Tie-breaker rule in practice

The tax court recently ruled on the following family drama:

A child lived in a home with several adult relatives including her mother, grandmother, and two aunts.

The mother had no income, and so did not file a tax return for the tax year in question, 2005. The grandmother received Social Security and did not have sufficient taxable income to require filing a return. However, both aunts had earned income and filed tax returns claiming the child. Let's call them Aunt A and Aunt B. Aunt A had an adjusted gross income (AGI) of $23,176. Aunt B had an AGI of 29,798.

According to IRS rules, only ONE tax return can claim the child. Either Aunt A or Aunt B could qualify to claim the child, but not both.

Since both aunts filed returns claiming the child, the IRS was forced to intervene and apply the tie-breaker rule.

Aunt A was able to show to the satisfaction of the IRS and the Tax Court judge that she provided some of the child's support. There is no evidence that Aunt B provided any support for the child.

Which aunt won the right to claim the tax benefits associated with the child (dependency deduction, Earned Income Credit, and Child Tax Credit) on her return?

You might think it would be Aunt A, the aunt who contributed some of the child's support according to the IRS stipulation.

But you would be wrong.

Aunt A lost out to Aunt B, because the amount of support provided has no bearing on the tie-breaker. Even if Aunt A had provided 100% of the support for the child, she still would have lost out to Aunt B!

Why? The tie-break rule awards the tax benefits for the child to the aunt with the higher AGI.

As this tax court ruling demonstrates, the amount of support provided by the two aunts has no bearing on who gets to claim the child. The judge and the IRS agree with Aunt A's claim that she provided more support than Aunt B, but the tie-breaker rule state that the other aunt wins because her Adjusted Gross Income (AGI) was higher. In fact, the winning aunt would still win even if she provided zero support to the child and the losing aunt had provided 100% of the support to the child.

The AGI tiebreaker rule seem arbitrary and can certainly be unfair in practice. However, the fairer alternative, awarding the tax benefits for the child to the person who contributed most to the child's support, was not really practical for the IRS to enforce. In a household with multiple adults who may be paying for different expenses (groceries, utilities, rent, clothes, medical bills, etc.), it may be very impractical to determine who paid what the previous year. This is especially true for those among the estimated 10 million households who are "unbanked" or "underbanked," and who may not having checking accounts or credit cards that could document which member of a household paid which expenses.

Of course, Aunt A and Aunt B could saved themselves a good deal of trouble if they'd talked things over first and decided that only one of them should file for the child. Then the IRS would not have had to get involved in applying the tie-breaker rule.

The IRS says that if only eligible adult in the household attempts to claim the child, there is no need to apply the tie break rule.

And, in fact, often the household will wind up with more money if the taxpayer with the lower AGI claims the child. That is likely the case for the Aunt A and Aunt B household, based on the facts stated in the Tax Court Opinion.

I used the NBER's Taxsim simulator to determine that Aunt A would likely have gotten a much bigger tax benefit from claiming the child than Aunt B did. The tax benefits of the child to Aunt A would have been about $2,700, while the tax benefits of the child Aunt B were only about $1,700. That's basically because both Aunt A and Aunt B are in the phase-out region of the Earned Income Credit schedule, so Aunt A's EIC if she'd been able to claim the child would have been about a thousand dollars higher than Aunt B's EIC.

Bottom line: under current tax law, the household can come out ahead (and save a good deal of hassle in dealing with the IRS) if they work out an arrangement among themselves as to who will claim the child.

From a greater tax equity perspective, this case raises interesting issues. The child lives in a household with four adult relatives whose total income is likely over $60,000. In addition, the child receives support from a non-resident great-uncle, who owns the house and does not charge rent, and possibly from a non-resident father as well. Moreover, the Tax Court opinion states that food stamps provided the child's food, presumably because the mother had no income. An adult relative who lives in the household and who does not contribute toward household expenses and provides no support whatsoever to the child is eligible, under current law, to claim thousands of dollars of tax benefits for that child. She gets the same Earned Income Credit, Child Tax Credit, and dependency exemption benefit as she would if she were the sole support of the child.

The Earned Income Credit is designed as an anti-poverty program, to reduce the number of children growing up in impoverished circumstances. This case illustrates that it's hard to write tax laws to target benefits as well as we might like.