Parental support tax savings opportunities.

EXECUTIVE SUMMARY

* Individuals who share in the financial support of a parent should use an MSA to realize the maximum tax benefit from the additional dependency exemption.

* A single taxpayer who supports a dependent parent may be entitled to HOH filing status.

* Taxpayers who incur expenses for the care of a parent may be entitled to a dependent care credit or be eligible to pay the expenses through their employer's dependent care assistance program.

For clients who support a parent, tax savings are available in the form of dependency exemptions, head of household filing status, dependent care credit, dependent care assistance programs and medical expense deductions. This article examines these opportunities, explains eligibility and offers planning examples.

There is increasing concern about the financial burden on taxpayers who support their parents. Various tax proposals(1) have been introduced to provide relief. In the meantime, several well-established (but often neglected) tax breaks are available to eligible taxpayers who provide their parents with financial support, including an additional dependency exemption, head of household (HOH) filing status, a dependent care credit and a medical expense deduction. This article reviews each of these tax breaks and presents planning opportunities.

Dependency Exemptions

Requirements

A taxpayer can claim a dependency exemption for another individual if the following five requirements are met:

1. Gross income test. Under Sec. 151(c)(1)(A), the dependent's gross income cannot exceed the personal exemption ($2,750 for 1999).

2. Support test. Under Sec. 152(a), the taxpayer claiming the exemption must provide over half of the dependent's support for the year.

3. Relationship test. The dependent must either be related to the taxpayer (as defined in Sec. 152(a)) or reside with him as a member of his household for the entire tax year. Parents and grandparents qualify under Sec. 152(a)(4).

4. Citizen or resident test. Under Sec. 152(b) (3), the dependent must be either a U.S. citizen or resident, or a resident of Canada or Mexico.

5. Joint return test. Under Sec. 151(c)(2), the dependent cannot file a joint return, unless fried solely to claim a refund.

These tests are relatively straightforward; typically, they do not present major problems for taxpayers attempting to claim a dependency exemption for their parents. Qualification of a parent as a dependent usually hinges on passing the gross income and support tests, which are reviewed below.

Gross Income Test

Sec. 151(c)(1) provides that a dependent's gross income must be less than the personal exemption amount. Kegs. Sec. 1.151-2(a) states that, for this purpose, gross income is defined in Sec. 61; hence, receipts excludible from income are not counted in applying the gross income test. Although the personal exemption is relatively low ($2,750 for 1999), taxpayers supporting parents whose primary source of income is Social Security income are often able to meet the test.

Taxpayers handling their parent's financial affairs should closely monitor the amount and type of income the parent earns. Planning may enable a taxpayer to meet the gross income test and qualify for a dependency exemption with only minor changes to a parent's investment portfolio.

Example 1: A supports his father, B. B's 1999 gross income is as follows:

Social Security benefits       $12,000
Pension income                   2,000
Taxable bond interest            1,000

For purposes of the gross income test, B's gross income is $3,000, which exceeds the personal exemption. Thus, the gross income test is not met. However, if B reduced his gross income by investing a portion of his savings in tax-exempt bonds, rather than taxable bonds, his gross income would not exceed the personal exemption; he would meet the gross income test.

Other planning opportunities may be available to taxpayers whose ability to claim a parent as a dependent hinges on the gross income test. A dependent parent's income should be reviewed before year-end to determine if any income-shifting strategies are available.

A gift of income-producing property to children or grandchildren may be another way to reduce taxable income below the exemption amount. The dependent parent must be willing to part with his entire interest in the property to shift the income tax consequences to children or grandchildren. However, the additional income tax cost to the donee may outweigh the benefit of an additional personal exemption.

Support Test

A taxpayer claiming another person as a dependent must provide over half of that person's support. Regs. Sec. 1.152-1(a)(2) states that "support" includes food, shelter, clothing, medical and dental care, education and the like. Payment of medical expenses (including medical insurance premiums) are support; on the other hand, medical insurance benefits are not. In addition, basic and supplementary Medicare benefits are not considered items of support.(2)

According to Regs. Sec. 1.152-1(a) (2)(i), the total amount of support received from the taxpayer is compared to the entire amount of support received from all sources, including support the individual himself provided. The amount spent on support is measured by actual cost, except for lodging (which is measured by its fair market value (FMV)). The FMV of lodging is the amount one could reasonably expect to receive from an unrelated party for the same kind of lodging.

