Filing Status
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A taxpayer's filing status is often critical in determining whether they can be a dependent of another taxpayer and whether someone else can claim a deduction for their medical costs.
When people are financially unable to provide for their own care in the event of disability or long term disease, there are two choices. One is some form of government aid, such as Medicaid. The other is financial assistance from children, parents, siblings or other relatives.
The cost of a nursing home, full time nurse or other long term care is hard enough. But the tax law makes it even more difficult by preventing family care providers from being able to secure any tax benefit for relieving the government of the cost. One of the major obstacles is the technical requirement that a taxpayer can only claim a medical expense deduction for a dependent. But the rules for being able to claim a dependent deduction (technically an exemption) are outdated and represent an obstacle course.
The dependent exemption is only $3,000 (for 2002) but where there are substantial medical costs, the person paying the medical costs can't deduct them unless the person who needs the medical care is a dependent.
This article is an attempt to explain the requirements for a dependent exemption as clearly as possible, with a minimum of tax jargon.
First, there are two kinds of personal exemptions. One is for each taxpayer. For additional details about the personal exemption available to each taxpayer see the article on Personal Exemptions.
The other exemption is for "dependents" of a taxpayer. There are five requirements that must be met in order to claim an exemption deduction for a dependent. The dependent must ....
1. be a member of the household or a relative
2. be a citizen of the U.S. or a permanent resident
3. not file a joint return
4. must have less than $3,000 (for 2002) of "gross" income
5. must provide less than half of his or her support.
All five of these tests must be met in order to claim someone (other than a spouse) as a dependent.
Member of Household or Relative
If you provide support for someone who is not a relative, then they must be a member of your household. This rule usually applies in connection with claiming a dependent exemption for an unrelated child rather than for a parent or other relative.
You may claim a dependent exemption for someone whom you support even if they are not a member of your household -- meaning they don't live in your home. But, they must be a relative such as a parent, grandparent, child, grandchild, brother or sister, aunt or uncle or a relative of your spouse.
Citizen of the U.S. or Permanent Resident
For most people this requirement is not an issue. But there may be permanent residents of the U.S. who are supporting alien relatives who live in another country. Such relatives could not be claimed as dependents.
May Not File a Joint Return
If the person you are supporting is married and files a joint return, you may not claim him or her as a dependent. If the dependent files a separate return, then this requirement would not be an obstacle.
Must have Less than $3,000 of "Gross" Income
This is often the most difficult test in order to claim someone else as a dependent. (The test is not applicable for a child under the age of 19 or child under the age of 24 who is a student.) For this purpose, "gross" income does NOT include tax exempt income such as non-taxable social security benefits or tax exempt interest. However, "gross" income is not reduced by any deductions, including deductions for rental income or business income. The $3,000 limit is adjusted each year to equal the amount of the exemption for a dependent, which is increased by an inflation adjustment factor.
Must provide Less Than Half of His/Her Support
To be claimed as a dependent by someone else, the taxpayer must provide more than half of the dependent's support. Support provided by the dependent may be from any source, including taxable income, any exempt income, borrowed money, social security benefits, welfare benefits and any non-taxable pension benefits. The focus is not on the source or nature of the income used to provide the support, but on what is spent on behalf of the dependent.
Other Alternatives if An Exemption Can't Be Claimed
There are a variety of ways that children or other family members can achieve substantially the same result even when they are not able to pass all of the preceding tests that are required to claim an elderly relative as a dependent. Instead of getting a tax deduction for helping an elderly relative, you can use some of these methods to divert income to the person you are helping. You will remove the income from your tax return -- which is actually better than getting a deduction. Your elderly relative will probably be a very low tax bracket or might owe no tax at all on small amounts of income.
A simple method that can be used to avoid taxes on capital gains is to make gifts of appreciated assets to the elderly person. When that person sells the appreciated asset, they would be subject to the capital gains tax. In most cases, the gain would be taxable at a zero tax rate or a 10% rate. If the amount of the gift were more than the amount needed for immediate care, the funds could be invested to produce an income that could also be used to help with medical costs.
The 2003 tax law provides for the same reduced tax rates
on dividend income as on capital gains. Thus, if you own a
stock that is paying a generous dividend, you can give the
stock to the elderly relative and they will receive the
dividends at a 10% or 15% reduced tax rate.
Another method is to contribute income producing assets to a family limited partnership or limited liability
company (LLC) and to make gifts of the partnership or LLC to the
elderly relative. Income generated by the assets is then taxable to the
elderly person who is then able to claim a medical expense deduction
for long term care expenses such as a nursing home. However, the
partnership or LLC interest would be included in the estate of the
family members and would be passed on in accordance with their will or
other probate arrangement.
Another alternative is to contribute assets to an irrevocable trust for the benefit of family
members, including those who are elderly and in need of additional
funds. An independent trustee would be given the duty and authority to
decide which family members needed the income from the trust each year.
The income of a trust that is distributed to a beneficiary is taxable
to the beneficiary rather than to the trust. Upon the death of the
elderly family member, the trustee could make distributions to other
beneficiaries or could distribute the corpus to the other
beneficiaries. However, care must be exercised to avoid limiting the
discretion of the trustee and the person creating the trust must not be
a beneficiary of the trust.
If the elderly person is capable of making financial decisions, another
alternative would be to make them a loan
that would be repaid from their estate -- if there was anything left.
Copyright, 2003, Vernon K. Jacobs
Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/ Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/
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