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Turn fruitless parental support into a tax-break feast

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in Small Business Tax

If one of your parents or in-laws is suffering a financial pinch, you might chip in with part of the rent or some other expense. In return, grandma or grandpa happily volunteers to watch your children after school while you work. Unfortunately, you can’t claim a dependency exemption for this trade-off if your relative’s earnings rise above the gross-income test for dependents.

Strategy: Convert those support payments into “child care” payments. Instead of writing a check to your relative’s landlord, you can pay the relative a fair amount for babysitting duties. As a result, you qualify for the dependent care credit (commonly called the child care credit).

You can then slice as much as $1,200 off the top of your 2006 tax bill … without paying one thin dime more than you do now! That’s better than you’d do with an extra dependency exemption.

Earmark payments for after-school care

You can claim the credit for dollars you spend on child care (for kids under age 13) if the care is needed to allow you and your spouse to work. Those expenses aren’t limited to day care providers. You can also claim the credit for services provided by a relative, such as a parent, if he or she can’t be claimed as a dependent.

The credit is equal to 30 percent of the first $3,000 spent for one child, and 30 percent of $6,000 for two or more children. But the credit percentage gradually falls according to your adjusted gross income (AGI), until it reaches 20 percent for taxpayers with an AGI above $43,000. That means most higher-income people can grab a maximum $1,200 credit for two or more kids.

Example: Let’s say your mother earns $8,500 a year from her taxable investments. To help her make ends meet, you and your spouse pay her monthly rent of $750. Returning the favor, she watches your two children, ages 9 and 6, so both you and your spouse can work full time. You expect to be in the 28 percent tax bracket for 2006.

You can’t claim your mother as your dependent, even though you provide more than half of her annual support. Reason: She earns more than the dependency exemption amount ($3,300 for 2006).

But you can still cut your tax bill by simply changing the way you support mom. All you have to do is write the check to your mother—instead of directly paying her landlord—and indicate that the payments are for child care services. That allows you to claim the child care credit for the amounts paid to mom. If your AGI exceeds $43,000, you’ll be in line for a $1,200 tax credit (20 percent of the first $6,000 of expenses).

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 an account on a pretax basis. Any distributions for qualified expenses are tax free (see box below).

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