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Retain child’s exemption by giving the right graduation gift

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in Small Business Tax

Are you the proud parent of a soon-to-be college graduate? You might want to give your child a large cash gift to celebrate the occasion. But if the money isn’t used for the child’s “support,” the gift won’t help you secure a dependency exemption for the child on your 2006 return. And this is probably the last year you’ll have a shot at earning the dependency exemption for that child.

Strategy: Give your child a car instead of cash. Since the cost of the vehicle is considered support that you provide your child, it can help you overcome a key tax rule and preserve the dependency exemption one final year. Best of all: The entire cost of the car counts as support, even if it’s financed.

The tax rules for dependency exemptions were recently modified, but the basic thrust is the same as before: You can generally claim an exemption for a child if you provide more than 50 percent of his or her total support.

Normally, you can’t grab the exemption if the dependent earned taxable income above the personal exemption amount ($3,300 for 2006). But this gross income requirement is waived if your child is under age 19 or a full-time student under age 24.

A child who attends college full time between January and May 2006 is considered a full-time student for the entire year.

Of course, money that you give your child can count toward the support you provide, but only if it’s actually spent on support. If your child simply sticks the cash in the bank or invests it, it’s not treated as a support item. But that’s not a problem with a car.

Example: Give a car, not cash

Suppose your son Scott is graduating from school in May. You had planned to give him a $10,000 graduation gift on top of the $1,000 in support (cash, food and lodging) you provide to him each month. Scott has a job lined up after graduation and will provide $15,000 of support for himself in 2006.

If Scott banks your cash gift, you won’t qualify for a dependency exemption because he’d be providing more than half of his own total annual support (his $15,000 to your $12,000).

Better approach: Change the tax result by changing the nature of your gift. Buy Scott a $20,000 car to commute back and forth from his new job. If you put down only $10,000 and finance the rest, you’re not spending anymore on the graduation gift than you had originally intended. Now, you’re providing more than 50 percent of Scott’s support—your $32,000 to his $15,000—so you’re entitled to the extra $3,300 dependency exemption for 2006.

Potential roadblock: The tax benefit of your personal exemptions, including dependency exemptions for your children, is phased out for certain high-income taxpayers.

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