Sixth Commandment: Thou shalt not claim Head of Household status for thy taxpayer based on his unrelated roommate.

An unrelated deadbeat (or otherwise down on their luck) roommate who lived with the taxpayer all year can sometimes qualify as the taxpayer's "Qualifying Relative" (QR) dependent. (Check the rules in Table 2 here to be sure.) In that case, the taxpayer would be entitled to claim a dependent exemption for the deadbeat roommate and subtract the value of his $3,700 exemption from his taxable income.

However, unrelated roommates--even if they are QR dependents--are NEVER "Qualifying Persons" (QP) for the Head of Household (HoH) filing status!

HoH filing status requires that the taxpayer support a household containing a sufficiently related "QP". Unrelated roommates, girlfriends, boyfriends, or even distant relatives such as cousins are NOT QP's for HoH status, even though they might be QR's for dependent exemption purposes.

How "closely related" does a QP have to be for HoH status? Check the table on page B-3 here.

Once again, this illustrates that the IRS does not use English the same way the rest of us do. You don't necessarily have to be "related" by blood or marriage to be a "Qualifying Relative" dependent, but you DO have to be closely related by blood or marriage to be a "Qualifying Person" for HoH status.

Fourth commandment: thou shalt enter each and every box of thy taxpayer's W-2 data faithfully and verbatim.

Fourth commandment: When thou usest tax software, thou shalt enter each and every box of thy taxpayer's W-2 data faithfully and verbatim.

There is a lot of important tax information embedded in a W-2, including some mysterious items that may not be obvious at first glance, so whenever you use tax software, you need to create a faithful verbatim electronic copy of the data in every box of the W-2.

If you do that meticulously, TaxWise should do the work of putting everything in the correct place on the Federal 1040 and NYS IT-201 tax forms, but it's important to understand WHAT you are doing and WHY you are doing it.

A few important observations:

0) "Verbatim" is a slight exaggeration: you are allowed--and encouraged!--to round dollar amounts to the nearest whole dollar.  Also, the IRS computers are apparently allergic to punctuation, so do not include it.  (E.g., if the taxpayer or employer's name has an apostrophe in it--like mine--leave it out.  Otherwise, as I learned the hard way a decade ago, you run the risk of giving the IRS computers a bad case of indigestion.)

1) Not all W-2s are laid out in exactly the same way. Some W-2s are vertical, some are horizontal, some are large, some are small. What is key is matching up the box numbers, box by box.

2) Be VERY careful to distinguish the words employEE from employER. A common source of problems is mixing up the employEE SSN with the employER tax ID number, or the employEE address with the employER address. (I'm capitalizing those letters distinctively for emphasis here, but the W-2 provides no such help.)

3) Those mysterious letters and codes in Boxes 12 through 14 give important information about contributory retirement plans (e.g., 401(k)'s) and other fringe benefit compensation that may have special tax treatment. As an example, let's consider Quincy Bennett's W-2 above from the IRS Pub 4491W workbook. (You can click on the image to see a larger and clearer view.)

Mr. Bennett's W-2 shows in Box 12a that he contributed $531 to his traditional 401(k) plan at Luther Petroleum. (How do I know that? The mysterious Code D in Box 12a. You can read more about what W-2 codes mean here.) That contribution reduced his wages subject to income tax in Box 1 by $531, but it did not affect his Box 3 and Box 5 wages for Social Security and Medicare payroll tax purposes. It also reduced his Box 16 wages subject to state income tax by $531.

4) The information in Box 2, federal withholding, and Box 17, state withholding, is especially important! It is literally "money in the bank," because it represents money that the employer has withheld from the employee's pay that needs to be credited against his federal and state tax liability. If you accidentally omit that data input (it's especially easy to overlook the Box 17 information), you can literally give your poor taxpayer a heart attack by wrongly telling him he owes a lot of money, when in fact, he actually owes much less or may even be entitled to a refund.

