Paul L. Caron

Monday, May 13, 2019

Lesson From The Tax Court: Get It In Writing!

Last week’s case of Jason Aaron Cook v. Commissioner, T.C. Memo. 2019-48 (May 7, 2019) (Judge Colvin), teaches a straightforward lesson: if you are not the custodial parent of a child and want to claim the child as your “dependent” within the meaning of §152, you need to obtain a Form 8332, or an equivalent document, from the custodial parent.  You need to get it in writing.

The case also teaches a more fundamental lesson in some of the complexities of family taxation.  The lesson here shows how the tax law indirectly defines families through the concept of dependents.  When a taxpayer can claim someone as a dependent, that triggers a host of different tax rules for that taxpayer---mostly good.  The cumulative effect creates the rules of family taxation. 

The biggest group of dependents are children, at least until more Boomers hit their dotage.  When spouses stay together the idea of defining families through the concept of dependents works pretty well.  When spouses split up, however, it becomes much harder figuring out the appropriate family unit to tax.  Section 152(e) uses a concept of "custodial parent."  Last week’s case is a good illustration of the Tax Code’s basic approach, and its limitations.

Law: The Forest

The basic unit of taxation in the Tax Code is the individual.  While married couples can elect to be taxed as a unit, that requires an affirmative act of filing a joint return.  Otherwise they will be treated as individuals.  Families qua families are not recognized by the Tax Code as a single economic unit for purposes of reporting income, taking deductions, getting tax credits, or paying tax.  It is the individual who reports, takes, gets, and pays.  It is true that the Tax Code defines “family” for some specific purposes: e.g. §267(c)(4) (definition for rules restricting loss deductions); §704(e)(2) (definition for rules relating to purchase of partnership interests).  But it contains no overall definition of “family.” 

And yet politicians of all stripes talk about how whatever changes they are proposing to the tax laws will help families.  For example, in August 2016 then candidate Trump boasted “In the days ahead, we will provide more details on this [tax reform] plan and how it will help you, and most importantly your family.”  In November 2017, then Speaker Ryan said “This [tax reform] plan is for the middle-class families in this country who deserve a break. It is for the families who are out there living paycheck to paycheck, who just keep getting squeezed.”  Just last month, a bunch of Democratic senators introduced legislation they optimistically titled “Working Families Tax Relief Act.” 

The way Congress taxes families through the Tax Code is by giving individual taxpayers subsidies for the costs of maintaining a family.  C. Eugene Steurele explained in this 1997 testimony before the House Ways and Means Committee.  Though from long ago, it is definitely worth your time reading.  Mr. Steurele there noted the “traditional view” that the tax system “should be designed primarily to distribute tax burdens in a way that is fair to all individuals, irrespective of their family circumstances.”  But, he continues, “a tax system cannot be fair to individuals unless it takes into account the differences in ability to pay that result from the way that resources are shared within families of different sizes.” 

The Tax Code does what Mr. Steurele says it should do (takes into account how resources are shared) through the concept of dependents in §152.   Central to the definition of dependents is their financial relationship to the individual taxpayer.  The idea is this: if the taxpayer has enough responsibility for another person’s welfare---whether that responsibility comes from state law, private agreements, or moral or religious teachings---then that financial dependency should be recognized.  Hence the term “dependent.”  Dependents make it family.  There are other requirements for dependency status that are beyond the scope of today's lesson but suffice to say that financial dependency is a necessary, though not always a sufficient, requirement. 

The biggest group of dependents are children.  Those of us at a certain age know that children are central to family.  Mr. Steurele concluded his 1997 testimony with this thought: “Of all the issues I have raised, perhaps the largest and most important are those that relate to the ways that any tax system adjusts for the presence of children through child credits, dependent exemptions, and the earned income tax credit.”

