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Tax Issues Related to Child Custody Agreements

When you prepare a child custody agreement for your client, the party entitled to claim the child is often a highly contested issue. After you have worked so hard to obtain the dependency exemption for your client, you need to be absolutely certain that you draft the agreement to avoid any unfavorable tax consequences.
 
Custodial Parent
 
In the absence of any written agreement, the custodial parent may claim the child as a dependent. For tax purposes, a “custodial parent” is the parent with whom the child lived for the greater part of the year. This is not necessarily the same as your state family law definition, which may permit either parent to be the “custodial parent” in order to make the decisions for the child. If both parents claim the same child as a dependent, the Internal Revenue Service (IRS) will reject the second tax return received. That parent, if truly entitled to the exemption, must then mail in a copy of his or her tax return along with any written agreement or proof that the child resided with that parent for more than half of the year. In the meantime, that parent’s tax refund will be placed on hold until the matter is resolved.
 
Noncustodial Parent
 
Unlike the custodial parent, the noncustodial parent does not have the first right to claim the child. In order for a noncustodial parent to claim the child, that parent must have a valid written agreement, which must include all of the following:
  1. The noncustodial parent can claim the child as a dependent without regard to any condition, such as payment of child support or alimony. (Any conditions make the agreement invalid for tax purposes.)
  2. The custodial parent will not claim the child as a dependent for all years or those specifically stated.
  3. The years for which the noncustodial parent, rather than the custodial parent, can claim the child as a dependent. 
If all of these items are contained in the written agreement, the noncustodial parent must attach the following pages of the divorce decree, separation agreement, or custody agreement to his or her tax return:
  1. The cover page (write the other parent’s social security number on this page).
  2. The pages that include all of the information identified in 1-3 above.
  3. The signature page with the other parent’s signature and the date of the agreement.
In the absence of such an agreement, the noncustodial parent can use IRS Form 8332 or a similar statement for the custodial parent to make a written declaration to release the exemption to the noncustodial parent. The noncustodial parent must then attach the form to his or her tax return. (IRS Form 8332 can be obtained at www.IRS.gov.) The custodial parent can release the exemption for one year, for any number of years specified, or for all future years. Because this form is easily obtainable, not to mention free, it would be highly beneficial to have all custodial parents agreeing to release the exemption sign this form in addition to any written custody agreement in order to avoid any potential problems.
 
Other Considerations
 
You may encounter times when the issue of the dependency exemption is highly contested between the parties. In these cases, some attorneys make agreements in which the custodial parent keeps the exemption but gives the noncustodial parent a break in child support equal to the dollar about of the exemption, which was $3,400 per dependent for 2007 but changes regularly. Do NOT do this!!!! An exemption is not the same as a tax credit, which is a dollar-for-dollar tax reduction. An exemption is only worth the amount of the tax bracket of the parent claiming the child. This could be as low as 10%, which is only $340. If you encounter this problem, consult an accountant or tax preparer, fill out a copy of IRS 1040 to see the value, or simply do not agree to such a stipulation.
 
Another issue that sometimes comes up when the exemption is contested is which party will benefit the most from the exemption. Many attorneys at this point will simply look at the parents’ gross income and believe that the parent with the highest income would benefit the most. However, this is not necessarily true. If the parent with the highest income has more dependents, a lot of other tax credits and adjustments, capital or business losses, etc., they may benefit less from the exemption than the parent with the lower income. If you are faced with this issue, you owe it to your client to look at all of the factors rather than simply going by the highest gross income.
 
In Closing
 
There are many agreements to draft and forms to complete as part of any custody agreement, and most of us practicing family law are not tax experts. But keep these tips in mind when you are preparing custody agreements. When in doubt, consult an expert to guide you through the difficult maze of tax laws and regulations.
Reference:
 
Your Federal Income Tax for Individuals (2007) (Otherwise known as IRS Pub. 17.)