Calculating the tax impact of your custody agreement

By Kelly Walsh of Scaringi Law posted in Tax Law on Thursday, October 20, 2016.

Amidst the negotiation and emotion that can go into reaching a child custody agreement, one of the most vital repercussions often is ignored. That issue is the future tax implications of the custody arrangement itself.

The financial fallout with the IRS can be major, from incentives to deductions to credits.

A key question that often goes unasked is which spouse will claim the children as dependents on future federal income taxes.

Also, depending on the relative income of the spouses, one of the households could qualify for lucrative federal tax credits for each child. There are other tax implications, too, including child care expenses and other costs - all of which can be deducted on your IRS return.

Here are some tax tips to consider when negotiating your custody agreement.

When to withhold

Even before two parties negotiate their custody agreement, some spouses try to game the system by adjusting their federal tax withholding status with their employers. By bumping up the withholding amount, a spouse can make his or her take-home pay appear much smaller than it actually is. As a result, this sleight of hand can shrink the amount the spouse ultimately pays in child support.

Conversely, a dependent spouse may persuade her unsuspecting breadwinner husband to decrease his tax withholding in the year she planned to divorce him. The result would be an artificial boost in his take-home pay that made it seem as if there was more money for spousal and child support. So, knowing when (and how much) to withhold is important when approaching a divorce or separation, especially when it involves children.

The amount you withhold during a custody battle can also have a major impact on what you owe at tax time. If you are withholding based on the assumption you will get to claim your children as dependents, but the other parent ultimately gets to claim them instead, you are in for a bit of a shock when you see your tax bill.

Who gets the dependents? It depends

Without question, the biggest tax impact of a custody agreement is which spouse will be able to claim the children as dependents on their IRS tax return. The IRS does have rules and formulas for making this determination after the fact, but the matter can be negotiated as part of the custody agreement.

What's at stake?

The parent who claims the kids on a tax return can exempt $4,000 of income per child. It also can provide an extra $2,950 in Standard Deduction if claiming a dependent allows you to qualify to file as Head of Household rather than Single or Married Filing Separately. It offers the ability to deduct up to $3,000 in child care expenses each year. And it opens the door to some very significant tax credits, including the Child Tax Credit and the Earned Income Tax Credit. It's major money.

Give and take

The tax benefits of one party claiming the kids can be a reason to adjust the child support payment amount up or down. Another thing to consider are those child and earned income tax credits. If one spouse can meet the IRS income guidelines to claim these credits, the benefit may spur compromise elsewhere in the agreement, such as on physical custody, also impacting the final support amount.

In this give-and-take, an agreement on who may claim the kids as dependents supersedes the usual IRS rules covering this issue.

When a spouse claims the kids anyway

Despite careful custody negotiations, an unscrupulous ex-spouse can still claim the children on their taxes anyway. If they do -- and their tax return is filed first -- the IRS will deny your return claiming the same children as dependents -- even when you are clearly the right party to claim the children under an agreement or the tax code.

Should this happen, immediately consult with a tax attorney who can provide the necessary proof to the IRS to right this wrong. The worst thing you can do is amend your tax return and not claim the deduction, essentially waiving a major tax benefit that's rightly yours.

You should revisit your tax planning and withholding status as soon as you know you suspect a family law dispute. You can also request to involve a tax attorney in your family law case to ensure important tax implications are addressed throughout the process. Then you can effectively negotiate the terms of your divorce, marital settlement and custody agreement with full confidence that your financial interests are being protected along with your parental rights.

Kelly M. Walsh focuses her practice at Scaringi Law on family law, wills and estates, and personal and business tax law. She can be reached toll free at 877-LAW-2555 or at info@scaringilaw.com