Law: The Trees

In her 2001 Report To Congress (a mere 273 pages total...really!), the National Taxpayer Advocate laid out the case for a uniform definition of a dependent child.  Treasury followed up with a 2002 proposal to so amend §152.  The idea was that a uniform definition of a dependent child would help taxpayers coordinate all the family tax policies mentioned by Mr. Steurele, as well as other tax benefits keyed to children such as head of household filing status, medical expense deductions, child care credit, non-taxable employee fringe benefits.  Congress bought it, and amended §152 in the Wording Families Tax Relief Act of 2004 (I guess that’s a popular title). 

As amended, §152 therefore divided the universe of dependents into two: Qualifying Child and Qualifying Relative.  The titles are misleading because a person does not have to be a biological child of the taxpayer to be a Qualifying Child, nor does a person have to be a relative of any kind to be a Qualifying Relative.  But those are matters for a different lesson. 

What is important for this lesson are the rules in §152(e) for treatment of a child (as defined in §152(f)(1)) whose parents are divorced or separated.  Those rules basically try to identify which of the now separated parents the kids should be grouped with as to make that grouping a “family” for tax policy purposes and give one parent or the other the benefits of family taxation.  But only one parent is welcomed into the tax family.  The other is left out in the cold.

Curiously, §152(e) does not create straightforward rules to identify what Mr. Steurele said was the central idea of family taxation in a system that uses the individual as the unit of taxation: the differences in ability to pay that result from the way that resources are shared within families, albeit those now split.  Instead, §152(e)(1) links financial dependency to both parents combined, and then allocates the dependency status to the custodial parent.  The parents can then reallocate the dependency status if the custodial parent “signs a written declaration...that such custodial parent will not claim such child as a dependent....”  (e)(2).  In other words, the custodial parent releases their claim.  The non-custodial parent then attaches the release to their own return in order to properly claim the child as a dependent. 

As relevant to today’s lesson, Treas. Reg. 1.152-4 adds two important details to this statutory scheme.  First, subsection (e) tells custodial parent to use the right document to transfer the dependency claim to the noncustodial parent.  One document is Form 8332, which has the awkward title of “Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent.”   Treas. Reg. 1.152-4(e) also permits a custodial parent to sign any other document that serves the same purpose, but warns that such document “must be a document executed for the sole purpose of serving as a written declaration under this section.  A court order or decree or a separation agreement may not serve as a written declaration.”  (emphasis supplied).

Second, Treas. Reg. 1.152-4(d) makes clear that the term “custodial parent” has nothing---I repeat, nothing---to do with which parent is treated by state law or a state court judgment as having custody!  State court judges simply cannot direct which parent is the custodial parent for federal tax purposes.  That is why I emphasized the above regulatory language: the noncustodial parent cannot just attach a court order as a substitute for Form 8332.  Instead, subsection (d) creates an overnight rule: the custodial parent is “the parent with whom the child resides for the greater number of nights during the calendar year.”  The noncustodial parent is the other one. 

And if the child resides with neither parent during the year, but instead lives with grandparents or other relatives for the year?  Why then neither parent can claim the child as a Qualifying Child because one of the basic rules to be a Qualifying Child is that the child have “the same principal place of abode as the taxpayer for more than one-half of such taxable year.”  Again, those rules go beyond today’s lesson.  Today let’s just focus on what happened in Mr. Cook’s case.

Lesson: The Release Is Critical 

Mr. Cook had a daughter with a woman named Tara (whose last name at that time is not disclosed in the opinion).  The opinion does not say the daughter’s name but instead uses her initials, all of them: C.D.C.  I keep thinking “Center for Disease Control” when I see those letters, so I will just use the daughter’s first name initial: C. 

In October 2011, Tara secured a court order from the Virginia Juvenile and Domestic Relations court in York County, Virginia, that Mr. Cook pay her $788 per month in child support and pay for C’s medical and dental expenses when they topped $250 per year.  Apparently Mr. Cook made those payments during 2012, the year at issue. 

