Yet Another Preparer Penalty Starting In 2018

We have spoken before of social-worker duties the tax Code expects of a professional preparing a return with an earned income credit, a refundable child credit or the American Opportunity (that is, the college) credit.

Take the earned income credit, for example. If you have two children, that credit can be $5,616; have three and the credit can reach $6,318. Remember that the credit is refundable – meaning the IRS will write you a check – and no wonder this provision is rife with fraud.  

If the IRS wanted to push-back on the fraud, it could require a preparer to review documentation that a child (or several) actually lives with the parent/taxpayer.

To be certain to get the preparer’s attention, the IRS could also impose a penalty if the preparer failed to do so.

Let’s have the IRS tighten this up a notch by also requiring a form or schedule with the return requiring the preparer to declare that he/she did all of this Sherlocking.

Which is why I will not prepare a return with these credits unless I have known (or, alternatively, my partner has known) the client for a while.

This rule is expanding in 2018 to include head of household filing status.

Oh boy.

Let’s go through a Tax Court case I was reviewing recently.

(1)  Joe and Cerice lived together and had a child in 2006.

(2)  The relationship went south either late 2014 or early 2015.

(3)  Cerise moved in with her mother.

(4)  Joe and Cerise started sharing custody, although Joe’s parents also took care of the child while he was working.

(5)  There was a custody proceeding in 2015, and the Court order gave each parent equal time. For some reason, the Court came back in 2016 and reduced Joe’s share of parental time.

(6)  The Court stated that Cerise could claim the child in 2015 and all odd-numbered years. Joe could claim the child in even-numbered years.

QUESTION: Who claims the child in 2014?

The technical detail here is that head-of-household status requires the child to spend more than one-half of the year with the claiming parent.

Let’s say that I have never met Joe or Cerise. I meet with either one, who asks me to prepare the 2014 return. Whoever I meet with wants to claim the child, of course, as it will power head of household status, an earned income credit and a child credit. I suspect either Joe or Cerise could present a formidable argument that the child was with him/her for more than one-half of the year.

What am I supposed to do?

I would of course look at the custody agreement, but that doesn’t start until the following year. No help there.

I could get assurance from the other parent that he/she is not claiming the child.

Let’s say that fails.

I could get a letter from the pediatrician, I suppose.

Or the school, if the child were old enough.

Or maybe the landlord where either Joe or Cerise lives.

Here I am social-working this situation. If I don’t, the IRS can penalize me $510. For each instance. Miss both the head of household and refundable child care credit and the penalty is $1,020.

Which might be more than I am charging to prepare the return.

How keen would you be to accept Joe or Cerise as a client?

That is my point.

A Sad Grandma Story

 You know a tax case is going to irritate when you read this sentence early on:

The Commissioner does not defend the justice of this result, but says the law requires it.”

The story involves a grandmother, a son and daughter-in-law and two grandkids. Grandma appears to be the only one working and that as a nursing assistant in Texas. She also collected social security, which was just enough to keep the household afloat.

          []’s job is hard, and it does not pay much.”

It was 2012. He son did not work. Her daughter-n-law…

          … stayed home and took care of the babies.”

She filed her 2012 tax return and claimed the two grandchildren as dependents. That made sense, as she was the only person there with a job.

This allowed her to claim head of household and the dependent exemptions. Much more important than that, however, it allowed her to claim the child and earned income credits. She got a refund of almost $5,300, almost half of which was those credits.

Good for grandma.

The IRS sent her a notice. They wanted the money from the credits back.

Being the warm, fuzzy IRS we have come to know, she was also assessed a $1,000 penalty.

She figured ID theft. Somebody else must have claimed the kids.

She was right, partially. Somebody else did claim the kids.

Their parents.

That would be her son, the one who …

… did not work, and he was into dealing with drugs.”

Sigh.

We all know what a child is, but in the tax Code must rise to the level of a “qualifying child” before the tax goodies flow. There are requirements, of course – such as age and where they live – and grandma easily met those.

But only one person can claim each qualifying child, which is why one is required to include dependent social security numbers on the return. The IRS tracks those numbers. If you are the second person to use a dependent’s number, the IRS will bounce (or at least hold up) your return.

Grandma was the second to file, so she got bounced.

Now, there are families where more than one person can say that a child was his/her qualifying child. Congress anticipated this and included tie-breaker rules. For example, if two people contest and have equal claim, then the tie-breaker goes to the person with more income.

Or if the parents and someone else claim, then the parents win the tie-breaker.

However, this can be sidestepped if the parents DO NOT claim the child.

In grandma’s case, her son and daughter-in-law filed and claimed.

Can this situation be saved?

You bet.

How?

Amend the return. Have the parents “unclaim” the kids.

To their credit, the son and daughter did amend. They handed the amended return to the IRS attorney.

And here we have the technicality that makes you cringe.

Filing a return means sending it on to a service center or handing it to “any person assigned the responsibility to receive hand-carried returns in the local Internal Revenue Service office.”

