Mortgage Forgiveness Debt Relief
Act of 2007
Late on Dec. 18, the House of Representatives approved by voice vote the Senate-passed version of H.R. 3648, the "Mortgage Forgiveness Debt Relief Act of 2007." Thus, the Act is cleared for the President's signature. The centerpiece of the Mortgage Relief Act is a limited exclusion for discharged home mortgage debt. However, the Act includes a wide range of provisions not connected to mortgage forgiveness relief, such as: a liberalized exclusion rule for home sales by surviving spouses; an extension of the deduction for mortgage insurance; a limited exclusion for qualifying state or local rebates or payments to firefighters and other emergency responders; and a modification of the qualification tests for cooperative housing corporations. Additionally, there's a stiffened penalty for failure to timely file partnership returns, a new penalty for failure to file S corporation returns, and higher estimated tax installments for large corporations in 2012.
Home Mortgage Debt
Unless a specific exception applies, income realized by a debtor from the discharge of indebtedness is included in his gross income. Under pre-Mortgage Relief Act law, exceptions applied under Code Sec. 61(a)(12) and Code Sec. 108 for debtors in Title 11 bankruptcy cases, insolvent debtors, certain student loans, certain farm indebtedness, and certain real property business indebtedness. Generally, the discharge of indebtedness amount equals the difference between the adjusted issue price of the debt being cancelled and the amount used to satisfy the debt. Taxpayers reduce certain tax attributes, including basis in property, by the amount of excluded discharged debt.
Under Code Sec. 163(h)(3), taxpayers may claim itemized deductions for qualified residence interest-interest on up to: (a) $1,000,000 ($500,000 for married individuals filing separately) of acquisition indebtedness and (b) $100,000 of home-equity debt.
New law. The Mortgage Relief Act, effective for indebtedness discharged on or after Jan. 1, 2007 and before Jan. 1, 2010, generally allows taxpayers to exclude up to $2 million of mortgage debt forgiveness on their principal residence. Specifically, the Mortgage Relief Act provides that gross income doesn't include any discharge of qualified principal residence indebtedness. (Code Sec. 108(a)(1)(E), as amended by Act § 2(a)) Qualified principal residence indebtedness is acquisition indebtedness under Code Sec. 163(h)(3)(B) with respect to the taxpayer's principal residence, but with a $2 million limit ($1 million for married individuals filing separately). (Code Sec. 108(h)(2), as amended by Act § 2(b)) "Principal residence" has the same meaning as under the homesal6 exclusion rules of Code Sec. 121. (Code Sec. 108(h)(5)) Acquisition indebtedness of a principal residence is indebtedness incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. It includes refinancing of debt to the extent the amount of the refinancing doesn't exceed the amount of the refinanced indebtedness. (Joint Committee on Taxation JCX-86-07)
The basis of the taxpayer's principal residence is reduced by the excluded amount, but not below zero. (Code Sec. 108(h)(1))
Observation: The mortgage forgiveness exclusion only applies with respect to a taxpayer's principal residence. Thus, while interest for a taxpayer's vacation home may be deductible, debt forgiven with respect to a taxpayer's vacation home isn't excludible.
If any loan is discharged, in whole or in part, and only part of the loan is qualified principal residence indebtedness, the mortgage forgiveness exclusion applies only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before the discharge) which is not qualified principal residence indebtedness. (Code Sec. 108(h)(4))
The exclusion doesn't apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the taxpayer's financial condition. The exclusion also doesn't apply to a taxpayer in a Title 11 bankruptcy. (Code Sec. 108(h)(3)) An insolvent taxpayer (other than one in a Title 11 bankruptcy) can elect to have the mortgage forgiveness exclusion not apply and can instead rely on the Code Sec. 108(a)(1)(B) exclusion for insolvent taxpayers. (Code Sec. 108(a)(2), as amended by Act § 2(c))
Extension of Treatment of Mortgage
Insurance Premiums as Interest
Premiums paid or accrued by a taxpayer during the tax year for qualified mortgage insurance in connection with acquisition indebtedness with respect to a qualified residence of the taxpayer are treated as qualified residence interest, subject to a phase-out based on the taxpayer's adjusted gross income (AGI) (below).
