The AICPA Looks at the Uniform Definition of a Child

As established by the Working Families Tax Relief Act of 2004, the uniform definition of a child (UDOC) provides a definition for five different child-based benefits. This article focuses on the unintended results of the UDOC and examines some proposed solutions.

Ellen D. Cook, MS, CPA
Acting Dean
B.I. Moody III College of Business Administration
Fanny E. Winn Educational Trust/BORSF Professor of Accounting
University of Louisiana at Lafayette
Lafayette, LA

For more information about this article, contact contact Ms. Cook at edcook@louisiana.edu.

Editor’s note: Ms. Cook is a member of the AICPA’s Individual Income Tax Technical Resource Panel (TRP).
 

Executive Summary

• Under the UDOC, as adopted in the WFTRA, a qualifying child must satisfy the abode, relationship and age tests.
   

• The UDOC provides a uniform definition for five of the child-based benefits, but unintended results have led to calls for corrective action.
   

• The Administration’s fiscal-year 2007 revenue proposals include several provisions to solve some of the UDOC’s problems and issues.
   

The inclusion of a uniform definition of a child (UDOC) as part of the Working Families Tax Relief Act of 2004 (WFTRA)¹ represented the culmination of simplification efforts in the area of family taxation by the Bush Administration, the Joint Committee on Taxation (JCT), Treasury, the National Taxpayer Advocate (NTA) and professional organizations, including the AICPA, the American Bar Association (ABA) and the Tax Executives Institute (TEI). While the final legislation includes a uniform definition for five of the child-based benefits—the Sec. 152 dependency exemption, the Sec. 32 earned income tax credit (EITC), the Sec. 24 child credit, the Sec. 21 child and dependent care credit and Sec. 2(b)(1) head-of-household (HOH) status—unintended results have led to calls for corrective action. The Administration’s fiscal-year 2007 revenue proposals² include a number of provisions aimed at solving some, but not all, of the problems raised before and during the 2006 filing season. A handful of tax professionals have called for the repeal of the UDOC, and at least one bill currently before Congress would do just that.³ This article examines the UDOC’s development and basic rules, the unintended results and potential corrective actions.

Development of the UDOC

In its 2001 report on tax simplification, the JCT stated that adopting a uniform definition of a qualifying child would make it easier for taxpayers to determine whether they qualify for the various tax benefits for children and to reduce inadvertent taxpayer errors arising from confusion due to different definitions. It recommended a residency test as the basis for the uniform definition, because it is easier to apply than a support test.⁴

Treasury, in 2002, issued “Proposal for Uniform Definition of a Qualifying Child,”⁵ which called for a three-pronged test—relationship, residence and age—in determining a qualifying child for purposes of the five child-based benefits. The proposal eliminated both the support and gross income tests, as well as the household maintenance test used to claim the child and dependent care credit. Treasury reported that 52 million taxpayers would benefit from the simplification, by reducing both taxpayer confusion over differing definitions and the recordkeeping burdens of the support and maintenance tests. More recently, the NTA reported that the family-based tax benefits affect 81 million taxpayers and 79 million children.⁶

The proposal garnered general support from the AICPA, ABA and TEI, as reported in their September 2002 “Tax Simplification Recommendations.”⁷ Their joint letter commended Treasury, the NTA and the JCT, but recommended several changes to the proposal, some of which are discussed below.

“Care For” Test

In defining familial and adoptive relationships that qualify for child status, in addition to “traditional” relationships (i.e., children, stepchildren and their descendants), Treasury’s proposal stated, “if the child is the taxpayer’s sibling or stepsibling or a descendant of any such individual, the taxpayer must care for the child as if the child were his or her own child.” While the AICPA, ABA and TEI agreed that siblings, stepsiblings and their dependents should be included in the definition of qualifying relationships, they felt that the language was, in essence, a “backdoor support test” that was vague and would be hard to administer. They recommended eliminating the phrase, a view consistent with that of the JCT, noting that the tie-breaker rules and residence test would be sufficient to avoid any potential abuses. While the phrase was eliminated by the WFTRA, as discussed below, its elimination has led to both hardships and abuses.

