Parenting · Tax Avoidance

Gaining Independence

[As with anything tax-related, see my disclaimers.]

This week my oldest daughter headed off to college. She’s excited and we’ll see how well the university keeps the kids safe during the pandemic. She’s pretty good at following rules but I’m not so sure how well her peers will follow rules. Either way, she’ll be coming home around Thanksgiving and we’re still waiting to see what happens during 2021.

As I’ve evaluated the various tax breaks, the one thing I noticed is that even though I don’t qualify for some of the breaks, like the American Opportunity Tax Credit, she could as long as she was no longer a dependent on my tax return.

What is the AOTC worth?

The AOTC is capped at $2,500 per student. Assuming only W2 income and no other tax credits/deductions, in 2019 a single, student taxpayer could have used the AOTC to cancel out all tax due on up to $34,650 of income ($12,200 standard deduction + $9700 @ 10% + $12,750 @ 12%).That’s not bad, but also not likely for a student unless they are working full time, which may hold true in their final year of college as they head into the workforce, but probably not before.

However, the credit is refundable up to $1,000 (40%). During the years when she’s hitting the books and not earning much, it could still be valuable.

In order for her to take the AOTC herself, she needs to be her own dependent. I would lose the $500 qualifying dependent tax credit.

In the end, we’re talking about a net $500 (maybe?) to $2,000 (unlikely for any year but senior year) credit across both of our returns.

What does it depend on?

There are several tests that must be met for a child to be considered a dependent. Or in other words, If any of these tests fail, the child cannot be considered a dependent and ready to take the AOTC. So let’s take a look at the tests.

  • Relationship: She’s my descendent so a solid PASS.
  • Age: She’ll be 18 at the end of the year and also a student, so another PASS.
  • Residency: She’s lived with me more than 50% of the year and even though she’ll be at school for more than 50% of next year, the IRS considers that “living with me” so another PASS.
  • Joint Return: She’s not married so again, another PASS
  • Support: This one requires some calculation (below), so for now I’ll give it a MAYBE?

Unless I can get a FAIL on the SUPPORT test, above, the next test result really doesn’t matter. However, if I can get a SUPPORT FAIL, then I’ll need to check the next rule:

  • Income: She’s earned more than $4,200 of W2 income this year, so this would be a FAIL.

What is Support?

So how can I score a FAIL in Support? Glad you asked. 

First, what is support? 

The IRS has a handy worksheet in Publication 501 to help you determine what is support, titled “Worksheet for Determining Support”. Basically:

Support = Income + Savings @ year start – Savings @ year end – Non-support Spending

Another way to look at is to combine all of the household expenses, divide by the number in the household, and that’s support.

Take the following example of a household with 8 people, including the student:

Category Amount
Rent (or equivalent) $3,200/month
Food $1,200/month
Utilities $350/month
Auto $350/month
Clothing $300/month
Entertainment $120/month
Medical/Dental Insurance $800/month
Other $400/month
Total $6,720/month

In this example, the child’s portion is $840/month, or $10,080 for the year. To get a FAIL on the Support question, the child would need to contribute at least $5,041 of that amount, either through income or savings, or both.

To further complicate things, education expenses paid by the parent should be included in the support equation. Assuming that I pay 100% of the tuition bill of $6,000 for the year, then the student would need to contribute another $3,000 in addition to her household portion, for a total of $8,041. This includes money that I use out of a 529, somewhat canceling out the state income tax benefits.

Can I Gift Support?

Before I go further, please realize I’m neither a tax lawyer or accountant and everything below could be complete hogwash. Read on for entertainment value only.

One possible loophole I can foresee is the net-savings side of the equation.

Let’s extend the example above by gifting $15k to the child during 2018 (the limit to stay under the gift tax annual limits). In 2019, the parents ask the child to contribute at least 50% of their share of the expenses, or $8,041. 

Does this example break the Support test? 

Maybe?

Is exposing myself in this way worth helping my daughter get an additional $1,000 on her tax return while reducing mine by $500? Probably not.

Conclusion

Basically I’m resigned to the fact that my daughter will be my dependent for several more years. I’m also resigned to never getting the benefit of the AOTC on my tax returns. However, I’m hopeful that when my daughter graduates, she may be able to take the AOTC for at least one year. 

Woe is me. 🙂

What are your thoughts about my analysis? Any gotchas that I’m missing? I’d love to hear what you think in the comments.

Hasta luego!

5 thoughts on “Gaining Independence

  1. “What does it DEPEND on?” I got the pun! Ha!

    While I have a pretty decent understanding of the US tax code, prior to reading your blog post I had zero understanding of the ATOC other than a vague memory of having qualified for it for a few years in my past as a self-supported student.

    I like your proposed arbitrage idea (the “gift” reciprocated with the 50.0001% self support for subsequent years), but something tells me that the IRS wouldn’t like it. You’ve maybe inspired me to search the Bogleheads forum to see if anyone else has done that successfully.

    1. Marrying during my undergrad, much like most of our religious tradition, was the ultimate arbitrage that opened the door for Pell Grants that covered 100% (if not more) of my cheap tuition.

      I remember something wonky about the timing of when you’d have to be married. If the wedding happened on/before 7/31, you could qualify as an independent for the prior academic year. If the wedding happened on 8/1 or after then the prior year was off limits, so you’d forfeit about $9k / person back when I was a student. I have fond memories of my brother getting married at the end of July and filling for the FAFSA in his wedding tuxedo and her wedding dress in my parents’ home office.

      1. Both my wife and I had full tuition scholarships so the Pell Grants were pretty small. I do not recall anything about the FAFSA and it’s relation to when we got married. Didn’t even consider it. But that’s a pretty funny image you portray.

        I also doubt the IRS would like the “50.0001% independent through a previous gift” scenario.

        1. One thought occurred to me today after reading your article this morning. Tuition paid by you counts as support, thereby screwing up this formula:

          Parental support = parental assistance / (parental assistance + daughter’s contributions)

          If you include tuition as part of “parental assistance”, then the “Parental support” fraction is mechanically increased, since it hits both the numerator and denominator.

          Doesn’t this create a perverse incentive for your daughter to take on student loan debt? If she does so, wouldn’t the accounting work out in her favor? If so, couldn’t you just forgive her student debt through a gift (or series of gifts) after she graduates?

          If she takes on $10k/year in debt at 5% interest, I suppose that would completely negate the $500 AOTC benefit.

          But I wonder if there is a Pell Grant angle to pursue using this similar logic…..

          1. Yes, tuition and education expenses are included in the support equation. It would reduce my ability to get the 529 tax benefit from Virginia, a benefit that my daughter’s couldn’t take advantage of herself because her income is so low.

            We did fill out the FAFSA, but I think she only qualified for unsubsidized loans. I believe that the FAFSA doesn’t consider tax dependency at all and the expected family contribution would have made the Pell Grant angle impossible. Unless she was married, in which case FAFSA would no longer care about my resources. Although I could be totally wrong there.

            FAFSA does create a perverse incentive to not save a penny, for education or otherwise. That and maximize retirement accounts and paying down mortgages, which isn’t so perverse.

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