Qualified mortgage insurance means mortgage insurance provided by the Veterans Administration (VA), the Federal Housing Administration (FHA), or the Rural Housing Administration (RHA), and private mortgage insurance, as defined by Sec. 2 of the Homeowners Protection Act of '98 (12 U.S.C. 4901), as in effect on Dec. 20, 2006.
Except for amounts paid for qualified mortgage insurance provided by the VA or the RHA, any amounts paid by the taxpayer for qualified mortgage insurance that is properly allocable to any mortgage the payment of which extends to periods that are after the close of the tax year in which that amount is paid are chargeable to capital account and must be treated as paid in those periods to which they are allocated.
But, no deduction is allowed for the unamortized balance of premiums that have been capitalized if the mortgage is satisfied before the end of its term.
The amount of mortgage insurance premiums otherwise treated as qualified residence interest under the rule above must be reduced (but not below zero) by: (a) for taxpayers other than married persons filing separately, 10% of the amount of qualified mortgage insurance for each $1,000 (or fraction thereof) that the taxpayer's AGI for the tax year exceeds $100,000, and (b) for married persons filing separately, 10% of the amount of qualified mortgage insurance for each $500 (or fraction thereof) that the taxpayer's AGI for the tax year exceeds $50,000.
Under pre-Mortgage Relief Act law, the rules treating qualified mortgage insurance premiums as deductible qualified residence interest apply only if the amounts: (1) are paid or accrued before Jan. 1, 2008; (2) aren't properly allocable to any period after Dec. 31, 2007; and (3) are paid or accrued with respect to a mortgage insurance contract issued after Dec. 31, 2006.
New law. The Mortgage Relief Act extends the rules treating qualified mortgage insurance premiums as deductible qualified residence interest for three years. Thus, they apply if the amounts: (1) are paid or accrued before Jan. 1, 2011; (2) aren't properly allocable to any period after Dec. 31, 2010; and (3) are paid or accrued with respect to a mortgage insurance contract issued after Dec. 31, 2006. (Code Sec. 163(h)(3)(E)(iv), as amended by Act § 3)
Co-ops Can Qualify Under Two Additional Tests
Tenant-stockholders of cooperative housing corporations (i.e., co-ops) are entitled to certain important tax benefits. All tenant-stockholders may deduct amounts paid or accrued to the corporation to the extent they represent the shareholder's proportionate share or separately allocable share of the real estate taxes and interest paid by the corporation.
A co-op is a corporation that meets the following four requirements:
(1) It has one class of stock;
(2) Each of its stockholders is entitled, solely by reason of ownership of stock in the corporation, to occupy a dwelling owned or leased by the cooperative;
3) None of its stockholder are entitled to receive any distribution not out of its earnings and profits, except on the co-op's complete or partial liquidation; and
(4) Under pre-Mortgage Relief Act law, 80% or more of its gross income for the tax year in which the taxes and interest are paid or accrued must be derived from tenant-stockholders.
New law. The Mortgage Relief Act adds, effective on the enactment date, two alternate methods of meeting the 80% test in (4), above. In addition to the pre-Act 80% test, the fourth requirement is met if, for the tax year in which the taxes and interest are paid or accrued:
(a) at all times during that tax year, 80% or more of the total square footage of the corporation's property is used or available for use by the tenant-stockholders for residential purposes or purposes ancillary to residential use; or
(b) 90% or more of the corporation's expenditures paid or incurred during the tax year are paid or incurred for the acquisition, construction, management, maintenance, or care of its property for the benefit of tenant-stockholders. (Code Sec. 216(b)(1)(D), as amended by Act § 4(a))
Observation: This provision apparently addresses the problem that some co-ops face because of the increasingly profitable rental market. As a result, coops charging market-rate rent find that they are receiving too much commercial rent (i.e., totaling more than 20% of gross income). These two alternatives will make it easier for co-ops to take advantage of the commercial rental market and still qualify as a co-op.
