Recently-released IRS Publication 4694 highlights various tax breaks that may be available to an individual who is raising a grandchild. These include head of household filing status, exemption for the child, earned income credit (EIC), child tax credit (CTC), credit for child and dependent care expenses, credits or deductions for qualified education expense, and deductions for medical and dental expenses. Because it is increasingly common for practitioners to have clients in this situation, this Practice Alert explains the key details of these tax breaks, which are only briefly summarized in the publication.
Head of household filing status. An individual who is considered unmarried and has a qualifying child may be eligible to use head of household as his or her filing status. It generally is more favorable than the single filing status.
An unmarried taxpayer may qualify as a head of household by maintaining as his home a household that is the principal place of abode for more than half the year of a qualifying child of the taxpayer (as defined in Code Sec. 152(c), see below). (Code Sec. 2(b)(1)(A)(i)) However, the taxpayer won't qualify as a head of household if the qualifying child is married at the close of the taxpayer's tax year (Code Sec. 2(b)(1)(A)(i)(I) and isn't a dependent of the taxpayer because he filed a joint return (Code Sec. 152(b)(2)), or because he isn't a U.S. citizen or resident (Code Sec. 152(b)(3)), or both. (Code Sec. 2(b)(1)(A)(i)(II))
A “qualifying child” is an individual who: (1) bears a specified relationship to the taxpayer including being a grandchild of the taxpayer; (2) has the same principal place of abode as the taxpayer for more than one-half of that tax year; (3) hasn't attained a specified age (see below); and (4) hasn't provided over one-half of his or her own support for the calendar year in which the taxpayer's tax year begins. (Code Sec. 152(c))
An individual meets the age requirement in (3), above, if he:
... hasn't attained the age of 19 as of the close of the calendar year in which the tax year of the taxpayer begins;
... is a student who hasn't attained the age of 24 as of the close of that calendar year; or
... is permanently and totally disabled at any time during the calendar year. (Code Sec. 152(c))
Exemption for the child. A grandparent who has a child living with him or her may be able to claim the child as a dependent and, if so, qualify for other tax breaks, as noted below.
A taxpayer is entitled to a deduction equal to the exemption amount for each person who qualifies as his “dependent.” (Code Sec. 151(c)) A person generally qualifies as the taxpayer's dependent if the person is the taxpayer's qualifying child (see above) or qualifying relative. (Code Sec. 152(a))
Earned income credit. A grandparent who is working and has a qualifying child living with him or her may be able to take the EIC, even if the grandparent is 65 years of age or older. This could generate a refund even if the grandparent owes little or no tax.
An eligible individual (see below) is allowed an EIC equal to the credit percentage of earned income (up to an “earned income amount”) for the tax year. (Code Sec. 32(a)(1)) The EIC for a tax year (determined under IRS tables) can't be more than the excess (if any) of (1) the credit percentage of the earned income amount, over (2) the phaseout percentage of AGI (or earned income, if greater) over a phaseout amount. (Code Sec. 32(a)(2))
An individual who has a “qualifying child” for the tax year is an eligible individual. (Code Sec. 32(c)(1)(A)(i)) A “qualifying child” for EIC purposes means a qualifying child of the taxpayer, as defined for the dependency exemption in Code Sec. 152(c) (see above), but without the requirement that the child didn't provide more than half of his own support. (Code Sec. 32(c)(3)(A))
Child tax credit. A grandparent who is raising a grandchild may be able to take the CTC and, under specific circumstances, the additional CTC. The latter may provide a refund even if no federal income taxes are owed.
For 2010, individuals may claim a maximum $1,000 CTC for each qualifying child (see above) the taxpayer can claim as a dependent. (Code Sec. 24(a)) The child must be under 17 and a U.S. citizen or resident alien. (Code Sec. 24(c))
The amount of the allowable credit is reduced (not below zero) by $50 for each $1,000 (or fraction thereof) of modified AGI (AGI increased by excluded foreign, possession, and Puerto Rico income) above: $110,000 for joint filers; $75,000 for unmarried individuals; and $55,000 for marrieds filing separately. (Code Sec. 24(b))
The CTC is refundable, but only to the extent of the greater of: (1) 15% of taxable earned income above $3,000 for 2010; or (2) for a taxpayer with three or more qualifying children, the excess of his social security taxes for the tax year over his EIC for the year. (Code Sec. 24(d)) IRS calls the amount of the CTC that's refundable (on Form 8812) the “additional child tax credit.”