Tradability of Dependency Exemption

Treasury’s proposal awarded the child-based benefits, in the case of divorce, to the custodial parent and prohibited release to the noncustodial parent except in the case of grandfathered child-support agreements. The AICPA, ABA and TEI disagreed with the non-tradability feature of the dependency exemption. In the end, the WFTRA provided that a child is considered the qualifying child or qualifying relative of the custodial parent, unless (1) under the divorce or separate maintenance agreement, the noncustodial parent is entitled to the dependency exemption or (2) the custodial parent signs a written declaration stating that he or she will not claim the child as a dependent. However, the Gulf Opportunity Zone Act of 2005⁸ included amendments to the WFTRA that revert to prior law and do not recognize a divorce decree in determining the dependency exemption, but, rather, give the exemption to the custodial parent (who may sign it over to the noncustodial parent). 

Shared Custody Safe-Harbor Rules

Because Treasury’s proposal grants a custodial parent all the child-based benefits, the AICPA, ABA and TEI also recommended safe-harbor rules to reduce potential disputes in the case of shared physical custody of a child. Specifically, they suggested the following:

• ‑If one parent has been awarded physical custody, the child should be presumed to be a qualifying child as to that parent, unless the presumption is rebutted by evidence that the child spent at least 183 days of the year with the noncustodial parent (the six-month test);

• If the parents have been awarded joint physical custody and the child does not satisfy the six-month test as to one parent, the child should be treated as a qualifying child of the parent who claims the child-based benefits, provided the other parent does not also claim such benefits; and

• If the parents have been awarded joint physical custody and the child does not satisfy the six-month test as to one parent, the child should be treated as a qualifying child as to the parent who has the higher adjusted gross income (AGI). A clarification should provide that, for this purpose, the parent’s income is determined without regard to the income of a spouse with whom that parent may file a joint return.

• No such safe harbors appeared in the final legislation.

Definition

Sec. 152(c), as adopted by the WFTRA, defines a qualifying child of a taxpayer as one who meets three tests: 

1. Abode test: The child has the same principal place of abode as the taxpayer for more than half the tax year.⁹ As was true under prior law, temporary absences due to special circumstances such as education, illness, business, vacation or military service, would not be absences.

2. Relationship test: The child has a specified relationship to the taxpayer.¹⁰ Such relationships include (i) a taxpayer’s child (i.e., natural child, stepchild, adopted child and eligible foster child) or a descendant thereof; and (ii) a taxpayer’s sibling (including half-brother and half-sister) or step-sibling, or a descendant of the taxpayer’s sibling or step-sibling.¹¹ As mentioned previously, the pre-WFTRA rule requiring a taxpayer’s sibling, step-sibling or descendant of such individual to be cared for “as if the child were the taxpayer’s own child,” no longer applies.

3. Age test: The child has not yet attained a specified age as of the end of the tax year.¹² The age varies depending on the child-based benefit, as follows: 

• For the dependency exemption, HOH status and the EITC, the child must be under age 19 (under age 24 if a full-time student for any part of five months during the year).¹³

• For the child credit, the child must be under age 17.¹⁴

• For the child and dependent care credit, the child must be under age 13.¹⁵

• Except in the case of the child credit, no age limit applies to individuals who are totally and permanently disabled (within the meaning of Sec. 22(e)(3)) at any time during the year.¹⁶

Further, except for EITC purposes, a child who provides more than half of his or her own support is not deemed a qualifying child.¹⁷

The Sec. 152(c)(4) tie-breaker rules, adopted from the EITC rules, apply when a person may be (and is) treated as a qualifying child of more than one taxpayer on more than one return. Ties are broken as follows:

• If only one of the taxpayers is the child’s parent, the child is the qualifying child of that parent.

• If both taxpayers are the child’s parents, the child is the qualifying child of the parent with whom he or she resides for the greatest period of time.

• If the child resides with both parents for the same amount of time, he or she is the qualifying child of the parent with the highest AGI.

• If neither taxpayer is the child’s parent, the child is the qualifying child of the taxpayer with the highest AGI.

Unintended Results and Abuses

Even before the 2006 filing season began, it became clear that the new law was problematic in many respects. Two of the most difficult areas are the dependency exemption and the EITC. 