New Exclusion for Volunteer Firefighters and
Emergency Medical Responders
Under pre-Mortgage Relief Act law, IRS took the position that reductions or rebates of property taxes by State or local governments on account of services performed by members of qualified volunteer emergency response organizations were in-kind payments for services, and so were taxable income to the volunteers.
Specific statutory exclusions are provided where a reimbursement is for expenses incurred in performing volunteer services under certain government programs (e.g., the Foster Grandparent program). Under pre-Mortgage Relief Act law, there was no specific statutory exclusion for reimbursements received by volunteer emergency medical responders. A taxpayer's unreimbursed expenses incurred in connection with providing services to a charitable organization are deductible as a charitable contribution deduction under Code Sec. 170 if the expenditures' primary purpose is to further the charitable organization's aims, rather than those of the taxpayer. Under pre-Mortgage Relief Act law, no specific limits applied for a charitable deduction by members of a qualified volunteer emergency response organization.
New law. The Mortgage Relief Act provides, effective for tax years beginning after Dec. 31, 2007 and before Jan. 1, 2011, an exclusion from gross income to members of qualified volunteer emergency response organizations for:
(1) any qualified State or local tax benefit; and
(2) any qualified payment. (Code Sec. 13913(a), as added by Act § 5(a))
A qualified State or local tax benefit is any reduction or rebate of State or local income, real property, or personal property taxes on account of services performed by individuals as members of a qualified volunteer emergency response organization. (Code Sec. 139B(c)(1)) The amount of State or local taxes taken into account by a taxpayer in determining his deduction for taxes under Code Sec. 164 is reduced by the amount of any qualified State or local tax benefit. (Code Sec. 139B(b)(1))
A qualified payment is a payment (whether reimbursement or otherwise) provided by a State or political subdivision on account of the performance of services as a member of a qualified volunteer emergency response organization. The amount of these payments is limited to $30 multiplied by the number of months during the year that the taxpayer performs such services. (Code Sec. 139B(c)(2)) Expenses paid or incurred by the taxpayer in connection with the performance of services are taken into account for a charitable contribution deduction by him only to the extent they exceed the amount of excluded qualified payments. (Code Sec. 139B(b)(2))
Observation: The maximum exclusion for qualified payments in a year is $360 ($30 x 12 months).
Observation: A transfer in a particular month isn't required to get the $30 exclusion for that month. Rather, the exclusion for a particular month of service is allowed regardless of when paid. Thus, a taxpayer who serves for 12 months could exclude $360 received during the year even if it was received all in one month (for example, in the first or last month of the year).
A qualified volunteer emergency response organization is any volunteer organization which is: (1) organized and operated to provide firefighting or emergency medical services for persons in the State or its political subdivision; and (2) required (by written agreement) by the State or political subdivision to furnish firefighting or emergency medical services in the State or political subdivision. (Code Sec. 139B(c)(3))
Clarification of Student Housing Eligible for Low
Income Housing Credit
Under pre-Mortgage Relief Act law, a unit will not fail to qualify as a low-income unit for purposes of the low-income housing tax credit merely because it is occupied:
(1) by an individual who is one of the following:
... a student receiving AFDC (i.e. Aid to Families with Dependent Children) payments.
... enrolled in a job training program receiving assistance under the Job Training Partnership Act or under other similar federal, state, or local laws.