Unlike the gross income test, Regs. Sec. 1.152-1 (a) (2) (ii) states that excludible income (i.e., Social Security and other tax-exempt interest) actually spent on support is taken into consideration.

Example 2: A lives with her son, B, and his four children. In 1999, A receives $3,000 in Social Security benefits; she has no other income. In 1999, A spends $2,000 on clothing and recreation and $1,000 on medical expenses. For 1999, the FMV of lodging provided to her is $2,000 per year; the household's total food expense is $6,000. As shown below, A's total support is $6,000, half provided by A and half by B.

                            Total        B          A
                           support    provided   provided

FMV of lodging              $2,000     $2,000
Clothing and recreation      2,000               $2,000
Medical expenses             1,000                1,000
A's share of food
 ($6,000/6)                  1,000      1,000
Total                       $6,000     $3,000     $3,000

Because B provided only 50% of A's support, not more than 50%, he does not meet the support test. However, support is measured by the amount spent; B could meet the support test in future years by increasing the amount he spends on A's support. For example, had B paid $200 of A's medical expenses in 1999, he would have provided 53.3% ($3,200/$6,000) of her support and met this test.

Planning and documentation are particularly important for parents who receive Social Security benefits. A rebuttable presumption exists that such amounts are used to support the person receiving them. In Example 2 above, B would have to prove that A did not use all $3,000 of her Social Security benefits for support; A could have given part to charity or to a trust created to benefit a grandchild. As long as there is evidence of the actual use of the Social Security payments, the presumption would be rebutted. The presumption could also be rebutted by depositing such benefits into a savings account. A does not have to give the benefits away; it just has to be proven they were not used for her support.

Married taxpayers are treated as a unit. Social Security benefits received by married taxpayers are rebuttably presumed to be spent equally on each, even if only one parent receives them.(3)

MSAs: A multiple support agreement (MSA) may be used to realize tax savings when several individuals share in their parent's support. Under Sec. 152(c), an MSA allows a group of taxpayers to claim a dependency exemption for another individual when no one of them individually provides more than 50% of support. As long as the taxpayers, as a group, provide more than 50% of another's support, they can decide among themselves who should claim the dependency exemption. However, that member must contribute more than 10% of such support. Only one exemption may be claimed each year, as agreed to by the group; however, a different person may claim the exemption each year.(4)

The adjusted gross income (AGI) and marginal tax brackets of the individuals who together provide more than half of a parent's support should be analyzed before deciding which taxpayer should claim the exemption. A few principles should be kept in mind; first is the effect of the Sec. 151(d)(3) dependency exemption phaseout rules. The exemption should never be claimed by a taxpayer who will lose some (or all) of the exemption's benefit because of high AGI. For 1999, dependency exemptions are phased out beginning at AGI of $189,950 for married taxpayers filing jointly ($126,600 for single taxpayers). Exemptions are phased out by 2% for each $2,500 of AGI over the threshold, resulting in complete phaseout at $312,450 of AGI for married taxpayers filing jointly ($249,100 for single taxpayers).(5) In general, the highest-bracket taxpayer who is not subject to phaseout of the exemption will receive the most benefit from claiming it.

Example 3: P has three children, M, N and O, who are all married filing jointly. P's sources of support, and M's, N's and O's 1999 AGI and marginal tax brackets, are as follows:

                                             Marginal
        Support   Percentage      AGI       tax bracket

M        $4,000      40%         $320,000      39.6%
N         2,100      21%           30,000        15%
O           900       9%          150,000        31%
P         3,000      30%
Total   $10,000

Together, M, N and O provide over 50% of P's support. O, by himself, provides less than 10% of P's support and does not qualify for an MSA. Because M and N each provide more than 10% (and together provide more than 50%) of P's support, they can execute an MSA; one of them can claim a dependency exemption for P, if otherwise eligible. Because M would receive no benefit from an additional exemption (because of the phaseout rules), N should claim it.

O could become a member of the group eligible to claim P as a dependent by providing, for example, an additional $120 of support. If O provided more than 10% of P's support and became eligible for the exemption, O (rather than N) should claim it. O would receive a tax benefit of $853 ($2,750 X 31%), while N's tax benefit would be only $413 ($2,750 X 15%).