Dependency Exemption

Under Sec. 152(a), taxpayers may claim exemptions for two groups of individuals: (1) qualifying children as defined under the UDOC and (2) qualifying relatives as defined under the “old” dependency rules, which include the five tests (gross income, support, relationship, joint return and citizenship tests). The requirement that an individual who is a qualifying child of any taxpayer cannot be a qualifying relative of any other taxpayer has produced some unexpected results. In a Feb. 6, 2006 letter to the IRS Commissioner, the National Association of Enrolled Agents¹⁸ (NAEA) discussed several problems with the “new” definition, as follows:

Example 1: A 30-year old boyfriend who lives with and completely supports his girlfriend (age 28) and her son (age 5) could claim the girlfriend as a dependent under the qualifying relative rules (assuming the relationship does not violate local law), but would not be able to claim the child, because the child is her qualifying child. Is it Congress’s intent that no one be allowed to claim the child as a dependent?

Example 2: The facts are the same as in Example 1, except the boyfriend is 60 years old, the girlfriend is 58 and the son is 35 (and does not earn any income). The boyfriend could claim both as dependents under the qualifying relative rules, because the son is no longer the girlfriend’s qualifying child. Does it make sense that the intent of the law is to allow taxpayers to claim only older dependents?

Example 3: Twin nine-year old children of deceased parents, who live with their adult cousin for the entire year (who fully supports and cares for them), cannot be claimed as dependents by the cousin. The result would be the same if the children were not twins. Under the new rules, the cousin cannot claim the two children as qualifying relatives, because they meet the definition of a qualifying child with respect to one another and the law prohibits an individual from being a qualifying relative of one taxpayer if he or she is a qualifying child of another taxpayer. The problem does not exist if there is only one such child living with a cousin because, without the residence test, the children would not satisfy the definition of qualifying child with respect to one another. Thus, if each twin were to be taken in by a different cousin, they could be claimed as qualifying relative dependents of those respective cousins. It does not make sense that the intent of the law was to allow siblings in such a predicament to be claimed only when they are separated from one another.

Example 4: Twin 19-year-old-brothers of deceased parents live together in their home and attend school full-time. Although they have part-time jobs and earn about $5,000 annually, their principal support comes from their aunts and uncles, who together provide more than 50% of their support. Because each brother meets the definition of a qualifying child with respect to the other (age, residence, relationship test), theoretically, each could claim the other as a dependent. However, the dependency rules prohibit each from claiming the other, because a “dependent” cannot have dependents. The loop continues endlessly, resulting in what the NAEA calls the “qualifying child paradox.” It questions whether the intent of the law could possibly have been to create a situation in which the outcome of applying the law cannot be determined.

In addition to these cases, the NTA¹⁹ describes the following situations:

Example 5: A six-year-old boy lives with his grandparents, whose only income is $12,000 pension income per year. Throughout the year, the boy’s father sent $25,000 to the grandparents for the child’s support. The boy is the qualifying child of the grandparents, because the relationship, residency and age tests are met. Even though the father provided more than half the son’s support, he may not claim his son as a qualifying child, because he did not share a principal place of abode with his son. Further, the father may not claim his son as a qualifying relative, because the son is a qualifying child of the grandparents.

Example 6: Parents earning $400,000 live in a home with their 28-year-old son (who earns $25,000 per year as a medical resident) and their two teenage daughters. The daughters are qualifying children of both the parents and the brother. Under the tie-breaker rules, the parents are entitled to the dependency exemption. However, the parents do not benefit from claiming dependency exemptions for their daughters, because of the phase-out rules and the alternative minimum tax. Under the current rules, if the parents do not claim the daughters as dependents, the 28-year-old son can claim his younger siblings as qualifying children. Did Congress intend to give wealthy families this new tax planning tool?

The NTA suggests that adding the words “claimed as” to Sec. 152(d)(1)(D), so that the term “qualifying relative” means an individual “who is not claimed as a qualifying child of such taxpayer or of any other taxpayer for any taxable year beginning in the calendar year in which such taxable year begins,” would address the issues in Examples 1–5 above. To those who criticize the potential for “shopping around” the dependency exemption, the NTA counters that this would simply open the door for someone to qualify as a qualifying relative and “treat taxpayers as mature individuals who are able to structure their affairs rationally and decide among themselves who is the ‘right’ person to claim various family status benefits.”²⁰ However, the amended language would not “solve” the issues raised in Example 6.

