property can be put in a trust or a custodial account
under the Uniform Gift to Minors Act. With a custodial
account, you or any other adult serves as custodian
until the child reaches the age of majority. That
means the adult manages the property. But once the
child reaches 18 or 21, depending on your state, you
have no control over what is done with the money. A
trust can keep the child from getting the control until
much later. In order to work, the trust must be
irrevocable, which means you cannot get the property or
income back. It is best that the trustee be someone
other than you or your spouse. You also should not
have any transactions with the trust, such as getting
loans or selling assets. When a large amount of money
is at stake, you probably should set up a trust. But
for smaller sums the custodial account is better
because it is simple and has few overhead costs.
- Alimony is deductible; child support is not. Be
sure your payments qualify as alimony and avoid the new
IRS crackdown. Each year about 500,000 taxpayers claim
alimony deductions, but only 350,000 report receiving
alimony payments as income. Therefore, the IRS has
concluded that a number of people are either
overstating alimony payments or understating alimony
income. New rules became effective in 1985, but they
were so complicated that Congress changed the rules
again. For divorce and separation agreements after
1986, an alimony payment is deductible if it is paid in
cash, is not for child support, and the obligation to
make payments terminates on the death of the recipient.
Unlike pre-tax reform law, the termination of payments
at death need not be explicitly stated in the divorce
or separation agreement. A payment is considered to be
paid in cash even if it is paid to a third party that
provides goods or services instead of being paid
directly to the recipient spouse.
Tax reform also revised the "recapture" rules.
These revised rules require payments to be spread out
in order to be deductible. The payments must be made
over at least a three year period. Further, the
payments in the first year cannot exceed the average of
the second and third year payments plus $15,000. The
amount of payments in the second year cannot exceed the
third year payments plus $15,000. Any excess alimony
payments that were deducted in a prior year must be
added to your ordinary income the following year. The
purpose of this rule is to ensure that nondeductible
property settlements are not disguised as deductible
alimony payments. After the third year, payments can
be made in whatever amount the parties agree to.
The IRS often will try to recharacterize some
alimony payments as nondeductible child support. It
can do this in three instances. The first instance is
when the separation agreement or divorce decree
specifically states that the payment is child support.
The second instance is when an alimony payment declines
as a result of a particular event happening to the
child. The event could include the child's reaching a
particular age, getting a job, or graduating from
school. The third instance is when the payment
declines at a particular time that is clearly
associated with an event related to the child. For
example, the divorce agreement might state that alimony
payments are reduced on June 20, 1995, and it turns out
that the child turns 21 during June 1995. The lesson
is to be careful about alimony payments that decline
over the years. Be sure that there is no implication
that the declines are related to changes in your
child's life.
- Child care & dependent expenses still result in
major tax reduction. When child care expenses are
incurred to enable a taxpayer to work while a dependent
is cared for, a tax credit is available. When a
taxpayer is a full-time student, the credit is more
valuable than a deduction because the credit directly
reduces your tax bill. You can get a credit of 20% to
30% (depending on your income) of the first $2,400 you
spend on the care of a child under 13 years of age (15
for tax years before 1989). When you have more than
one child, the credit is available against up to $4,800
of expenses. But the credit is not allowed for the
costs related to a dependent's overnight stay at a
camp. If you participate in a dependent care
assistance program run by your employer, your qualified
child care expenses that are eligible for the credit
must be reduced by any benefits received under the
employer plan. To protect your child care credit, make
sure you have the day care provider fill out form W-10,
available from the IRS.
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