Dependency exemption issues for college students.

• Author: Nichols, Nancy B.

College students combine many sources of funds to pay for their education, including personal savings, family savings, income from jobs, scholarships, and/or student loans. As the percentage of funds from the student's sources increases, parents risk losing the student as a dependent on their tax return. Not only do the parents lose the exemption deduction, but they also lose available higher education tax benefits (the Hope scholarship, American opportunity, and lifetime learning credits, and the tuition deduction). The combined effects can be significant in dollar terms. In addition to these tax issues, there are other material financial issues at stake with the loss of dependent status.

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Taxpayers and tax professionals need to carefully evaluate the impact that the sources of college funding can have on the net tax and financial position of the family unit. Blindly assuming that a student qualifies as a dependent on the parents' tax return can result in noncompliance with the tax law and can have other financial implications (for example, for benefits provided by the parents' employer and federal student aid calculations). With some advance preparation, tax professionals can plan for the dependency exemption issue and maximize the family's net tax savings.

Escalating College Costs

College costs continue to increase at a rate greater than inflation. The average annual cost of college for 2007-2008, including undergraduate tuition, room, and board, was $13,424 for a four-year public university and $30,393 at a private institution. (1) Many parents begin saving early for their child's education. The introduction of qualified tuition plans (QTP) under Sec. 529 in 1996 provided a tax-effective vehicle for college education savings. As of December 2008, nearly $105 billion in assets was invested in more than 11 million QTP accounts. (2) Many of the student beneficiaries of these plans are now entering college, and the tax implications of plan distributions should be considered before making withdrawals from the accounts.

Given current economic conditions, students are borrowing more money for higher education than ever before. The average student loan debt for those graduating during the 2003-2004 academic year was $12,750 for public institutions and $16,950 for private institutions. (3) More recent data issued by the Project on Student Debt indicates that the average debt level for graduating seniors has increased to $19,200 and $22,125 for those graduating from public and private universities, respectively. The percentage of students with student loans rose to 66.4% in 2004. (4) Both student loans and QTPs have a direct impact on the support test for a qualifying child.

What Are the Requirements to Remain a Dependent?

A dependent is defined under Sec. 152(a) as either a qualifying child or a qualifying relative. To be a qualifying child under Sec. 152(c), a student must meet four tests:

* Relationship: The child must be the taxpayer's child or stepchild (whether by blood or adoption), foster child, sibling or stepsibling, or a descendant of any of them.

* Age: The child must be under age 19 or a full-time student under age 24 at the end of the year. To be considered a full-time student, the child must be enrolled for the number of hours or courses the school considers to be full time and must be a student for at least five months during the year.

* Residency: The child must live with the taxpayer for more than one-half of the year. The child is considered to live with the taxpayer while he or she is temporarily away from home due to education, illness, business, vacation, or military service.

* Support: The student cannot have provided more than one-half of his or her own support.

If a student meets these four tests, the parents may claim the exemption if the student also meets the general dependency tests under Sec. 152(b). The general tests include:

* Marital status: If married, the student did not file a joint tax return for the year, unless the return is filed only to claim a tax refund and no tax liability would exist for either spouse.

* Citizen or resident: The student must be either a U.S. citizen, resident, or national or a resident of Canada or Mexico.

The support test for a qualifying child is the main focus of the remainder of this article. We assume that if the support test is met, the child meets the remaining requirements to be a dependent of the taxpayer.

Amount of Support Provided by the Student

To determine whether the student provided more than one-half of his or her support, the amount provided by the student must be compared with the total amount of support the student received from all sources. The amount provided by the student may come from the student's own income or student funds. Only the amounts actually spent are considered support provided by the student.

The IRS provides a worksheet to help taxpayers evaluate the support test. (5) The first section of the worksheet calculates the amount of support provided by the student, the second section totals household expenses, and the third section determines the student's total support expenses. As with any attempt to simplify a complicated calculation, the form does not take into account some of the nuances of the calculation. For example, the household expense section is not designed to accommodate a college student living at home for a portion of the year and living either on or near campus for a portion of the year.

Total Expenses

The support test depends on two factors: the source of funds and total expenses. Regs. Sec. 1.152-1 (a)(2) provides that support includes food, shelter, clothing, medical and dental care, education, and other similar items. Generally, the actual cost incurred is included in the support total, except for lodging and capital expenditures, which are valued at fair market value (FMV).

Over the years, the courts have ruled on specific items that do and do not count in determining total support expenses. Typical expenses for a college student might include tuition and fees, lodging and meals, transportation, clothing, and personal expenses. Health insurance premiums plus out-of- pocket medical and dental expenses would also be included in total support. However, the amount paid by the insurance provider would not be included. (6)

Whether the cost of operating an automobile is a support item depends on whether its use benefits the individual. (7) In many cases a ear is purchased and registered in the parents' names and the parents allow the student to use the car full time. Because the parents own the car and did not give it to their child, the cost of the car is not included in the child's total support. However, the parents' costs for operating the car are included in the parent's portion of the child's support. The car must be registered in the child's name for the purchase price of the vehicle to be included in total support. The second issue regarding autos is when the student purchases a vehicle. Rev. Rul. 77-282 provides that in the year the child purchases a vehicle, the vehicle's FMV is included in total support and is considered support provided by the child. (8)

The FMV of lodging is its fair rental value. No additional amount can be taken into account for real estate taxes, repairs, and utilities if they are reflected in fair rental value. (9) The amount of lodging and other household expenses attributed to the support of an individual living in a household equals the proportion of fair rental value and expenses reflecting the individual's per capita proportionate share. This proportionality rule applies to lodging, utilities, and food. The proportionality rule should be altered if some members of the household are present for significantly greater periods than others. (10) For instance, blindly allocating summer months to the parents' portion of the support calculation may not hold if the child has a summer internship in another city or attends summer classes.

Example 1: Child S attends a qualifying educational institution during the traditional academic school year, September-April. S lives with his parents during the summer months, May-August. Support attributable to S during the summer months would include any specific expenses incurred plus his per capita share...