EITC

In Example 6 above, in addition to affecting the dependency exemption, the UDOC also introduces some new planning possibilities for the EITC. Specifically, elimination of the phrase “cared for the sibling as if the sibling was the taxpayer’s own child” has effectively opened the door for affluent families to claim the EITC, while eliminating from eligibility some low-income families for which the credit was intended.

The EITC is available to eligible working taxpayers based on both earned income and AGI levels, as well as the presence of a qualifying child (there is a reduced credit for those without qualifying children). The qualifying child (1) must be under age 19 or a full-time student under age 24, unless the individual is permanently and totally disabled, (2) must share an abode for more than half the year with the individual claiming the child, (3) cannot be a qualifying child of another taxpayer and (4) must be a U.S. citizen or resident alien.

The general explanations of the Administration’s fiscal-year 2007 revenue proposals²¹ provide several cases of inequities with regard to the EITC, as follows:

Example 7: A 20-year-old taxpayer works 30 hours a week at a minimum-wage job while going to school full-time. Her parents are dead, and she is the legal guardian of her 15-year-old brother, with whom she resides for over half the year. Under prior law, she could claim her brother for the EITC because, in addition to meeting other requirements, she “cared for him as if he were her own child.” Under the WFTRA, the brother is still considered the sister’s qualifying child. However, eliminating the “care for” test means that the 20-year-old is also considered to be the qualifying child of her 15-year-old brother: she meets the relationship, residency and age tests. Because a qualifying child cannot claim another qualifying child, the older sister is not eligible for the EITC, surely not Congress’s intention.

Example 8: A couple lives with their 26-year-old son and 16-year-old daughter. The son is not a qualifying child because of his age and lack of a permanent and total disability. In addition, he earns less than $30,000 a year, placing him in the EITC income range. If the parents have moderate income, they may find that they could receive larger child tax benefits if their son claims his sister as a qualifying child and receives the EITC. For a very high-income couple, the gain to the family of allowing the son to claim the sister as a dependent may be even greater, because the couple’s income is too high to benefit from the dependency exemption and child tax credits, as well as the EITC. This situation is similar to that presented by the NTA in Example 6 above.

Administrative Proposals to Amend the UDOC

In recognizing some of the issues described earlier, the Administration’s fiscal-year 2007 revenue proposals include several provisions aimed at solving some of the complexity, unintended results, and abuses brought about by the UDOC. These provisions are summarized in Exhibit 1 . All would be effective for tax years beginning after 2006. However, none of the proposals address the dilemmas described in Examples 1–5.

The first proposal would limit the definition of a qualifying child. The JCT notes that this provision will restore eligibility for the EITC to certain lower-income siblings with respect to their siblings when no other taxpayers reside in the household (Example 7 above), but would not address the situation of a younger sibling supporting an older sibling.²² They suggest that this circumstance could be addressed by denying status as a qualifying child to siblings with lower incomes, rather than to siblings who are younger.

A second proposal would restrict qualifying tax benefits to the child’s parent. It addresses the fact patterns in Examples 6 and 8 above, in which the uniform definition inadvertently extended tax benefits to certain families who otherwise would not qualify, thereby providing a tax planning opportunity for affluent families.

A final proposal specific to the EITC simplifies the rules for claiming the EITC for workers without children. While it provides equitable use of the EITC in today’s common multi-generational families, the JCT cautions that it will add complexity for both taxpayers and the IRS. The proposal does provide flexibility for taxpayers, so that they can allocate the qualifying child in the most advantageous manner. However, the JCT cautions that different rules for unmarried taxpayers create complexity and place unmarried parents at a disadvantage when compared to other types of extended family situations.

Conclusion

In response to recent criticism of the UDOC, the NTA reminded critics that “the intent of the law was to bring about some uniformity for the vast majority of taxpayers who had to meet five or six different tests just to determine whether basic family status provisions under the code actually applied to them,”²³ and that simplifying the definition for 160 million Americans outweighs the concerns that have been raised in a few circumstances that affect relatively few taxpayers. While it appears that, despite problems, support for the UDOC has not significantly eroded, practitioners and their clients will be watching and waiting for action by Congress.