Unrelated child as a qualifying relative.

One requirement for claiming a qualifying child (QC) for purposes of the dependency exemption deduction is that the child must be related to the taxpayer, that is, the taxpayer's child (including stepchild or foster child), sibling, half-sibling, step-sibling or descendant of any of them (IRC [section] 152(c)(2)).

However, dependents alternatively may be claimed as qualifying relatives (QRs), who can be unrelated if they live with the taxpayer for the entire year (section 152(d)(2)(H)) and meet other qualifying tests. One such test is that they must not be a QC of any other taxpayer in that tax year (section 152 (d) (1) (D)).

The latter requirement would seem to rule out a taxpayer's claiming a dependency exemption for the child of an unrelated person, even if the taxpayer provides a home for all three (taxpayer, unrelated person and child) and supports the child. But like so much else in tax law, it depends.

The IRS issued Notice 2008-5 to clarify that where a parent is not required to file a return and does not file or does so only to claim a refund of withheld income taxes, the child is not that parent's QC for purposes of being claimed as a QR of another taxpayer. It gives three examples based on a hypothetical taxpayer who supports his unrelated friend and her child. The taxpayer is not the biological father of the child, and he and his friend are not married.

Example 1. The friend has no gross income and does not have to file an income tax return under IRC [section] 6012. The child is not treated as a QC of her or any other taxpayer, so the taxpayer may claim both the friend and her child as QR exemptions, provided all other provisions of sections 151 and 152 are satisfied.

Example 2. The friend has earned income of $1,500, from which federal income taxes were withheld. She is not required to file a return under section 6012 but does so only to obtain a refund of the tax withheld. Consequently, her child is not a QC of her or any other taxpayer. The taxpayer may claim the friend and her child as QR exemptions, provided all other provisions of sections 151 and 152 are satisfied. Although the friend's earned income amount might qualify her for an earned income tax credit, she must forgo one.

Example 3. The friend has earned income of $8,000 and an earned income credit of $2,729. Since her gross income exceeds the personal exemption amount ($3,650 for tax year 2009), she cannot be a QR exemption for the taxpayer. If she files an income tax return to claim a refund of tax withheld and claims the earned income credit for the child, her return is not filed solely as a claim for refund. As a result, the child is a QC of the friend, and the taxpayer may not claim either of them as a QR exemption.

Taxpayers in situations like Example 2 should weigh the alternatives. If the friend files a return claiming her child as a QC, the child tax credit and earned income tax credit may exceed any tax benefit of applying their dependency exemptions to a higher marginal tax rate of the taxpayer. The credits and head-of-household status are not available to the taxpayer, since the earned income credit and child tax credit are limited to QCs (and the latter further restricted to QCs under age 17 at the end of the tax year). Head-of-household status is not available by reason of a QR who would not be a dependent except for being a member of the taxpayer's household with the same principal place of abode (sections 2(b)(3)(B)(i) and 152(d)(2)(H)). Also, the section 21 credit for employment-related dependent care expenses is available to the friend for a QC under age 13, but generally not to the taxpayer, unless the dependent is physically or mentally disabled.

Generally, single individuals under age 65 and not blind must file if their gross income exceeds the personal exemption amount plus standard deduction ($3,650 + $5,700 for tax year 2009). However, individuals who could be claimed as a dependent of a taxpayer (including as a QR) generally are required to file if their gross income exceeds the greater of (a) $950 or (b) their earned income (up to $5,400) plus $300. Other situations that may require the friend to file a return other than to obtain a refund include having received advance earned income credit payments from her employer during the tax year or owing FICA tax on tips she did not report to her employer or on wages for which it was not withheld. See Table 1-3 in IRS Publication 17 (2008). Also see ILM 200812024 and Matthew Rice v. Commissioner, TC Summary Opinion 2009-83, denying earned income, child tax and child and dependent care credits for a QR exemption.

By James M. Hopkins, CPA, ([e-mail]) professor of accounting, Morningside College, Sioux City, Iowa.