(2) entirely by full time students if the students are:
... single parents and their children, but only if neither the parents nor the children are dependents, determined without the rule that a dependent is ineligible to have dependents, the rule that a joint return filer can't be a dependent, and the gross income test for qualifying relatives, or
... married and file a joint return. (Code Sec. 42(i)(3)(D))
New law. The Mortgage Relief Act amends Code Sec. 42(i)(3)(D)(ii)(I) to allow certain full-time students who are single parents and their children to live in housing units eligible for the low-income housing tax credit provided that their children are not dependents of another individual (other than a parent of such children). This change applies to housing credit amounts allocated before, on or after the enactment date, and buildings placed in service before, on or after the enactment date to the extent Code Sec. 42(h)(1) (credit may not exceed credit amount allocated to building) does not apply to any building by reason of Code Sec. 42(h)(4) (credit for buildings financed by tax-exempt bonds subject to volume cap not taken into account).
Homesale Exclusion Liberalized for
Under Code Sec. 121, a qualifying taxpayer may exclude up to $250,000 ($500,000 for joint return filers) of gain from the sale or exchange of property that the taxpayer has owned and used as his or her principal residence. Under Code Sec. 121(b)(2)(A), married taxpayers filing jointly for the year of sale may exclude up to $500,000 of home-sale gain if (1) either spouse owned the home for at least 2 of the 5 years before the sale; (2) both spouses used the home as a principal residence for at least 2 of the 5 years before the sale; and (3) neither spouse is ineligible for the full exclusion because of the once-every-2-year limit on the exclusion.
Under pre-Mortgage Relief Act law, the up-to$500,000 exclusion was available only if a husband and wife filed a joint return for the year of sale. Thus, if the home was sold in a year after the year of a spouse's death - when a joint return would no longer be filed - the surviving spouse could only get a maximum home sale exclusion of $250,000.
New law. The Mortgage Relief Act, effective for sales and exchanges after Dec. 31, 2007, allows surviving single spouses to qualify for the up-to-$500,000 exclusion if the sale occurs not later than 2 years after their spouse's death and the requirements for the $500,000 exclusion under Code Sec. 121(b)(2)(A) were met immediately before the spouse's death. (Code Sec. 121(b)(4), as amended by Act § 7(a))
Caution: The measuring period is 2 years from a spouse's death. A sale or exchange in the second tax year following a spouse's death will not qualify for the relief provision if it occurs more than 2 years from the spouse's death.
Observation: Apart from the homesale exclusion, where the spouses jointly owned the residence, the surviving spouse's basis in the decedent's half of the property is stepped-up to its date-of-death or alternate-valuation-date value. That is, half of the gain on the property will be virtually eliminated since the gain (sales proceeds - property basis) on the decedent's half of the property will only be the difference between the fair market value of the property on the date of sale and on the date of the spouse's death (or alternate valuation date).
Limitation on Disclosure of Taxpayer Returns to
Partners, S Shareholders, and Beneficiaries
of Trusts and Estates
Returns and return information are confidential and not subject to disclosure except as specifically authorized by statute. Inspection or disclosure of returns or return information is also permitted to certain persons with a material interest or their duly appointed attorneys in fact, including:
... in the case of a partnership's return, any person who was a member of the partnership during any part of the period covered by the return.
... in the case of a corporation's or a subsidiary's return: (1) any person designated by resolution of its board of directors or other similar governing body; (2) any officer or employee of the corporation upon written request signed by any principal officer and attested to by the secretary or other officer; (3) any bona fide shareholder of record owning 1% or more of the outstanding stock of the corporation; (4) if the corporation was an S corporation, any person who was a shareholder during any part of the period covered by the return during which an S election was in effect; or (5) if the corporation has been dissolved, any person authorized by applicable State law to act for the corporation or any person who IRS finds to have a material interest which will be affected by information contained in the return.
