Commentary: Equitable distribution and tax credits

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A  lifeline for lower income families facing divorce in New York

While low income families struggle through divorce, judges and attorneys may often overlook an important resource: the federal and state child-related tax credits, including the Earned Income Tax Credit.

These valuable credits can provide cash assistance, on a sliding scale, up to more than $6,000 annually if family incomes are less than $20,000, and lesser amounts as incomes exceed $20,000 annually. While New York’s Domestic Relations Law never refers to distribution of these credits, judges and practitioners should nonetheless follow Ohio’s lead and make tax-based findings that the distribution of the credits serve the best interests of the children.

The EITC is a “refundable” federal and state tax income tax credit, enacted to reduce the disincentive to work caused by the imposition of Social Security taxes on earned income, to stimulate the economy by funneling funds to persons likely to spend the money immediately, and to provide relief for low-income families hurt by rising food and energy prices, Sorenson v. Secretary, 475 US 851,851 (1986). When the credit exceeds the amount of taxes owed, it results in a direct payment to the taxpayer in excess of the taxes paid. In essence, the taxpayer gets an additional direct cash payment if they claim the credit.

The EITC is not the only available credit. The child tax credit can be up to $1,000 per child for lower income families and phases out as incomes grow. There are also tax benefits for head of household status, credits for dependent care and exclusions from income for dependent care assistance that can assist low-income families enduring divorce.

Some simple rules dictate who qualifies for what.

First, the Internal Revenue Code allows parents or, if necessary, the courts by orders — through the IRS Form 8332 or its equivalent — to allocate the exemptions and child tax credit to the non-custodial parent, 26 U.S.C. §152(e). The New York courts have ordered distribution of the exemptions, see Dunham v. Dunham, 214 AD 2d 961 (4th Dept. 1995). In contrast, the EITC and the remainder of the valuable credits and exclusions, according to the code, remain with primary residential parent and can not be allocated by separation agreements or courts, 26 U.S.C. §32(c)(3)(A); Kotjok v. Commissioner, T.C. Summ. Op. 2012-68 (2012).

Second, to qualify for the EITC, the filer — the parent having residence with the child for more than half the year — needs “earned income” from employment. Maintenance, child support, food stamps or Social Security disability payments will not qualify as earned income for purposes of the EITC. The EITC is designed to encourage employment and hence, only earned income qualifies the filer for the credit.

Third, the EITC works on a sliding scale: The higher the income, the less benefit from the credit. There is a floor — the filer must meet some minimum income requirements – and a ceiling — the benefit ceases when the income of the filer rises above $47,000.

Fourth, applying for the credit involves some logistical challenges, which may be especially difficult for modest-income families. Qualifying children, whose numbers impact the size of the benefit, must have Social Security numbers, a tool to prevent parents from claiming the same children on multiple returns. The filer must be a citizen or resident of the United States.

The sine qua non of effective use of the EITC is that modest income families, either while enduring a divorce or thereafter, must file income tax returns. Often, in resolving matrimonial disputes among families with meager incomes, a parent may not file a return or may not be required by law to file (as head of household) if their income is less than $12,850. In either case, the failure to file may waste the federal and state EITC claims.

Fifth, New York has the most generous state earned income credit in the nation — 30 per cent of the federal credit — which can be added to the federal benefit.

Sixth, New York has one other rarity: A non-custodial parent tax credit for parents who have paid their annual child support under a support order and this credit — to a non-residential parent — can be more than $600 if the parent’s income is less than $16,420, NY Tax Law §606(d-1).

How valuable is the EITC — state and federal? The answer for low income families: extremely valuable.

A modest-income family of four who divorce in a year in which they can file a joint return can qualify for federal EITC with an income up to $48,378. The maximum federal benefit for a family of four is $5,372 if the combined family income is less than $22,870.

In this example, the state EITC could be as much as $1,500 more. A single filer with two children, after the divorce is final, can claim a credit with an income up to $43,038. If the income for the same filer is less than $17,530, the maximum benefit is $5,372 and the state EITC is tacked on top of that amount. In this circumstance, the filer can not only recoup every penny of paid tax but substantially in excess of that amount.

New York’s courts recognize the benefits of allocating the dependency exemptions. A recalcitrant former spouse must sign a Form 8332 if the settlement agreement directs them, Derasmo v. Derasmo, 190 AD 2d 655 (2d Dept. 1993). Often, however, when allocating dependency exemptions among parents with substantially different incomes — e.g., where one spouse has been the breadwinner and makes $70,000 and the other has just re-entered the workforce and makes only $15,000 — attorneys and judges tend to allocate the exemptions to the higher income parent because they pay taxes at a higher rate or, if the incomes are roughly comparable, then the parties split the exemptions, Welch v. Welch, 233 AD 2d 921 (4th Dept. 1996).

This conventional wisdom may ignore benefit of the EITC and other credits: In the above example, the lower income spouse, provided they qualify and meet income requirements, could realize more than $5,000 in cash benefits from the state and federal EITC annually.

