At a recent CSEA breakfast meeting, one of the Enrolled Agents asked a question about dependents. He outlined a situation where, in the spring and fall semester, the 'child' was a college student, under age 24. The boy had worked during the summer and collected unemployment in the fall.
The question was, since $2,400 of the unemployment is excluded from income, should we be taking that income into account when we compute the dependency exemption.
Even though we have the precedence of excluding the non-taxble Social Security income, this still felt like more of a policy question than a tax code question. It seemed wise to ask IRS directly. So I took the question to IRS spokesman Eric Smith. It took a while to get clarification. Smith replied that we should not take this tax-free income into account when computing the dependent's income.
As long as we were talking about untaxed income, I asked if we should be taking into account the income from tax-free municipal bonds and related investments when applying the gross income test?
IRS spokesman Bruce Friedland replied. "The answer is no, even though receiving tax-exempt interest affects the taxability of social security benefits and other things, and even though it is reported on Form 1040 as an information item."
Hopefully, this will help when you do your year-end planning with your clients who have college-age children.
Remember, you don't want to have those students preparing their own tax returns. They may have to be claimed as dependents on your client's return. If they file on their own and claim their own dependency exemption this will cause a rejection code when you e-file your client.