... in the case of the return of an estate, the administrator, executor, or trustee of the estate, and any heir at law, next of kin, or beneficiary under the will, of the decedent, but only if IRS finds that the heir at law, next of kin, or beneficiary has a material interest which will be affected by information contained in the return; and
... in the case of the return of a trust, the trustee or trustees, jointly or separately, and any beneficiary of such trust, but only if IRS finds that the beneficiary has a material interest which will be affected by information contained therein. (Code Sec. 6103(e))
New law. Effective on the enactment date, in the case of an inspection or disclosure under Code Sec. 6103(e) relating to the return of a partnership, S corporation, trust, or an estate, the information inspected or disclosed is not to include any supporting schedule, attachment, or list that includes the taxpayer identity information of a person other than the entity making the return or the person conducting the inspection or to whom the disclosure is made. (Code Sec. 6103(e)(10), as amended by Act § 8(c))
Revenue Raising Provisions
To offset the cost of the new tax breaks, the Mortgage Relief Act includes the following revenue raisers:
... Extension of the period for calculating the monthly failure-to-file-penalty for partnership returns from 5 to 12 months and an increase in the per-partner penalty amount from $50 to $85 per partner, effective for returns required to be filed after the enactment date. (Code Sec. 6698(a) and Code Sec. 6698(b), as amended by Act § 8(a) and (b))
... Imposition of a monthly penalty for any failure to timely file an S corporation return or any failure to provide the information required to be shown on such a return, effective for returns required to be filed after the enactment date. The penalty, assessed against the S corporation, is $85 times the number of shareholders in the S corporation during any part of the tax year for which the return was required, for each month (or a fraction of a month) during which the failure continues, up to a maximum of 12 months. (Code Sec. 6699, as added by Act § 9)
... Increase in the required installment amount for estimated tax payments by corporations with assets of $1 billion or more that is otherwise due in July, August, or September of 2012 by 1.50 percentage points. (Tax Increase Prevention and Reconciliation Act of 2005 § 401(1)(B), as amended by Act § 10) Thus, the "115.75%" amount is increased to "117.25%" of any required installment of corporate estimated tax that is otherwise due in July, August, or September of 2012. As under pre-Mortgage Relief Act law, the next payment is reduced accordingly.
Energy Act includes two tax changes
On Dec. 18, the House of Representatives by a vote of 314-100 approved the Senate-passed version of H.R. 6, the "Energy Independence and Security Act of 2007." The Act was signed into law one day later.
Title XV of the Energy Act carries the following tax changes:
... FUTA surcharge extended by one year. The Federal Unemployment Tax Act (FUTA) imposes a 6.2% gross tax rate on the first $7,000 paid annually by covered employers to each employee, consisting of a permanent tax rate of 6%, and a temporary surtax rate of 0.2%. Under pre-Energy Act law, the temporary surtax only applies through the end of 2007. Under the Energy Act, the temporary surtax rate is extended through Dec. 3 1, 2008. (Code Sec. 3301, as amended by Energy Act § 1501) Thus, the FUTA rate remains at 6.2% through the end of 2008.
... Longer writeoff for large oil companies geological and geophysical expenditures. Under pre-Energy Act law, major integrated oil companies must amortize their geological and geophysical expenditures over five years (instead of the 24 month period that applies for other taxpayers). Effective for amounts paid or incurred after Dec. 19, 2007, major integrated oil companies must amortize their geological and geophysical expenditures over seven years. (Code Sec. 167(h)(5), as amended by Energy Act § 1502)
Eased Rules for above-the-line health insurance deduction for 2% S shareholders
Notice 2008-1, 2008-2 IRB new notice explains when a 2% shareholderemployee in an S corporation is entitled to the Code Sec. l62(1) above-the-line deduction for health insurance premiums that are paid or reimbursed by the S corporation and included in his gross income.
Observation: Without affirmatively saying so, Notice 2008-1 effectively repudiates guidance appearing in an article on IRS's web site last year. That guidance had concluded that an S corporation's sole shareholder-employee couldn't buy health insurance in his own name and get the above-theline deduction for the premium expense. As explained below, if certain requirements are met, such a deduction is now possible and may be gained for a prior year by filing an amended return.