HOH

A single person who supports a parent may be able to use HOH filing status. Under Sec. 2(b)(1)(A)(2), if a parent qualifies as a dependent, HOH status is available to an unmarried taxpayer who maintains a household that constitutes for the tax year the parent's principal place of abode. (For this purpose, Regs. Sec. 1.2-2(b)(3)(ii) states that the dependency exemption cannot be based on an MSA.) According to Regs. Sec. 1.2-2(d), a taxpayer "maintains a household" if he pays more than half of the cost of maintaining it during the tax year.(6) Thus, a single taxpayer who provides more than half the cost of maintaining a home in which he and his dependent parent live qualifies for HOH status.

However, Sec. 2(b)(1)(B) provides a special rule--a dependent parent does not have to live with the taxpayer. HOH status is available under Regs. Sec. 1.2-2(c)(2) as long as the taxpayer provides more than half the cost of maintaining a household that is the parent's principal place of abode. Thus, a single taxpayer who pays more than half the cost of a dependent parent's nursing home expenses can qualify as an HOH.

Under Regs. Sec. 1.2-2(c)(2), the parent must occupy the household maintained by the taxpayer for the entire tax year. The parent is deemed to occupy the household notwithstanding temporary absences due to special circumstances, as long as (1) it is reasonable to assume such person will return and (2) the taxpayer continues to maintain the household (or a substantially equivalent household) in anticipation of such return. In addition, a physical change in the location of the home is allowed. Moreover, the parent's death during the tax year will not prevent the taxpayer from qualifying as an HOH.

Dependent Care Credit

Taxpayers who incur expenses for the care of a parent may be entitled to a dependent care credit under Sec. 21. Although this credit is typically used for child care expenses, Sec. 21(b)(1)(B) states that it is also available to a taxpayer who maintains a household and incurs employment-related expenses for a dependent "who is physically or mentally incapable of caring for himself." Regs. Sec. 1.44A-1(b)(4) states that an individual is incapable of self-care if he is incapable of caring for his hygienical or nutritional needs, or requires full-time attention of another person for his own safety or that of others.

The dependent care credit is available for expenses incurred on behalf of qualified individuals to enable the taxpayer to be gainfully employed. Sec. 21(a) (2) and (c) explain that the credit is 30% of up to $2,400 ($4,800 for two or more qualified individuals) of qualified expenditures. However, Sec. 21(a)(2) reduces the credit by 1% for each $2,000 of AGI in excess of $10,000. Thus, a 20% credit is available for eligible taxpayers whose AGI exceeds $28,000.(7)

Sec. 21(b)(2)(A) defines qualified expenses as expenses for (1) household services and (2) caring for a qualifying individual, if such expenses enable the taxpayer (or his spouse) to be gainfully employed. For example, if a taxpayer hires a home healthcare provider to care for his parent while he is at work, the payments are qualifying expenditures eligible for the credit. The credit helps give taxpayers the option of caring for relatives in their homes instead of institutionalizing them. Sec. 21(b)(2)(B) states that expenses incurred outside the home are eligible for the credit only if they are provided by a qualified dependent care center (as defined in Sec. 21(b)(2)(C) and (D))(8) and the dependent spends at least eight hours a day in the taxpayer's household. Thus, expenses incurred to keep a parent in a nursing home full-time are not eligible for the credit. (As discussed below, however, these expenses may be deductible medical expenses.)

Planning for the dependent care credit may result in significant tax savings. Regs. Sec. 1.44A-1(b)(1)(ii) states that the credit is available for any Sec. 152 dependent incapable of self-care. Thus, the credit may be available to taxpayers who cannot claim a parent as a dependent under Sec. 151 or would not receive a benefit from doing so (e.g., because of high AGI subject to phaseout of the exemption).

Example 4: F lives with his daughter, E. F receives a taxable pension of $4,000 in 1999 and no other income. F cannot care for himself and pays $4,000 a year to a home healthcare provider to assist him while E is at work. F's other support is provided by E, as follows:

                              Total           E.              F
                             support       provided       provided

FMV of lodging               $3,000         $3,000
Clothing and
 recreation                   3,000          3,000
F's share of food
 ($2,000/2)                   1,000          1,000

Home healthcare
 expenses                     4,000                        $4,000
Total                       $11,000         $7,000         $4,000

E cannot claim F as a dependent under Sec. 151, because F does not meet the gross income test. However, E and F could structure their arrangement to take advantage of the dependent care credit. If E paid $2,400 of the home healthcare expenses and F paid $2,400 of the clothing and recreation costs, the financial arrangement between the two of them would not change, but E would be eligible for a $480 ($2,400 x 20%) dependent care credit.

