Parental support tax savings opportunities.

• Author: Koski, Timothy R.

EXECUTIVE SUMMARY

* Individuals who share in the financial support of a parent should use an MSA to realize the maximum tax benefit from the additional dependency exemption.

* A single taxpayer who supports a dependent parent may be entitled to HOH filing status.

* Taxpayers who incur expenses for the care of a parent may be entitled to a dependent care credit or be eligible to pay the expenses through their employer's dependent care assistance program.

For clients who support a parent, tax savings are available in the form of dependency exemptions, head of household filing status, dependent care credit, dependent care assistance programs and medical expense deductions. This article examines these opportunities, explains eligibility and offers planning examples.

There is increasing concern about the financial burden on taxpayers who support their parents. Various tax proposals(1) have been introduced to provide relief. In the meantime, several well-established (but often neglected) tax breaks are available to eligible taxpayers who provide their parents with financial support, including an additional dependency exemption, head of household (HOH) filing status, a dependent care credit and a medical expense deduction. This article reviews each of these tax breaks and presents planning opportunities.

Dependency Exemptions

Requirements

A taxpayer can claim a dependency exemption for another individual if the following five requirements are met:

1. Gross income test. Under Sec. 151(c)(1)(A), the dependent's gross income cannot exceed the personal exemption ($2,750 for 1999).

2. Support test. Under Sec. 152(a), the taxpayer claiming the exemption must provide over half of the dependent's support for the year.

3. Relationship test. The dependent must either be related to the taxpayer (as defined in Sec. 152(a)) or reside with him as a member of his household for the entire tax year. Parents and grandparents qualify under Sec. 152(a)(4).

4. Citizen or resident test. Under Sec. 152(b) (3), the dependent must be either a U.S. citizen or resident, or a resident of Canada or Mexico.

5. Joint return test. Under Sec. 151(c)(2), the dependent cannot file a joint return, unless fried solely to claim a refund.

These tests are relatively straightforward; typically, they do not present major problems for taxpayers attempting to claim a dependency exemption for their parents. Qualification of a parent as a dependent usually hinges on passing the gross income and support tests, which are reviewed below.

Gross Income Test

Sec. 151(c)(1) provides that a dependent's gross income must be less than the personal exemption amount. Kegs. Sec. 1.151-2(a) states that, for this purpose, gross income is defined in Sec. 61; hence, receipts excludible from income are not counted in applying the gross income test. Although the personal exemption is relatively low ($2,750 for 1999), taxpayers supporting parents whose primary source of income is Social Security income are often able to meet the test.

Taxpayers handling their parent's financial affairs should closely monitor the amount and type of income the parent earns. Planning may enable a taxpayer to meet the gross income test and qualify for a dependency exemption with only minor changes to a parent's investment portfolio.

Example 1: A supports his father, B. B's 1999 gross income is as follows:

Social Security benefits $12,000 Pension income 2,000 Taxable bond interest 1,000 For purposes of the gross income test, B's gross income is $3,000, which exceeds the personal exemption. Thus, the gross income test is not met. However, if B reduced his gross income by investing a portion of his savings in tax-exempt bonds, rather than taxable bonds, his gross income would not exceed the personal exemption; he would meet the gross income test.

Other planning opportunities may be available to taxpayers whose ability to claim a parent as a dependent hinges on the gross income test. A dependent parent's income should be reviewed before year-end to determine if any income-shifting strategies are available.

A gift of income-producing property to children or grandchildren may be another way to reduce taxable income below the exemption amount. The dependent parent must be willing to part with his entire interest in the property to shift the income tax consequences to children or grandchildren. However, the additional income tax cost to the donee may outweigh the benefit of an additional personal exemption.

Support Test

A taxpayer claiming another person as a dependent must provide over half of that person's support. Regs. Sec. 1.152-1(a)(2) states that "support" includes food, shelter, clothing, medical and dental care, education and the like. Payment of medical expenses (including medical insurance premiums) are support; on the other hand, medical insurance benefits are not. In addition, basic and supplementary Medicare benefits are not considered items of support.(2)

According to Regs. Sec. 1.152-1(a) (2)(i), the total amount of support received from the taxpayer is compared to the entire amount of support received from all sources, including support the individual himself provided. The amount spent on support is measured by actual cost, except for lodging (which is measured by its fair market value (FMV)). The FMV of lodging is the amount one could reasonably expect to receive from an unrelated party for the...