5 Requirements for the Child Tax Credit

In this episode of Toni Talks, enrolled agent (EA) Toni Covey is joined by special guests Sergey Garayants, Esq. and Gary McHenry, CPA, to discuss qualifications for the Child Tax Credit, other dependent credits, and who is entitled to take these credits.

Updated November 10, 2020

Understanding Tax Credits

Before we go into the specifics of the child tax credit, it’s a good idea to step back and discuss tax credits in general. Tax credits differ significantly from tax deductions. While a tax deduction works to lower your taxable income, thereby lowering your tax liability, a tax credit provides a dollar-for-dollar reduction of any taxes owed. The distinction between reducing your taxable income (with a tax deduction) and reducing any taxes owed (with a tax credit) is an important one. Ultimately, tax credits have a direct impact on your tax liability for a given year.

Refundable vs. Nonrefundable Tax Credits

Tax credits are further broken down into refundable or nonrefundable credits. As the name implies, the big difference here is whether the tax credit could actually entitle you to a tax refund, depending on your overall tax liability.

For instance, if I have a $2,000 refundable tax credit and my tax liability for the year is $1,000, then that extra $1,000 would be refunded to me. If the $2,000 tax credit is nonrefundable and my tax liability for the year is $1,000, then I wouldn’t owe any taxes, but would not be entitled to a refund.

The Child Tax Credit: Partially Refundable

The child tax credit itself is $2,000 per year per child under the age of 17. There are caps to this, however: $200,000 for single filers, and $400,000 for married joint filers. And while you’ll receive a dollar-for-dollar deduction for the full $2,000, only $1,400 is currently refundable. This amount may be adjusted for inflation before 2025 to allow the entire $2,000 credit to be refundable; however, this has not yet happened and, as it stands, only $1,400 of the $2,000 is refundable right now.

Requirements for the Child Tax Credit

For the child tax credit, there are certain parameters worth noting. First, it’s only applicable to US residents and children under the age of 17 — not just any dependents. If you have dependents who are age 17 or older, you can still receive a tax credit, but it’s less: $500 per dependent. The credit will appear on the tax return where that child is claimed as a dependent. This can get a bit more complex when we’re working with parents who are separated or divorced, and we’ll discuss that in a bit.

As a reminder: a dependent is defined as someone for whom you provide more than 50% of their support.

Dependent Care Credit

Another child-related tax credit is the dependent care credit, which is exactly what it sounds like. This provides a tax credit for incurring expenses on child care for dependents aged 13 and under. This credit is exclusive to working taxpayers. If you are married filing jointly, then both spouses need to be working in order to take this credit. If you qualify, this credit entitles you to up to $3,000 of the expenses you paid for single filers, or $6,000 for married joint filers.

One additional item of note related to the dependent care credit is that, while the child tax credit is linked to dependents listed on a tax return, the dependent care credit involves an entirely separate form, Form 2441.

The Child Tax Credit & Divorce

This is all well and good, but what about in the instance of divorce? Who is entitled to take the child tax credit, and how does that work?

Most married couples — but not all — file joint tax returns. With a divorce, that arrangement essentially stops with a divorce decree. This could even happen during a separation, before there’s a divorce decree. If a couple is no longer eligible to file a joint tax return, then an election needs to be made on who will carry the benefit of the child tax credit on their tax return.

The most common situation for the vast majority of divorced couples is that the parent with primary custody over the child claims the child as a dependent and, thus, claims the child tax credit for that child. There are some instances wherein a noncustodial parent can still carry the child tax credit benefits so long as it does not conflict with an ex-spouse, but there are special tests for this that we would be happy to elaborate upon during an individual consultation.

It’s important to note that, in the case of divorce, both parents cannot claim the child tax credit for the same child on their separate returns. However, it’s not uncommon to see divorced parents allocate children to each ex-spouse in the event of multiple children so that both parents can receive the credit.

Even if you are not the primary custody holder in the case of divorce, there are still tax deductions that may be available to you. Again, keep in mind the distinction between tax deductions and tax credits mentioned earlier.

Tests for the Child Tax Credit

There are a couple of other small technical rules that one should be mindful of related to the child tax credit. We’ve already covered the big rules — the child’s age, dependency, and residence — but there are two others of which to be aware: the relationship and citizenship tests.

First, to claim a child as your dependent, the child must either be a US citizen, a US national — which is essentially similar status to a US citizen except that it applies to certain territories that the US has jurisdiction over — or a resident of the US, more commonly referred to as a green-card holder.

Second, the relationship test dictates that anyone who claims the child tax credit for a child must actually be the parent or legal custodian of that child, whether by blood or adoption.

Both of these tests are specific to children age 16 and under. If we’re discussing children aged 17 and up, then it’s another type of dependent. Again, dependents are defined as someone for whom you provide more than 50% of their support. So, in addition to children aged 17 or older, other dependents could include parents or others for whom you provide more than 50% of their support. There are special rules for dependents who do not fit the IRS definition of a child, and those need to be addressed separately.

Other Tax Techniques for Dependents Age 17 and Up

What happens if I’m phased out of the child tax credit but am still taking care of a dependent aged 17 or older? Are tax benefits still available?

There are a couple of different techniques our clients have seen success with in this regard. A few of my clients own small family businesses and actually employ their children, which allows for a few benefits. However, there are also pitfalls related to this strategy, so it’s important to work with a professional and experienced advisor before hiring your child. For instance, child labor laws and regulations related to contracts and minors under the age of 18 come into play.

The Takeaway

Overall, if you’re interested in utilizing any of these strategies, it’s critical that you consult with an experienced professional before moving forward. No one wants to run afoul of labor laws or the IRS, so professional guidance is key here.

As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, another great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets. One of my favorites as well is our Infinity Investing Workshop.

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