DCAP

Sec. 129(a) provides that employees can exclude up to $5,000 ($2,500 if married filing separately) of amounts paid or incurred by their employer for dependent care assistance. "Dependent care assistance" is defined by Sec. 129(e)(1) as amounts which, if paid by the employee, would be employment-related expenses for dependent care credit purposes. Taxpayers whose employers offer a dependent care assistance program (DCAP) may use it, rather than the dependent care credit, for expenses incurred in supporting a parent.(9) Whether a taxpayer should use a DCAP or claim a dependent care credit depends on his marginal tax bracket. Taxpayers in high marginal tax brackets should forgo the dependent care credit and use their employer's DCAP (if available).

Medical Expenses

Sec. 213(a) allows taxpayers an itemized deduction for medical expenses paid on behalf of themselves, their spouses and their dependents. Although medical expenses are deductible only to the extent they exceed 7.5% of AGI, a taxpayer may qualify if he pays such expenses for a dependent parent. In addition, the medical expense deduction is available under Regs. Sec. 1.213-1(a)(3) for expenses paid for parents who do not qualify as dependents because of failure to meet the joint return or gross income test.

Deductible medical expenses include amounts paid for the diagnosis, cure, mitigation, treatment or prevention of disease, and amounts paid to affect any structure or function of the body. Also included are hospital bills, doctor bills and medical insurance premiums. Many other types of expenses incurred by the elderly (e.g., artificial limbs, nursing care services, hearing devices and batteries, oxygen and wheelchairs) also qualify.(10)

The cost of nursing home care can create a large medical expense deduction. According to Kegs. Sec. 1.213-1(e)(1)(v)(a), the deductibility of the cost of care in an institution other than a hospital is a question of fact that depends on the individual's condition and the type of care received. If the availability of medical care in the institution is a principal reason for the person's presence there, the entire cost of care, meals and lodging are deductible. However, the meals and lodging are not deductible, according to Regs. Sec. 1.213-1(e)(1)(v)(b), if the individual is in the institution for "personal or family considerations and not because he requires medical or nursing attention." Several cases have applied these principles. In Counts,(11) the Tax Court allowed the deduction of meals and lodging paid on behalf of a dependent father residing in a nursing home when constant medical care was provided. Several cases, however, have disallowed the deduction in the absence of proof that the nursing home provided medical services.(12) Thus, taxpayers should be prepared to substantiate the need for continual medical care.

Sec. 213(d)(1)(D) states that qualified long-term care services (as defined in Sec. 7702B(c)) also qualify as medical expenses. Such services include maintenance or personal care services required by a chronically ill individual and prescribed by a licensed healthcare practitioner. These services do not have to be performed in a nursing home. The cost of a home health aide to assist a parent in his daily living activities qualifies as long as the services are provided under a plan of care prescribed by a licensed healthcare practitioner.(13) Under Sec. 213(d)(1)(D), eligible long-term care insurance premiums also qualify as medical expenses (i.e., amounts paid for a qualified long-term care insurance contract). The deductible premium depends on the individual's age.(14)

Medical Expense Deduction vs. Dependent Care Credit

Taxpayers who provide nursing care Services for their parents often qualify for both the dependent care credit and a medical expense deduction. When the same expenses qualify for both, taxpayers should carefully analyze their situation to determine which is more beneficial. Whether a taxpayer should claim a medical expense deduction or a dependent care credit depends on his marginal tax bracket and the amount of dependent care credit for which he is eligible.

Example 5: L is a single taxpayer who supports his mother, S. S lives with L. S cannot care for herself; thus, L pays $6,000 in 1999 for home healthcare services for her. L's 1999 AGI is $60,000; he is in the 28% tax bracket. The $6,000 L pays for the home healthcare services is eligible for either the dependent care credit or a medical expense deduction. If L's employer pays his health insurance premiums and L incurs no uninsured medical expenses for himself, he should take the dependent care credit.

L can claim a $480 dependent care credit for the first $2,400 of expenses paid for S. This leaves him $3,600 of medical expenses, none of which is deductible because of the 7.5% of AGI floor. His alternative is to forgo the dependent care credit and use the entire $6,000 for the medical expense deduction. His deductible medical expenses would be $1,500, resulting in a tax benefit of $420 ($1,500 x 28%).