Background. For purposes of applying the income tax provisions relating to employee fringe benefits, an S corporation is treated as a partnership, and any 2% shareholder of an S corporation is treated as a partner of the partnership. (Code Sec. 1372(a)) For this purpose, a "2-percent shareholder" is any person who owns (or is considered as owning under the constructive ownership rules of Code Sec. 318) on any day during the S corporation's tax year more than 2% of the outstanding stock of the corporation or stock possessing more than 2% of the total combined voting power of all stock of such corporation. (Code Sec. 1372(b))
Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2% shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments under Code Sec. 707(c). (Rev Rul 91-26, 1991-1 CB 184) An S corporation may deduct the cost of such employee fringe benefits under Code Sec. 162(a) subject to the capitalization rules of Code Sec. 263).
A 2% shareholder is not an employee for purposes of the Code Sec. 106 exclusion for employer-provided health coverage. (Reg § 1.106-1; Code Sec. 1372(a)) Accordingly, the premiums are not excludible from his gross income under Code Sec. 106.
The premium payments are included in wages for income tax withholding purposes on the shareholder employee's Form W-2 but are not wages subject to Social Security and Medicare taxes if the requirements for exclusion under Code Sec. 3121(a)(2)(B) are met. (Ann 92-16, 1992-5 IRB 53) The 2% shareholder is required to include the amount of the health insurance premiums in gross income.
A self-employed individual can deduct as a business expense 100% of the amount paid during the tax year for medical insurance on himself, his spouse and his dependents. (Code Sec. 162(1)(1)) However, no deduction is allowed for a self-employed individual's health insurance costs to the extent that the deduction exceeds his earned income (within the meaning of Code Sec. 401(c), i.e., net earnings from self-employment) derived from the trade or business with respect to which the plan providing the medical care coverage was established. (Code Sec. 162(1)(2)(A))
The deduction isn't available to any taxpayer for any calendar month for which the taxpayer is eligible to participate in any subsidized health plan maintained by any employer of the taxpayer or of the spouse of the taxpayer. (Code Sec. l62(1)(2)(B))
A 2% shareholder-employee in an S corporation, who otherwise meets the requirements of Code Sec. 162(l), is eligible for this deduction if the plan providing medical care coverage for him is established by the S corporation. (Rev Rul 91-26)
Eased position. A plan providing medical care coverage for a 2% shareholder-employee is established by the S corporation if: (1) the corporation makes the pre-mium payments for the health insurance policy covering the 2% shareholder-employee (and his spouse or dependents, if applicable) in the current tax year; or (2) the 2% shareholder makes the premium payments and furnishes proof of payment to the corporation and it then reimburses him. If the health insurance premiums are not paid or reimbursed by the S corporation and included in the 2% shareholder-employee's gross income, a plan providing medical care coverage for the 2% shareholder-employee is not established by the S corporation and he is not allowed the Code Sec. 162(I) deduction.
Thus, under Notice 2008-1, in order for a 2% shareholder-employee to deduct the amount of the health insurance premiums, the S corporation must report the health insurance premiums paid or reimbursed as wages on his Form W-2 in that same year. In addition, the shareholder must report the premium payments or reimbursements as gross income on his Form 1040. Notice 2008-1 illustrates this in four example that are set forth below. The examples assume that each shareholder is a 2% shareholder-employee in an S corporation, whose earned income from the S corporation exceeds the amount of the premiums for the health insurance policies covering the shareholder, his spouse and dependents. No shareholder is eligible to participate in any subsidized health plan maintained by an employer of the shareholder or his spouse. All examples involve tax year 2008.
Illustration (1): Shareholder Andy obtains a health insurance policy in his name and pays the premium on the policy. The S corporation makes no payments or reimbursements with respect to the premiums. Result: A plan providing medical care for Andy is not established by the S corporation and he may not deduct the premiums under Code Sec. 162(1).
Illustration (2): The S corporation obtains a health insurance plan in its name. The plan provides coverage for shareholder Betty, her spouse and dependents. The S corporation pays all premiums and reports them as wages on Betty's Form W-2 for 2008 and she reports them as gross income on Form 1040 for 2008. Result: A plan providing medical care for Betty has been established by the S corporation and she may take the Code Sec. 162(1) deduction for 2008.
