An important part of figuring income taxes is claiming dependency exemptions and credits. You can claim a dependency exemption for a "qualifying child" or a "qualifying relative." The IRS has new definitions for both of these exemptions. The rules on claiming dependents are complicated. Fortunately, free help is available for low-income taxpayers at Volunteer Income Tax Assistance (VITA) sites or Tax Counseling for the Elderly (TCE) sites in Iowa.

The definitions of qualifying child and qualifying relative impact who can claim children or other relatives as dependents - and who cannot. Each dependency exemption lowers a taxpayers taxable income by $3,300. Some very low-income taxpayers may not benefit from the dependency exemption itself. Where the taxpayer may benefit is from the refundable credit such as the Earned Income Credit. In most cases, you must be able to claim the dependency exemption in order to claim many of the child-oriented credits. There are exceptions for divorced parents, never married parents or separated parents. Non-custodial parents may be able to claim the dependency exemptions and child tax credit, while the custodial parent may be able to claim the child dependent credit and earned income credit and Head of Household filing status.

To make it easier to see what the changes are, here are three examples. These examples involve three kinds of tax credits:

• The Earned Income Credit.
• The Child Tax Credit. The child tax credit is for children under age 17 who live with a taxpayer for more than half of the tax year. For the 2005 tax year, a qualified person who earned more than $11,000 can claim a Child Tax Credit up to $1,000 per child. If the credit exceeds the amount of tax owed, a part of the credit may be refundable and is called the additional child tax credit ; and
• The Dependent Care Tax Credit. This tax credit helps families who qualify use their child care costs to reduce their taxable income. Depending on their income, this credit can be between 20 percent and 35 percent of the first $3,000 in child care costs for one child. For two or more children, it can apply to 20-35 percent of the first $6,000 in child care costs. For instance, a worker who earns $25,000 and spends $3,000 on her one child can get a $900 credit or 30% of the $3,000 she spent in child care.

Example 1: Unmarried Couple, Harry and Sally

Harry and Sally live together with Sally's daughter, Amy. Harry supports Sally and Amy and pays all the household expenses. Sally stays home with Amy and has no income. In tax year 2004, Harry claimed Head of Household status because he cared for Amy as his own. Amy was considered a "foster child" for tax purposes. Harry also claimed Sally as a dependent. In 2005, Amy continued to live with Harry and her mother but under the new rules Amy can be a "qualifying child" only for her mother. Amy cannot be Harry's qualifying relative and therefore cannot be Harry's dependent. To be considered an eligible foster child, the child must have been placed by an agency or court.

• Harry will have to file Single.
• Harry can claim Sally as a dependent. 
• Sally had no income so she will not file a return.

Because Sally does not have a filing obligation, Amy is not considered a qualifying child of Sally. Harry can claim Amy as a qualifying relative. If Sally had a filing obligation, Amy would be her qualifying child and therefore could not be Harry's qualifying relative.

Example 2: Father, Son and three grandchildren  

George, lives with his son, Alan, and his grandchildren, Jack, Jill and Jason. George earns $20,000 and Alan earns $12,000. George and Alan both help pay for household expenses. George contributes more than half the cost of maintaining the home. For the 2004 tax year, Alan could claim two children when he figured his Earned Income Tax Credit and gave all the dependency exemptions for his children plus one earned income credit to his father, George.

• He cannot do the same thing for the 2005 tax year.
• This year, if Alan takes the Earned Income Credit for any of his children, he will also have to take the dependency exemption for that child. The child tax credit also goes to the person claiming the exemption for the child in question.

TIP: It is best if George and Alan agree how to file. George will likely qualify as head of household so long as he uses one of the children as a dependent. Alan could file single and claim dependents and one or two children for the Earned Income Credit. This family shares expenses, so they should try to file taxes to make the most of the dependency exemptions and the Earned Income Credit. If the family disagrees and both use the same dependents for the Earned Income Credit, the IRS will give the Earned Income Credit and the Dependency Exemptions to Alan.

See how George and Alan maximized their Earned Income Credit, Dependency Exemptions and other credits:

If George claims Head of Household, 2 dependents and Alan claims single and one dependent, George will receive a refund of $6,559 and Alan will receive a refund of $4,102. Their refunds combined would be $10,038.

If George claims Head of Household, 1 dependent and Alan claims single and two dependents, George will receive a refund of $4,126 and Alan will receive a refund of $5750. Their refunds combined would be $9,876.

Example 3: A Divorced Couple, Harold and Nancy

Harold and Nancy got divorced in 2004. Neither Harold nor Nancy has remarried. They have three children. The children lived with Nancy for all of 2005. Harold had visitation. The divorce decree tells Harold he gets to take the children as dependency exemptions.

Each individual taxpayer's situation is different. These are meant only as examples of how taxpayers may often be better off if they discuss how to get the most out of available tax benefits. If the taxpayers don't discuss or can't agree, the IRS will assign the benefit and it may not be nearly as beneficial.

This information is not intended or written to be used and cannot be used to avoid penalties under the Internal Revenue Code.