If instead, L pays his own health insurance premiums and his other medical expenses total $4,500, he should take a medical expense deduction. The $1,680 ($6,000 X 28%) resulting tax benefit is more advantageous than the $1,488 ($480 dependent care credit + $1,080 ($3,600 X 28%) medical expense deduction) tax benefit he receives by using $2,400 of the expenses for the dependent care credit.

This example illustrates that the preferable treatment of expenses qualifying for both the dependent care credit and the medical expense deduction depends on the facts of each case. The tax benefit of all the alternatives should be calculated each year to make sure tax savings are being maximized. It may be that using the dependent care credit is more advantageous one year, while forgoing the credit and using the full amount as a medical expense deduction is more advantageous the next.

Conclusion

It is likely that most tax advisers have one or more clients who financially support a parent. These practitioners should be aware of these tax benefits and review their clients' tax situations thoroughly to ensure that they are being used to the fullest extent possible.

For more information about this article, contact Dr. Koski at [phone].

(1) For example, the Clinton Administration's fiscal year 2000 budget would expand the dependent care credit and provide a $1,000 maximum credit for long-term care paid on behalf of a taxpayer, his spouse or his qualifying dependent. See Joint Committee on Taxation, Description of Revenue Provisions Contained in the President's Fiscal Year 2000 Budget Proposal (JCS-1-99, 2/22/99).

(2) Rev. Rul. 79-173, 1979-1 CB 86, revk'g in part Rev. Rul. 70-341, 1970-2 CB 31.

(3) See generally, Rev. Rul. 64-222, 1964-2 CB 47, in which the IRS acknowledged that Social Security payments do not, in all cases, have to be considered applied solely to the recipient's support.

(4) According to Regs. Sec. 1.152-3(c), each group member who provides more than 10% of the support must complete and sign Form 2120, Multiple Support Declaration. All of the signed forms must be attached to the return of the taxpayer claiming the exemption.

(5) See Rev. Proc. 98-61, IRB 1998-52, 18, section 3.08.

(6) Regs. Sec. 1.2-2(d) defines "maintenance costs" to include mortgage interest, property taxes, rent, utilities, property insurance, repairs and food.

(7) In addition, under Sec. 21(d)(1)(A), qualified expenses cannot exceed the taxpayer's earned income for the year. For married taxpayers, the Sec. 21(d)(1)(B) limit is the lesser of the taxpayer's or his spouse's earned income for the year. Sec. 21(d)(2)(A) and (B) deem a spouse who is physically or mentally incapable of caring for himself to have earned income of $200 per month ($400 per month if there are two or more qualifying individuals).

(8) Regs. Sec. 1.44A-1(c)(5) defines a "qualified dependent care center" as any facility that provides full-time or part-time care for more than six individuals on a regular basis during the tax year, and receives a fee, payment or grant for providing such services. The Center must comply with all applicable laws and regulations.

(9) Under Sec. 129(e)(7), amounts excluded from income under a DCAP are not eligible for the dependent care credit.

(10) See generally, Sec. 213(d) and Regs. Sec. 1.213-1 (e); see also Rev. Ruls. 55-261, 1955-1 CB 307, and 68-295, 1968-1 CB 92, for the various expenditures that qualify as medical expenses.

(11) W.B. Counts, 42 TC 755 (1960).

(12) See, e.g., Edwin George Ball, TC Memo 1978-384; John Robinson, 51 TC 520 (1968), aff'd, 422 F2d 873 (9th Cir. 1970) (25 AFTR2d 70-807, 70-1 USTC [paragraph] 9310); James J. Math's, TC Memo 1964-248.

(13) Under Sec. 7702B(c)(2)(A), a chronically ill individual is one certified as being unable to perform (for at least 90 days) at least two activities of daily living, such as eating, toileting, transferring, bathing, dressing and continence. The IRS issued interim guidance on qualified long-term care services (including definitions of chronically ill individuals and related concepts) in Notice 97-31, 1997-1 CB 417.

(14) Under Sec. 213(d)(10)(A) and (B), the annual limit on deductible long-term care insurance premiums depends on the individual's age and is adjusted for inflation each year. For 1999, the annual limit is $210 for individuals age 40 or less, $400 for individuals 41-50, $800 for individuals 51-60, $2,120 for individuals 61-70 and $2,660 for individuals 71 and older; see Rev. Proc. 98-61, note 5, section 3.09.

Timothy R. Koski, J.D., LL.M.,
Ph.D., CPA
Assistant Professor of Accounting
University of Southern Indiana
Evansville, IN