Illustration (3): Shareholder Carl obtains a health insurance policy in his name. The S corporation pays all premiums and reports them as wages on shareholder Carl's Form W-2 for 2008. Carl reports them as gross income on his Form 1040 for 2008. Result: A plan providing medical care for Carl has been established by the S corporation and he may take the Code Sec. 162(I) deduction for 2008.
Illustration (4): Shareholder Donna obtains a health insurance policy in her name. She pays the premiums and furnishes proof of payment to the S corporation, which reimburses her for the payments. The S corporation reports the amount of the premium reimbursements as wages on Donna's Form W-2 for 2008 and she reports them as gross income on Form 1040 for 2008. Result: A plan providing medical care for Donna has been established by the S corporation and she may take the Code Sec. 162(1) deduction for 2008.
Amended returns for prior tax years. A taxpayer who did not claim a deduction for health insurance coverage described in Notice 2008-1 may file a timely amended tax return to claim the Code Sec. 162(1) deduction if he satisfies the notice's requirements. The statement "Filed Pursuant to Notice 2008-1" should be written on the top of the amended return.
Effect on single class of stock requirement. Notice 2008-1 states that IRS does not consider payments of health insurance premiums by an S corporation on behalf of 2% shareholder-employees to be distributions for purposes of the single class of stock requirement of Code Sec. 1361(b)(1)(D).
IRS eases dependency
exemptions for qualifying relatives
A new notice provides guidance under Code Sec. 152(d) for determining whether an individual is a qualifying relative for whom the taxpayer may claim a dependency exemption. The notice essentially provides an administrative exception to Code Sec. 152(d)(1)(D), which provides that an individual is not a qualifying relative of the taxpayer if the individual is a qualifying child of any other taxpayer. Specifically, the notice provides that an individual is not a qualifying child of any other taxpayer if the individual's parent (or other person with respect to whom the individual is defined as a qualifying child) isn't required by Code Sec. 6012 to file an income tax return and (i) does not file one, or (ii) files one solely to obtain a refund of withheld tax.
Background. A taxpayer is entitled to a deduction equal to the exemption amount for each person who qualifies as his "dependent." (Code Sec. 151(c))
A person qualifies as the taxpayer's dependent if the person is the taxpayer's qualifying child or qualifying relative. (Code Sec. 152(a)) The terms "qualifying child" and "qualifying relative" were added to Code Sec. 152 by the Working Families Tax Relief Act of 2004 (WFTRA), effective for tax years beginning 2004. WFTRA established a uniform definition of a "qualifying child" for determining whether a taxpayer may claim certain child-related tax benefits. It established the term "qualifying relative" to identify individuals (other than a qualifying child) for whom a dependency exemption deduction may be allowed.
A "qualifying child" of a taxpayer is an individual who: (A) bears a certain relationship to the taxpayer, (B) has the same principal place of abode as the taxpayer for more than one-half of the tax year, (C) meets certain age requirements, and (D) has not provided over one-half of his or her own support for the calendar year. (Code Sec. 152(c)(1))
A "qualifying relative" is an individual: (A) who bears a specified relationship to the taxpayer (Code Sec. 152(d)(1)(A)); (B) whose gross income for the calendar year in which that tax year begins is less than the exemption amount (Code Sec. 152(d)(l)(B)); (C) with respect to whom the taxpayer provides over one-half of his or her support for the calendar year in which that tax year begins (Code Sec. 152(d)(1)(C)); and (D) who isn't a qualifying child of that taxpayer or of any other taxpayer for any tax year that begins in the calendar year in which that tax year begins. (Code Sec. I 52(d)(1)(D))
Observation: An individual need not be technically related to a person to qualify as the person's qualifying relative. That's because, the specified relationships include in-laws and an individual who, for the tax year of the taxpayer, has as such individual's principal place of abode the home of the taxpayer and is a member of the taxpayer's household. (Code Sec. 152(d)(2))
Clarifying guidance. Commentators informed IRS that Code Sec. 152(d)(1)(D) could lead to unintended tax consequences that differ from those under preWFTRA law. For example, they pointed to a taxpayer who supports as members of her household two minor orphans who are brother and sister. The commentators questioned whether the children are qualifying children of "any other taxpayer" (i.e., one another), thus making the taxpayer ineligible to claim dependency exemption deductions for the children.
