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Divorced parents: Obey new regulations for dependents

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in Small Business Tax,Small Business Tax Deduction Strategies

Getting divorced or separated isn’t pleasant. In addition to dividing up your belongings, you could become embroiled in a custody battle with your ex-spouse. And you also must figure out all the tax ramifications.

For instance, if you have young children, who claims the dependency exemptions? Often, this becomes a point of contention.

Strategy: Follow the IRS’ lead. It has just issued new proposed regulations for divorced and separated taxpayers. The new regs provide some much-needed guidance in this area.

For 2007, each dependency exemption is $3,400. And be aware that more than just a dependency exemption is at stake. Other tax benefits, such as the child-tax credit and education-tax credits, may also be on the table.

Here’s the whole story: The rules for claiming dependency exemptions for children when the parents are divorced, legally separated or living apart for the last six months of the year (see box) were modified by tax laws enacted in 2004 and 2005. In brief, a parent may claim the exemption for a “qualifying child” who had the same principal place of abode as that parent for more than half of the year.

Generally, a noncustodial parent can claim a dependency exemption for a qualifying child only if the custodial parent releases his or her claim to the exemption.

The new proposed regs define the “custodial parent” as the parent with whom the child resides for the greater number of nights during the calendar year. The IRS defines the noncustodial parent as the parent who is not the custodial parent. If a child is temporarily absent from a parent’s home, the IRS treats the child as staying with the parent with whom he or she normally resides on that night.

Key point: If a child resides with each parent for an equal amount of time during the year, the IRS treats the parent with the higher AGI for that year as the custodial parent. This is a new tie-breaking rule feature in the proposed regulations.

The new regs also clarify the rules for waivers. The custodial parent must sign a written and unconditional declaration that he or she will not claim the child as a dependent. The noncustodial parent then attaches the declaration to his or her return for that year.

How to do it: Use Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, available at www.irs.gov, or state similar language in writing.

An exemption may be released for just one year, multiple years or all future years. A declaration specifying all future years begins in the first taxable year following the year the release is executed.

What if you want to revoke a waiver? Under the new regs, a custodial parent can revoke the release for future tax years by providing written notice to the noncustodial parent. The revocation should be made on an IRS-designated form or through a comparable written declaration. Furthermore, the revoking parent must keep a copy of the revocation and confirm delivery to the noncustodial parent.

Tip: The custodial parent also should attach the revocation to his or her tax return for any year he or she claims the dependency exemption.

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