A new notice provides guidance under Code Sec. 152(d) for determining whether an individual is a qualifying relative for whom the taxpayer may claim a dependency exemption. The notice essentially provides an administrative exception to Code Sec. 152(d)(1)(D), which provides that an individual is not a qualifying relative of the taxpayer if the individual is a qualifying child of any other taxpayer.

Specifically, the notice provides that an individual is not a qualifying child of any other taxpayer if the individual's parent (or other person with respect to whom the individual is defined as a qualifying child) isn't required by Code Sec. 6012 to file an income tax return and (i) does not file one, or (ii) files one solely to obtain a refund of withheld tax.

Background. A taxpayer is entitled to a deduction equal to the exemption amount for each person who qualifies as his “dependent.” (Code Sec. 151(c))

A person qualifies as the taxpayer's dependent if the person is the taxpayer's qualifying child or qualifying relative. (Code Sec. 152(a)) The terms “qualifying child” and “qualifying relative” were added to Code Sec. 152 by the Working Families Tax Relief Act of 2004 (WFTRA), effective for tax years beginning 2004. WFTRA established a uniform definition of a “qualifying child” for determining whether a taxpayer may claim certain child-related tax benefits. It established the term “qualifying relative” to identify individuals (other than a qualifying child) for whom a dependency exemption deduction may be allowed.

A “qualifying child” of a taxpayer is an individual who: (A) bears a certain relationship to the taxpayer, (B) has the same principal place of abode as the taxpayer for more than one-half of the tax year, (C) meets certain age requirements, and (D) has not provided over one-half of his or her own support for the calendar year. (Code Sec. 152(c)(1))

A “qualifying relative” is an individual: (A) who bears a specified relationship to the taxpayer (Code Sec. 152(d)(1)(A)); (B) whose gross income for the calendar year in which that tax year begins is less than the exemption amount (Code Sec. 152(d)(1)(B)); (C) with respect to whom the taxpayer provides over one-half of his or her support for the calendar year in which that tax year begins (Code Sec. 152(d)(1)(C)); and (D) who isn't a qualifying child of that taxpayer or of any other taxpayer for any tax year that begins in the calendar year in which that tax year begins. (Code Sec. 152(d)(1)(D))

OBSERVATION: An individual need not be technically related to a person to qualify as the person's qualifying relative. That's because, the specified relationships include in-laws and an individual who, for the tax year of the taxpayer, has as such individual's principal place of abode the home of the taxpayer and is a member of the taxpayer's household. (Code Sec. 152(d)(2))

Clarifying guidance. Commentators informed IRS that Code Sec. 152(d)(1)(D) could lead to unintended tax consequences that differ from those under pre-WFTRA law. For example, they pointed to a taxpayer who supports as members of her household two minor orphans who are brother and sister. The commentators questioned whether the children are qualifying children of “any other taxpayer” (i.e., one another), thus making the taxpayer ineligible to claim dependency exemption deductions for the children.

IRS noted that, before amendment by WFTRA, a taxpayer could claim a dependency exemption deduction for an unrelated child who was a member of the taxpayer's household for the entire year, provided all relevant requirements of former Code Sec. 151 and Code Sec. 152 were satisfied. The legislative history of WFTRA reveals that it generally was intended to permit taxpayers to continue to apply the dependency exemption rules of pre-WFTRA law to claim a dependency exemption for a qualifying relative who does not satisfy the qualifying child definition.

In view of this history and citing Rev Rul 54-567, 54-2 CB 108 affd Rev Rul 65-34, 1965-1 CB 86, IRS has concluded that a taxpayer otherwise eligible to claim a dependency exemption deduction for an unrelated child is not prohibited by Code Sec. 152(d)(1)(D) from claiming the deduction if the child's parent (or other person with respect to whom the child is defined as a qualifying child) is not required by Code Sec. 6012 to file an income tax return and (i) does not file an income tax return, or (ii) files an income tax return solely to obtain a refund of withheld income taxes.

Examples in the new guidance. Notice 2008-5 includes these examples.

Illustration: Andrew supports as members of his household for the tax year an unrelated friend, Betty, and her 3-year-old child, Carole. Betty has no gross income, is not required by Code Sec. 6012 to file an income tax return, and does not file an income tax return for the tax year. Accordingly, because Betty does not have a filing requirement and did not file an income tax return, Carole is not treated as a qualifying child of Betty or any other taxpayer, and Andrew may claim both Betty and Carole as his qualifying relatives, provided all other requirements of Code Sec. 151 and Code Sec. 152 are met. (Notice 2008-5)

Illustration: Same facts as Illustration (1), except that Betty has earned income of $1,500 during tax year 2006, had income tax withheld from her wages, and is not required by Code Sec. 6012 to file an income tax return. With one qualifying child, Betty may claim the earned income credit (EIC) in the amount of $519 for the tax year. She an income tax return solely to obtain a refund of withheld income taxes and does not claim the EIC. Accordingly, because Betty does not have a filing requirement and filed only to obtain a refund of withheld income taxes, Carole is not a qualifying child of Betty or any other taxpayer, and Andrew may claim both Betty and Carole as his qualifying relatives, provided all other requirements of Code Sec. 151 and Code Sec. 152 are met. (Notice 2008-5)

Illustration: Same facts as Illustration (1), except that Betty has earned income of $8,000 during tax year 2006, had income tax withheld from her wages, and is not required by section 6012 to file an income tax return for the tax year. With one qualifying child, Betty may claim the EIC in the amount of $2,729 for the tax year. Betty files an income tax return for the tax year to obtain a refund of withheld income taxes, and Betty claims the EIC on the return. Accordingly, because Betty filed an income tax return to obtain the EIC, and not solely to obtain a refund of withheld income taxes, Carole is a qualifying child of another taxpayer, Betty, and Andrew may not claim Carole as a qualifying relative.

OBSERVATION:  There could be close cases where it is beneficial to forgo the EIC in favor of the exemption and vice versa. This assumes that the two individuals are operating as a single economic unit and want to receive the best economic result for themselves as a couple. In other cases, personal financial considerations may outweigh joint considerations.

Effective date. Notice 2008-5 is effective for tax years beginning after 2004.

OBSERVATION:  The retroactive effective date may lead to a refund opportunity for a taxpayer who failed to claim a dependency exemption based on the concerns addressed in and rectified by Notice 2008-5

-- Notice 2008-5, 2008-2 IRB