Credit for child and dependent care expenses. This credit may be available if a grandparent pays someone to care for a qualifying individual, i.e., a dependent under age 13, or his or her spouse or a dependent who is physically or mentally not able to care for himself or herself, while the grandparent works or looks for work. (Code Sec. 21(a))
The credit for 2010 is 35% of employment-related expenses for taxpayers with AGI of $15,000 or less. The percentage decreases by 1% for each $2,000 (or fraction thereof) of AGI over $15,000, but not below 20%. (Code Sec. 21(a)(1), Code Sec. 21(a)(2); Reg. §1.21-1(a)) The maximum amount of employment-related expenses that may be used to compute the credit for 2010 is $3,000 for one qualifying individual, or $6,000 for two or more qualifying individuals. (Code Sec. 21(c); Reg. §1.21-2(a)(1))
Qualified education expense. There are several tax breaks that may be available to a grandparent who pays his or her grandchild's education costs. These include:
... Education credits. An individual taxpayer may claim an income tax credit for the Hope scholarship tax credit (renamed the American opportunity tax credit (AOTC) for 2010) and the Lifetime Learning credit for higher education expenses at accredited post-secondary educational institutions paid for themselves, their spouses, and their dependents. The AOTC is available in 2010 for qualified expenses of the first four years of undergraduate education; the Lifetime Learning credit is available for qualified expenses of any post-high school education at “eligible educational institutions.” Both credits can't be claimed in the same tax year for expenses of any one student, and it phases out for higher-income taxpayers. For tax years beginning in 2010, individuals may elect a personal, partially refundable tax credit equal to 100% of up to $2,000 of qualified higher-education tuition and related expenses plus 25% of the next $2,000 of expenses paid for education furnished to an eligible student in an academic period. (Code Sec. 25A(a)(1), Code Sec. 25A(i)(1)) Taxpayers may elect a Lifetime Learning credit equal to 20% of up to $10,000 of qualified tuition and related expenses paid during the tax year. The maximum credit is $2,000. (Code Sec. 25A(a)(2), Code Sec. 25A(c)(1)) Unlike the AOTC/Hope credit, which is available for the qualifying expenses of each qualifying student, the Lifetime Learning credit is available only per taxpayer.
... Coverdell Education Savings Accounts (CESAs). Taxpayers can contribute up to $2,000 per year to CESAs in 2010, formerly called education IRAs, for beneficiaries under age 18 (and, in 2010, special needs beneficiaries of any age). The account is exempt from income tax, and distributions of earnings from CESAs are tax-free if used for qualified education expenses. (Code Sec. 530)
... Qualified Tuition Programs (QTPs) —529 Plans. A person can make nondeductible cash contributions to a QTP/529 plan on behalf of a designated beneficiary. The earnings on the contributions build up tax-free, and distributions from a QTP are excludable to the extent used to pay for qualified higher education expenses. (Code Sec. 529)
... Higher Education Exclusion for Savings Bond Income. Qualified U.S. savings bond income is excluded if redemption proceeds don't exceed qualified higher education expenses. The exclusion phases out at higher levels of modified adjusted gross income. Qualified higher education expenses are tuition and fees required for the enrollment or attendance of taxpayer, taxpayer's spouse or any dependent for whom taxpayer is allowed a dependency exemption, at an eligible educational institution, e.g., most colleges, junior colleges, nursing schools and vocational schools. (Code Sec. 135)
... Above-the-Line Deduction for Higher-Education Expenses (before 2010). For tax years beginning before 2010, eligible individuals may deduct higher education expenses—i.e., “qualified tuition and related expenses” of the taxpayer, his spouse, or dependents—as an adjustment to gross income to arrive at adjusted gross income. (Code Sec. 222(a)) The higher education deduction can't exceed: $4,000 for taxpayers whose modified AGI for the tax year doesn't exceed $65,000 ($130,000 for a joint return); $2,000 for taxpayers whose modified AGI exceeds $65,000 ($130,000 for a joint return), but doesn't exceed $80,000 ($160,000 for a joint return); and zero for other taxpayers. (Code Sec. 222)
... Deduction for Interest on Qualified Education Loans. Qualifying individuals may claim an above-the-line deduction for up to $2,500 of interest paid on a qualified higher education loan, i.e., any debt incurred by the taxpayer solely to pay qualified higher education expenses that are: (1) incurred on behalf of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the debt was incurred; (2) paid or incurred within a reasonable period of time before or after the debt is incurred; and (3) attributable to education furnished during a period when the recipient was an eligible student (as defined for the AOTC/Hope credit purposes, i.e., at least a half-time student). (Code Sec. 221)
Medical and dental expenses An individual who itemizes can deduct the amount by which certain unreimbursed medical and dental expenses paid during the year for himself or herself, his or her spouse, and his or her dependents exceed 7.5% of his adjusted gross income. (Code Sec. 213)