5) UPDATE:  The Advance EIC is no longer an option.  It was eliminated 10 years ago.  Few taxpayers chose it (for reasons we will discuss in class) and it created more trouble than it was worth for some of those who did. A frequently overlooked item: "Advance EIC payment" in Box 9. For example, see Ms. Colby Bennett's W-2 below. (Again, click on the image for a clearer view.) There is $1,200 in Box 9. That tells me that me that--at her request, her employer, the William School District, included $1,200 of Advance Earned Income Credit (EIC) payments in her paychecks during the year. Effectively, her employer gave her an advance on part of her refund, and that advance needs to be subtracted from the refund she will get at the end of the year. If you enter the Box 9 information into the electronic W-2 in TaxWise, you should check to make sure that TaxWise puts that number into line 59 on the 1040.



In effect, "Advance EIC" is a form of negative withholding. This complication rarely happens in real life--only about 1% of EIC recipients choose to collect some of it in advance, but when it does happen, it is essential to take it into account! It comes up far more frequently in IRS workbook exercises (and maybe the the certification exam!) than in real life. In the interests of tax simplification, the provision for Advance EIC is ending with the 2010 tax year, so this should be the last year we need to worry about this.

Rock-Paper-Scissors rules for tax law

Okay--I'm out of hard-and-fast commandments for now, so I'll move on to another analogy: tax law can sometimes be like rock-paper-scissors.

1) When considering dependent status, Qualifying Child (QC) trumps Qualifying Relative (QR). In other words, if the potential dependent is anyone's QC, he can't qualify as a QR for anybody. Do not ever check for QR status without first ruling out the possibility that the potential dependent could be a QC for that taxpayer or for another taxpayer.

2) When considering QC status, relationship and residence trump support. In other words, if the potential dependent is a QC of more than one taxpayer, it does not matter which taxpayer provided more support. The tiebreak rules for QC give priority to relationship and residence. Remember that you don't need to support a QC to claim him! The support test for a QC exemption just requires that the QC does not provide more than 50% of his own support.

3) After ruling out QC status, then--and only then--can you consider the possibility of QR status, in which case support may possibly trump relationship and/or residence. You do need to support a QR to claim him or her, but you may not need to live with him (depending on how closely he is related to you.)

It is complicated! I've read Tax Court cases that make it clear that even IRS auditors have occasionally incorrectly applied the rules. That is why it is important to carefully work through the flowcharts in Tab C of Pub 4012 when determining QC and QR dependents.

For more on that topic, see here.

Third Commandment: All thy income is taxable ... unless tax law explicitly states it can be excluded.

Commandment #3: Thou shalt report all thy income on thy 1040 unless there is an explicit provision in tax law allowing thee to exclude it from thy tax base.

The general rule: all income is subject to income tax unless there is a provision in tax law explicitly excluding it from taxation.

Do not leave income off a taxpayer's return unless you can find an explicit provision allowing you to do so. Even there--be careful!

For example, even though gifts are excludable from taxable income, not everything called a "gift" is actually a "gift" for tax purposes. If your taxpayer's grandma gave him a gift, it's different from his employer giving him a gift. If in doubt, check with your professor!

And remember, "income" does not have to be in cash to be "income." That year's supply of dog food you won on a game show is income! So is that "designer purse" you won at a charity raffle. Or the Xbox you won in the Microsoft College Puzzle Challenge. So is the bike your employer gave you if you worked at Ikea. (See here for more on that.) Even a scholarship that provided free room or board is income. (See here for more on that.)

For more information on common types of taxable and non-taxable income, see here.

Second Commandment: thou shalt live for over half the tax year with thy EIC Qualifying Child

Commandment #2: Thou shalt live with thy Qualifying Child for over half the tax year in order to claim thy Qualifying Child for Earned Income Credit purposes.

In modern English: although there are special circumstances in which divorced or separated parents can claim a QC for other tax benefits, the Residence Requirement is an absolute requirement for Earned Income Credit (EIC).

A non-custodial parent with whom the child lived less than half the year NEVER, EVER, EVER gets to claim the QC for EIC purposes!

It doesn't matter if the custodial parent wants to give the EIC away to the non-custodial parent. If the noncustodial parent taxpayer did not live with the kid, the taxpayer is not allowed to claim the kid for EIC purposes!

Ya can't claim the kid for EIC without living with the kid!

Interestingly, you don't need to support your QC to claim him for EIC purposes, but you do need to live with him!

