Provocative question from a taxpayer

A newly divorced taxpayer named "Scott" wrote the following question to the TaxGirl blog.

I have two kids with split custody (they each live with my ex and myself half the time). The divorce decree says we each can claim one. However, we are going to figure the taxes according to the decree, and are willing to let the other claim the child if beneficial for tax purposes and split the difference. One of us makes about 60,000 and the other 17,000 with standard deductions and not much for other items (ie - loss, non itemized). Also, we were divorced in 2008 so we can make the child care expenses max out either way (6000).

Since the kids don’t actually live with one more than the other, I think it would be ethical to work it either way.

1. Low income parent: claims EIC on both, child care, HOH
High income parent: claims both dependents, single (can they also claim HOH), no child care

2. Low income parent: claims EIC on one child, HOH
High income parent: claims both dependents, HOH, child care on 1 child

I realize this is kind of complicated and probably not the greatest description, but would greatly appreciate any advise.

First of all, it should be noted that the rules for claiming a "Qualifying Child" dependent required that the Qualifying Child live with the taxpayer for "more than half the year," so technically if a child spends EXACTLY half the year with Scott and EXACTLY half with Scott's ex-wife, neither one could claim that child as their Qualifying Child. (In that particular situation, technically the child would only constitute a "Qualifying Relative" dependent, which would allow for a dependency exemption, but would rule out many of the other associated tax benefits associated with children.)

If the parents really want to maximize the benefits of the children, they should arrange it so that each child spends at least slightly more than half the year at one parent's home. It's obviously too late to do anything (retrospectively) about which child slept where and when last year, but it's certainly something they could arrange for 2009 and future tax years.

So let's consider the taxpayer's options for 2009, since there's plenty of time to make adjustments as to which kid spends which night where.

I'll need to make some assumptions: only income is wages, so there's no investment or other unearned income, neither parent itemizes deductions, and no other special tax breaks apply (e.g., no IRA, 401(k) contributions, no student loan interest, college tuition, etc.) I'll also assume no alimony payments. Child support payments would not make a difference, so there's no need to make any assumptions about those. I'll also assume that both children are under 17 (and, in fact, they need to be under 13--or disabled--in order for child care benefits to apply.)

I'll use the NBER's TaxSim model to project their federal tax bills. It's an easy to use and free tool for getting "quick and dirty" estimates of many scenarios like this.

Option 1:
Low income parent: claims EIC on both, child care, HOH.
High income parent: claims both dependents, single (can they also claim HOH?), no child care

First of all, to create this situation, the low-income parent would have to have both children live with her for more than half of 2009. Under that circumstance, the high income parent's filing status would be single, not HoH.

Estimated federal tax liability for high income parent under Option 1: $9,004
Estimated federal tax liability for low income parent under Option 1: -$5,476

Total federal tax liability for both parents combined under Option 1: $3,528.

Option 2:
Low income parent: claims EIC on one child, HOH.
High income parent: claims both dependents, HOH, child care on 1 child

Estimated federal tax liability for high income parent under Option 2: $4,225
Estimated federal tax liability for low income parent under Option 2: $517

Total federal tax liability for both parents combined under Option 2: $4,742.

So option 1 would definitely decrease their combined total tax liability quite a bit compared to option 2.

Of course, there's a third option that the taxpayer didn't ask about, but I'll include it here as Option 3, for completeness and policy discussion.

Option 3:
The parents reconcile and remarry before December 31, 2009. They move back into the same household and live together for the remainder of the year, so HoH status is no longer an option for either. They file a joint return, claiming both children as their dependents, so they get child tax credits and the child care tax credit. In this case, no EIC, since combined income is too high.

Total federal tax liability for both parents combined under Option 3: $5,120.

So these parents are definitely in a "marriage penalty" situation--reconciling and remarrying would raise their tax bill to a level 50% higher than their Option 1 total.

The marriage penalty would be MUCH worse if both parents earned low-incomes, as this discussion illustrates. And marriage penalties for low-income parents go far beyond the tax code, as this marriage penalty calculator on the HHS website illustrates.