Qualifying Child
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 Tax Law Changes
 The Definition of a "Qualifying Child"

Parents, stepparents and other people raising children need to be aware of a significant change in the way "qualifying children" are defined under the tax law for the purpose of claiming several benefits.

INVESTORS: Don't Forget Tax-Favored Treatment for Gains From Broad-Based Equity Index Options

The current federal income tax rates on long-term capital gains are so low, you should generally try to satisfy the more-than-one-year holding period rule before selling appreciated securities held in taxable investment accounts. That way, you’ll pay no more than the 15 percent maximum federal rate on long-term capital gains.

However, you may not always invest for the long term. For instance, you may sometimes speculate on stock index movements by making short-term trades in ETFs (exchange traded funds) like QQQ (which tracks the NASDAQ 100 index) and SPDR (which tracks the S&P 500 index). Of course, your short-term ETF trading profits will be taxed at ordinary income rates, which can be as high as 35 percent.

Fortunately, a special taxpayer-friendly exception applies to profits from trading in broad-based equity index options. The tax law treats these broad-based options as Section 1256 contracts. This is good for your 2005 tax return, because gains and losses from going long or short in Section 1256 contracts are automatically considered to be 60 percent long-term and 40 percent short-term. (Source: Internal Revenue Code Section 1256(a)(3))

In other words, your actual holding period for the option doesn’t matter. The tax-saving result is that your 2005 short-term profits from trading in broad-based equity index options will be taxed at a maximum effective rate of only 23 percent [(60 percent times 15 percent) plus (40 percent times 35 percent) equals 23 percent]. The effective tax rate is even lower if you’re not in the top 35 percent bracket.

You can trade broad-based equity index options that track major stock indexes and major industry sectors like oil, pharmaceuticals, defense, and biotech.

A qualifying child can enable a taxpayer to claim several tax breaks, such as head of household filing status, a dependency exemption, the child tax credit, the child and dependent care credit and the earned income tax credit. In the past, each of these items defined a qualifying child differently, leaving many taxpayers confused.

The Working Families Tax Relief Act set a uniform definition of a qualifying child, beginning with the 2005 tax year. This standard definition applies to all five of the tax breaks listed above, with each benefit having some additional rules.

However, in the process of standardizing the definition of a qualifying child, some unexpected consequences have occurred. Some taxpayers who could claim child-related tax breaks in the past are no longer eligible and other people may benefit in ways that Congress never intended.

In general, four tests must be met in order to be a taxpayer’s qualifying child:

  • Relationship – The child must be the taxpayer’s child or stepchild (whether by blood or adoption), foster child, sibling, stepsibling, or a descendant of one of these.
  • Residence – The child must have the same principal residence as the taxpayer for more than half the tax year. Exceptions apply, in certain cases, for children of divorced or separated parents, kidnapped children, temporary absences, and for children who were born or died during the year.
  • Age – The child must be under the age of 19 at the end of the tax year, or under the age of 24 if a full-time student for at least five months of the year, or be permanently and totally disabled at any time during the year.
  • Support – The child cannot provide more than one-half of his or her own support for the year.

If a qualifying child is claimed by two or more taxpayers in a given year:

  • The child will be the qualifying child of the parent.
  • If more than one taxpayer is the child’s parent, the qualifying child goes to the one with whom the child lived for the longest time during the year, or, if the time was equal, the parent with the highest adjusted gross income (AGI).
  • If no taxpayer is the child’s parent, the taxpayer with the highest AGI gets to claim the qualifying child.

Here are a couple of examples of taxpayers who could be affected by the law:

Winner - An over-age-19 child living in a parents' home could potentially claim a younger brother or sister as a qualifying child for purposes of the dependency exemption, the child tax credit, and other benefits — if the parents have income that is too high to benefit from those tax breaks. This may be true even if the older sibling provides no support to the younger child, because the new law only requires that the child not provide more than half of his or her support. With the right set of circumstances, this could benefit families with an older child living at home and earning too much money to be claimed as the parents' dependent. (Congress may amend the law in the future to eliminate this.)

Loser -
A taxpayer who lives with, and supports, a child who is not his or her own, generally does not get tax benefits for a qualifying child if he or she lives with but is not married to the child's parent.

As noted above, each of the child-related tax breaks has its own set of rules in addition to the four qualification tests that must be met. If you are supporting a child, your tax adviser can provide more information in your situation.


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