Because of the potential for a substantial financial reward in the allocation of the exemptions and the impact of the EITC, New York should consider following a path set by Ohio, which, by statute, requires a finding of a net tax savings to parents — and specifically requires an evaluation of the EITC — before exemptions are distributed, R.C. § 31119.82 (2013); King v. King, 2013 Ohio App. LEXIS 3515 at p.3 (Ct. App. 4th A.D. 2013)(abuse of discretion to grant exemption to nonresidential parent without finding net tax savings to the parties); Brandon v. Brandon, 2009 Ohio App. LEXIS 724 (Ct. App. 8th A.D. 2009)(case remanded because the trial court neglected to address the eligibility of either party for the EITC).

Ohio judges consequently scrutinize the tax consequences of the exemptions and credits more rigorously than often occurs in New York, where the exemptions can be reflexively allocated without a serious examination of the tax consequences and the benefits to the children.

Even in the absence of a statutory change in New York, practitioners in modest income divorce cases should give exemptions and tax credits a more discerning examination. Simply put, $4,000 to $6,000 in annual tax credits for a low income family annually — $20,000 to $40,000 over a decade for parents with young children — can make a sizable difference in the life of a family, easing the burdens of both payor and recipient, while benefitting the children.

Even in default divorces among low-income families, the dependency exemptions and EITC tax benefits should be examined by the courts before the divorce is signed.

Practitioners face challenges to secure the tax benefits as well. First, the settlement agreement should require the parents to obtain Social Security numbers for their children — if not already secured — to facilitate obtaining the exemptions and credits. Second, the agreement should require both parents to file income tax returns annually, regardless of the amount of their income and whether they are required by law to file, so the value of the exemptions and credits can be realized. If a party fails to file, the exemptions and credits should be transferable to the parent who does file and can qualify.

Third, if the exemptions and federal child tax credit are allocated to the non-residential parent, the residential parent should sign the federal tax allocation document simultaneously with the separation agreement. The form, dated, containing the Social Security numbers of both parents and the children and attached to the tax return, can prospectively list the years in which the exemptions can be used by the non-residential parent, Chamberlain v. Commissioner, T.C. Memo 2007-178 (Tax Ct. 2007)(if exemptions released for multiple years, the Form 8332 must be attached to any future years when exemptions or credits are claimed).

Fourth, even if the exemptions are allocated to the non-residential parent, the residential parent should still file for the EITC and other credits.

Fifth, the IRS will no longer accept a signed separation agreement allocating the exemptions and credits in lieu of the Form 8332, 26 CFR §1.152(e)(1) & (5); 26 CFR 1.152-4(1)(ii), as amended by T.D. 9408, 2008 CB 323, 327 cited in Armstrong v. Commissioner, 139 T.C. 468, 472 (Tax Ct. 2012).

While practitioners favor the language — “the spouse only gets the exemptions if they are current on their child support” — the IRS will no longer allow taxpayers to simply file agreements containing this language in lieu of Form 8332 because the agreement does not contain a definite description of the years for which the non-residential parent would qualify, Thomas v. Commissioner, T.C. Memo 2010-11 (Tax Ct 2010).

In addition, if the exemptions are transferred by decree after trial or a hearing, the IRS will not transfer the exemptions and any credits based on a court’s determination: The Form 8332 — or its nearly exact equivalent — from the residential parent is still required, Browning v. Commissioner, T.C. Summary LEXIS 114 (Tax Ct. 2012)(state court orders are not a valid substitute for From 8332 because they lack a parent’s signature); Israel v. Commissioner, T.C. Memo 2012-185 (Tax Ct 2012)(husband submitted divorce decree granting him exemptions but IRS denied exemptions because he failed to produce Form 8332 signed by his former wife, despite litigation in two states to get the document).

Sixth, the prudent use of the exemptions and credits requires parents, after a divorce, to engage in annual tax planning, even though there may be a substantial likelihood that a parent may lose contact with their former spouse after the divorce is final. Incomes change and the value of the exemptions — and credits — can fluctuate, especially as parents re-enter the workforce or, conversely, are laid off. Ideally, an agreement would also require that the parents annually share the benefit of the accumulated credit, with parents dividing the extra cash to assist both the payor and the recipient.

Finally, practitioners and the courts should consider the tax consequences if a divorced spouse remarries, as a parent filing jointly with a new spouse may lose the ample benefit of the exemptions, the EITC or other credits. An agreement should contain a provision that remarriage by either party should require some recalculation of the tax benefits to the parents and children.

The federal EITC and other credits generated billions in benefits to low income families in 2012 even though millions have never filed tax returns to ask for it. New York, which has the highest state EITC available and a benefit for a non-custodial parent, should follow Ohio’s lead, require judges to make tax-based findings before allocating these benefits and have practitioners find creative ways to secure them for eligible families.

Richard A. Dollinger is an acting Supreme Court Justice working in the matrimonial part in Rochester. Michael P. Maiorana is a senior at St. John Fisher College in the pre-law program. The authors thank attorneys Sherry S. Kraus and Scott D. Shimick for their assistance.