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Turn nondeductible support into child care credit

by on
in Small Business Tax

If an elderly parent or in-law is having trouble making ends meet, you might help him or her pay the rent or other expenses. In return, Grandma or Grandpa may gladly volunteer to watch your children while you and your spouse work.

Unfortunately, you probably can’t claim a dependency exemption for this trade-off, due to the gross-income test for dependents. But you still can reap a big tax benefit from the arrangement.

Strategy:
Convert support payments into child care payments. Instead of taking care of the relative’s rent, pay him or her a reasonable amount for baby-sitting duties. Then you can claim the dependent care credit (commonly called the “child care credit”).   

To top things off, you may even do better with a tax credit than you would with an extra dependency exemption.

Here’s the whole story: You’re entitled to claim the credit for qualified child care expenses of children under age 13. The credit is equal to 30% of the first $3,000 spent to care for one child; $6,000 for two or more children. However, the credit percentage gradually is reduced according to your AGI, until it bottoms out at 20% for taxpayers with an AGI above $43,000. 

Note that the credit isn’t limited to just day care centers or formal child care providers. You can also claim it for services provided by a relative like a parent or in-law as long as he or she can’t be claimed as your dependent (or is your child who is under age 19).

Example: Keep it all in the family

Let’s say your mother earns $9,000 a year from her taxable investments, and you and your spouse pay her monthly rent of $800. Returning the favor, she watches your two children, ages 9 and 6, so both you and your spouse can work full time. As a result, you don’t incur any other child care expenses. You expect to be in the 28% tax bracket for 2009.

You can’t claim Mom as your dependent, even though you provide more than 50% of her annual support ($9,600 of support versus $9,000 of income). Reason: She earns more in gross income than the dependency exemption amount ($3,650 for 2009). But you can still cut your tax bill by simply changing the way you support her.

All you have to do is pay your mother by check—instead of directly paying rent to her landlord—and indicate that the payments are for child care services. Now you can claim the child care credit for baby-sitting fees paid to Mom. Since your AGI exceeds $43,000, you’ll be in line for a tax credit of $1,200 (20% of the first $6,000 of expenses).

By way of comparison, the dependency exemption of $3,650 for 2009 would have been worth $1,022 to you in your tax bracket (28% of $3,650). That’s $178 less than the tax savings available through the credit ($1,200 minus $1,022).

Tip: Alternatively, you might work for a company that provides flexible spending accounts (FSAs) for dependent-care expenses. This type of plan allows you to transfer up to $5,000 to your account on a pre-tax basis. Any distributions for qualified expenses are tax-free.

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