Residence is the sine qua non requirement for EIC QC purposes.

That is really important, because the EIC is by far the largest tax benefit associated with children in low-income working families. As you can see from the graph below, whether a taxpayer has children can make a huge difference in their EIC refund, so it's critically important to get this detail correct, so the EIC goes to the taxpayer actually entitled to claim the QC for EIC purposes.



(Caveat: remember that the IRS does not define "live with" quite the same way as normal people do. If the child was born or died during the year or had temporary absences for college, medical reasons, etc. the IRS may deem that s/he "lived with" the taxpayer for all 12 months of the year for tax purposes.)

For more information about EIC rules, see here.

First Commandment: Dependents shalt claim no dependents

Commandment #1: Thou shalt have zero exemptions on thy own tax return if thou meetest the qualifications to be a dependent of another taxpayer.

In modern English: if you qualify to be claimed as the dependent of another taxpayer, you may NOT claim a personal exemption for yourself, nor may you claim any dependents of your own on your tax return.

No ifs, ands, or buts: as long as the other taxpayer(s) COULD have claimed you on their tax return, it does not matter whether they actually DID claim you on their tax return--you may not claim yourself on your return nor may you claim any dependents on your return.

For more information about rules for personal and dependent exemptions, see here.

There are some other negatives for taxpayers who can be claimed as dependents. In particular, if you can be claimed as a dependent by another taxpayer, you are NOT eligible for the Making Work Pay refundable tax credit.

This led to some unpleasant surprises for young dependent taxpayers last year. Some of them ended up owing money, when they had been expecting at least a small refund. That's because payroll withholding formulas did not take into account their dependent status, so they had not had enough federal tax withheld from their pay.

The "No King Solomon" rule

Who gets to claim the tax benefits for a "qualifying child" and can those benefits for a given "qualifying child" be "split" among different taxpayers?

Thes questions (both on the certification exam and in actual practice with clients) give preparers more trouble than any other type of problem.

A qualifying child can very easily be worth thousands of dollars in combined Federal and New York State tax refunds to the adult who gets to claim them.

As you now know from your study of tax law, frequently there may be multiple adults living in a household with a qualifying child, each of whom may be eligible to claim the child on their return. If the adults can't agree, there is a definite "pecking order" tie-breaking system imposed by the IRS (which is described at the bottom of page C-3 in Tab C of your Pub 4012. Tab C of Pub 4012 has all the answers to your questions--you just have to read it very carefully!)

You also know that a given "qualifying child" can generate many different tax benefits: dependent exemption, Child Tax Credit and/or Additional Child Tax Credit, Child Care tax credit, Earned Income Tax Credit, Education Tax Credits, qualification for Head of Household filing status, and more.

So it's very natural for taxpayers to ask what I call the King Solomon question: "Can the tax benefits for a qualifying child be split among multiple taxpayers?"

In general , the answer to the King Solomon question is NO, (with a very special and narrow exception for divorced or separated taxpayers)

Examples

1) Multiple children can be split in a household Example: If there are multiple "qualifying children" within a household and several adults eligible to claim them, the DIFFERENT CHILDREN can be split across taxpayers. If mom, grandma, and Uncle Bill lived with three kids last year and all met the criteria, mom trumps grandma and Uncle Bill, and she has first claim on all of them. However, mom can say, "I'll take Johnnie on my return, Grandma can take Jill, and Uncle Bill can take Susie."

2) "NO King Solomon rule" Example However, the tax benefits associated with a particular child can NOT be split across taxpayers. Mom can't say, "I'll claim the EIC for Johnnie, but Uncle Bill can take Johnnie's personal exemption."

3)EXCEPTION to "No King Solomon Rule" for non-custodial parent

Example: There is only ONE limited exception to rule #2. If there is a non-custodial parent in the picture, the custodial parent has the option to sign a Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents. However, this only releases the Personal Exemption and Child Tax Credit, and Additional Child Tax Credit eligibility to the noncustodial parent. The other tax benefits for the Qualifying Child (EITC, DC, and HoH filing status) ALWAYS remain with the parent who lives with the child---under no circumstances can they be given to a taxpayer who does not live with the child for at least half a year.