IRS noted that, before amendment by WFTRA, a taxpayer could claim a dependency exemption deduction for an unrelated child who was a member of the taxpayer's household for the entire year, provided all relevant requirements of former Code Sec. 151 and Code Sec. 152 were satisfied. The legislative history of WFTRA reveals that it generally was intended to permit taxpayers to continue to apply the dependency exemption rules of pre-WFTRA law to claim a dependency exemption for a qualifying relative who does not satisfy the qualifying child definition.
In view of this history and citing Rev Rut 54-567, 54-2 CB 108 affd Rev Rut 65-34, 1965-1 CB 86, IRS has concluded that a taxpayer otherwise eligible to claim a dependency exemption deduction for an unrelated child is not prohibited by Code Sec. 152(d)(1)(D) from claiming the deduction if the child's parent (or other person with respect to whom the child is defined as a qualifying child) is not required by Code Sec. 6012 to file an income tax return and (i) does not file an income tax return, or (ii) files an income tax return solely to obtain a refund of withheld income taxes.
Examples in the new guidance. Notice 2008-5 includes these examples.
Illustration (1): Andrew supports as members of his household for the tax year an unrelated friend, Betty, and her 3-year-old child, Carole. Betty has no gross income, is not required by Code Sec. 6012 to file an income tax return, and does not file an income tax return for the tax year. Accordingly, because Betty does not have a filing requirement and did not file an income tax return, Carole is not treated as a qualifying child of Betty or any other taxpayer, and Andrew may claim both Betty and Carole as his qualifying relatives, provided all other requirements of Code Sec. 151 and Code Sec. 152 are met. (Notice 2008-5)
Illustration (2): Same facts as Illustration (1), except that Betty has earned income of $1,500 during tax year 2006, had income tax withheld from her wages, and is not required by Code Sec. 6012 to file an income tax return. With one qualifying child, Betty may claim the earned income credit (EIC) in the amount of $519 for the tax year. She files an income tax return solely to obtain a refund of withheld income taxes and does not claim the EIC. Accordingly, because Betty does not have a filing requirement and filed only to obtain a refund of withheld income taxes, Carole is not a qualifying child of Betty or any other taxpayer, and Andrew may claim both Betty and Carole as his qualifying relatives, provided all other requirements of Code Sec. 151 and Code Sec. 152 are met. (Notice 2008-5)
lllustration (3): Same facts as Illustration (1), except that Betty has earned income of $8,000 during tax year 2006, had income tax withheld from her wages, and is not required by Code Sec. 6012 to file an income tax return for the tax year. With one qualifying child, Betty may claim the EIC in the amount of $2,729 for the tax year. She files an income tax return for the tax year to obtain a refund of withheld income taxes, and she claims the EIC on the return. Accordingly, because Betty filed an income tax return to obtain the EIC, and not solely to obtain a refund of withheld income taxes, Carole is a qualifying child of another taxpayer, Betty, and Andrew may not claim Carole as a qualifying relative.
Observation: There could be close cases where it is beneficial to forgo the EIC in favor of the exemption and vice versa. This assumes that the two individuals are operating as a single economic unit and want to receive the best economic result for themselves as a couple. In other cases, personal financial considerations may outweigh joint considerations.
Effective date. Notice 2008-5 is effective for tax years beginning after 2004.
Observation: The retroactive effective date may lead to a refund opportunity for a taxpayer who failed to claim a dependency exemption based on the concerns addressed in and rectified by Notice 2008-5.