Problem: the IRS attorney is not “assigned the responsibility” to receive or handle returns. Handing him/her a return is the equivalent of giving your return to a convenience store clerk or a Starbucks barista.

I suppose the attorney could bail you out by filing the return on your behalf upon returning to the office, but that did not happen here.

The return was never filed. Without an amended return, the son and daughter never revoked their dependency claim.

As the parents, they took priority over grandma, who only supported everyone that year.

And grandma could not claim the kids a second time.

Which cost her the child and earned income credits.

She had to repay the IRS.

The Court did not like this, not even a little bit.

We are sympathetic to []’s position. She provided all the financial support for …, had been told by her son that she should claim the children as her dependents, and is now stuck with a hefty tax bill. It is difficult for us to explain to a hardworking taxpayer like [] why this should be so, except to say that we are bound by the law.”

Sad.

At least the Court reversed those blasted penalties.

Spotting A (Tax) Dependent

Let’s talk about claiming someone as a dependent.

There are several tax “breaks” that require you to have a dependent, for example:

·        Head of household (HoH) filing status

·        A dependent exemption

·        Child credit

·        Child care credit

·        Education credit

·        Earned income credit

Some of these breaks go only so far. The head of household (HoH) filing status, for example, can get you to zero tax, but it cannot “create” a tax refund. You have to have tax withholdings before HoH can get you a refund; even then, you are getting your own money back. Not so with the child credit or the earned income credit, however.  Meet all the triggers and the EIC can refund you over $6,000, irrespective of whether you have any withholdings or not. It is a transfer payment from the government.

So what is required to claim someone as a tax dependent?

There are two overall categories of dependents. The first is your own child (or stepchild, adopted child, or descendants of the same) and is referred to as a “qualifying child.” This is the workhorse test: think a child at home with his/her parents.

There are five requirements for a “qualifying child”:

1. Are they related to you? 
2. Are they under age 19 or – if a full-time student – under age 24? 
3. Do they live with you for more than half the year?
4. Do you support them financially? 
5. Are you the only person claiming the child?

Any other type of dependent is a referred to as a “qualifying relative.” The requirements are as follows:

1. Do they live with you for more than half the year?
2. Do they make less than $3,950?
3. Do you support them financially?
4. Are you the only person claiming the child?

The term “qualifying relative” is misleading, by the way. The person does not need to be related to you at all. For example, a girlfriend could be my dependent – assuming that all the other requirements were met AND my wife allowed me to have a girlfriend.

Did you notice the age thing? A qualifying child ends at age 24 (unless we are talking permanent disability, which is a different rule). Past age 23 and the child is your dependent under the qualifying relative rules.

Which also means that an income test kicks-in. That after-age-23 child would not qualify as a dependent if he/she earned more than $3,950 for the year. This can be a cruel surprise at tax time for parents whose kids have moved back.

That answer, by the way, is the same for an over-18-under-24 child who does not go on to college.

Let’s take a little quiz on dependents. We will use the Tax Court case of James Edward Roberts v Commissioner. Here are selected facts:

1. In January, 2012 Roberts’ daughter became homeless. 
2. She had two young kids. 
3. She was pregnant with the third.

Roberts was a decent soul, and worked out a deal with a Ms. Moody, whereby he and the two children (very soon three) moved in with her. He agreed to pay 75% of the rent and utilities. He also agreed to pay 100% of the meals.

Then he did something unexpected. He wrote down the agreement, and both he and Ms. Moody signed and dated it.

Roberts and his (now three) grandchildren lived in the apartment from January until October, 2012. His daughter also lived there on-and-off. When she was not there, Ms. Moody helped take care of the kids.

When Roberts filed his 2012 tax return, he claimed the following:

(1)  Head of household

(2)  Dependent exemption for three grandchildren

(3)  Child credit

(4)  Earned income credit

The IRS bounced his return, and they wound up in Tax Court.

The IRS had an issue whether the kids were his dependents.

What do you think?

Let’s walk through it.

·        The kids are related (grandchildren) to Roberts. CHECK

·        The kids are young. CHECK

·        They lived with him from January through October, which is more than half the year. CHECK

·        He paid 75% of the rent and utilities and 100% of the food. Sounds to me like that would be over half the support for the kids. CHECK

·        The Court tells us that their mom did not claim them. CHECK

Seems that Roberts met all the requirements to claim the grandchildren as dependents for 2012. Why did the IRS press on this?

I don’t know, and the Court did not explain why. I can guess, though.

I see a person who…

·        moved

·        put three dependents on his return who were not there the prior year

·        was not living with the kids by the time the IRS contacted him

·        lived in an apartment with someone who (perhaps, who knows) might have been his girlfriend. This would raise the issue of who actually paid the expenses for rent, utilities and food – you know, the same expenses that Roberts needed to show that he supported the kids.

Roberts won his day in Court.

I suspect that written – and contemporaneously signed - agreement with Ms. Moody carried a lot of weight with the Court.

I allow that the IRS had cause to look at this return. After that, however, they should have left Mr. Roberts alone.  The IRS made a mistake on this one.