[IRS Notice 2006-86 (Sept. 20, 2006)]
For a copy: http://www.irs.gov/pub/irs-drop/n-06-86.pdf
The IRS has provided guidance on the "tiebreaking" rule under Code Section 152(c)(4) and on the "special rule for divorced parents" under Code Section 152(e) (the latter also applies to parents who are separated or living apart). By way of background, the tiebreaking rule determines which of two or more taxpayers may claim a qualifying child under the following: DCAP exclusion; dependent care tax credit (DCTC); child tax credit (CTC); earned income credit (EIC); head of household filing status; and the dependency deduction. Under the tiebreaking rule, a child is treated as the qualifying child of (1) the taxpayer who is the child's parent; or (2) if none of the taxpayers is the child's parent, the taxpayer with the highest adjusted gross income.
If, however, both taxpayers are the child's parents and they don't file a joint return together, the child is treated as the qualifying child of the parent with whom the child resides for a longer period of time during the year. If the child resides with both parents for the same amount of time, the child is treated as the qualifying child of the parent with the higher adjusted gross income. Furthermore, if the taxpayers are divorced, separated, or living apart and meet certain conditions (e.g., relating to custody, support, and a release of exemption claims), the special rule for divorced parents allows the noncustodial parent to claim the child for certain purposes. Not surprisingly, the application of the tiebreaking and special rules to the various tax provisions can be complicated.
The new guidance explains the practical consequences of applying the rules. When the special rule for divorced parents doesn't apply, and more than one taxpayer claims a child as a qualifying child (thus triggering the tiebreaking rule), "the child is treated as the qualifying child of only one taxpayer for all the provisions that employ the uniform definition of a qualifying child" (i.e., the DCAP exclusion, DCTC, CTC, EIC, head of household filing status, and dependency deduction). In contrast, if the special rule for divorced parents does apply and its requirements are met, the noncustodial parent may claim the child for purposes of the CTC and dependency deduction. But the noncustodial parent may not claim the child as a qualifying child for purposes of the DCAP exclusion, the DCTC, EIC, or head of household filing status; for these purposes the custodial parent is the only parent that can claim the child. The guidance includes five detailed examples based on hypothetical situations that illustrate how these rules apply.
EBIA Comment: This guidance provides welcome clarification on these complex tax rules. Important for DCAP administrators is the reminder that only the custodial parent may take the DCAP exclusion.
Administrators that have reason to believe that a participant does not qualify will need to inquire further. Note that the DCAP rule is completely different from the rule under Code Section 105(b) that applies to divorced (or separated) parents participating in health FSAs, under which a child may be treated as a dependent of both parents if, together, the parents provide more than half the child's support and have custody for over half the year. Stay tuned--the "interim"
guidance, which applies to taxable years beginning after December 31, 2004, is effective only until the IRS and Treasury issue "consistent"
regulations. For more information, see EBIA's Cafeteria Plans manual at Sections XI.E.4 ("Special Rule: Tiebreaker Where Two or More Taxpayers (Including Parents) Claim an Individual as a Qualifying Child"), XI.E.5 ("Two Special Rules for Divorced or Separated Parents"), and XXIV.H.1.b ("Special Rule for Child of a Divorced or Separated Custodial Parent").