On his 2012 return Mr. Cook claimed C was his dependent, thus becoming eligible for several tax benefits for families, including the head of household filing status, the child tax credit and an EITC based on having one Qualifying Child. 

The problem was that C lived all of 2012 with Tara, who by that time had acquired the last name Taylor through marriage.  Under the regulation's overnights rule, that meant that Tara was the custodial parent.  Yet Mr. Cook did not attach to his return either a Form 8332 or any other written declaration from Tara that she was releasing her claim on C as a dependent for 2012. 

The lack of a written release meant that Mr. Cook could not claim Tara as a Qualifying Child.  He testified that he and Tara had an oral agreement, but you can guess how much weight that carried in light of both the statutory and regulatory requirements for a written attachment to the return!  Since Mr. Cook had failed to get the release in writing, he lost the ETIC and child tax credit benefits.

Judge Colvin also found that even though Mr. Cook provided more than half of C’s support during 2012, he could not claim his daughter as a Qualifying Relative either. That mattered only for claiming head of household status and not for the other tax breaks, which key off a dependent being a Qualifying Child.  Mr. Cook lost that issue because of the rule in §152(d)(1)(D), which says that a person cannot be the Qualifying Relative of one taxpayer if the person is a Qualifying Child of another.  Since C was the Qualifying Child of Tara in 2012, C could not be the Qualifying Relative of Mr. Cook that year.

Coda:  I think it useful to keep in mind that the dependency status is the mechanism Congress uses to benefit families, not individuals.  For example, consider again the default rule for divorced parents.  If the purpose of the dependency concept is to ameliorate the cost to individual taxpayers of supporting a family, then one can question whether the focus on who is the custodial parent creates the right default rule.  An alternative default rule would be that the spouse who actually provides the greater amount of support (call them the “greater supporting parent”) is awarded the default claim for dependency, and can then reallocate to the lesser supporting parent by agreement.  Such a default rule would seem to be more consistent with the tie-breaker rules in §152(c)(4).

In many cases the default rules would work equally. The parent who is the custodial spouse under current rules would often also appear to be the greater supporting parent simply by virtue of putting a roof over the child’s head and food in the child’s body.  When that is the case, it would make no difference whether the default rule was based on economic support or overnights. 

When the rule would make a difference is when the custodial parent is also the lesser providing parent.  That is the situation in Cook.  The opinion says that Mr. Cook provided more than half of C’s support in 2012.  In that situation, the current default rule may be better at ensuring resources flow to the child.  That is, the parent with whom the child lives has every incentive to support the child.  The other parent, however, may view child support payments as just money going to the other parent and not the child.  The current default rule may be a better rule because it gives a custodial spouse leverage to secure child support payments from a recalcitrant noncustodial spouse.  That leverage may result in better resources for the child.  But then, the other default rule in favor of the greater supporting parent might also encourage each parent to contribute resources to the child, to outdo each other, as it were.   I don't know.  I am sure someone has studied this.  My point in the Code, however, is that the true target of any default rule should perhaps not be viewed as the parents.  Instead, the policy should be to connect the rule to families and that central part of families, the children. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law

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Another great article, however, I would like to make a few clarifications.

First, there is a six month or greater residency requirement of the child with the taxpayer (among other requirements) for purposes of Head of Household filing status and the EITC with the child included, so by definition those can never go to the non-custodial parent; the two benefits that can go to the non-custodial parent are the dependency exemption (now worth zero, but there may be related benefits with being able to claim it), and the Child Tax Credit.

Second, being a Qualifying Child has nothing to do with who provides the greater amount of support for the child, other than that the QC cannot provide more than half of his or her own support (that is the case for a Qualifying Relative, however).

Lastly, while there is supposed to be an 8332 attached to all relevant returns, in practice it has never mattered as long as everyone is in agreement.

Posted by: David Yos | May 14, 2019 10:26:36 AM

A very good article I am going to print and send to over half of my clients for their next year's return.

Posted by: Jack Harlow | May 13, 2019 11:07:30 AM