Dear Bob and Brad:

In your recent Educators' Tax Guide you mention cash gifts to individuals in the amount of $10,000. I have a few questions: (1) Where do you report this gift on your tax return? (2) Is it just one individual per year? (3) Can I use this deduction for supporting my son who attends college and lives away from home? Can I treat checks I have sent to pay for food, rent and educational expenses as a gift to him? I cannot claim Hope Scholarship or Lifetime Learning tuition tax credits because as a single parent earning more than $55,000, I am no longer eligible for these.

- B. A. (Via e-mail)

Brad: Quite a few taxpayers have discovered that the new tuition tax credit programs don't provide as much relief for college expenses as all the hype surrounding them suggested. And you're not alone in trying to figure out a tax loophole that might enable you to capture a greater tax benefit for the dollars spent on your son's higher education. Unfortunately, the gift loophole doesn't work. Here's why.

Bob: First, we have to make a distinction between a gift and a charitable contribution. Nothing against your son, but cash gifts to individuals are neither tax deductible by the donor, nor taxable income for the recipient. That's why there is no place on Form 1040 to enter these gifts. One can make as many of these gifts to individuals as one wants, provided the total given to any one individual does not exceed $10,000 in any given tax year. By the way, note that married couples count as two separate individuals when it comes to making gifts. So a married couple could give $20,000 to each child per tax year.

Brad: To be tax-deductible, the gift must be made to a charitable organization and not for the specific use of any one individual. There is a way to reap some benefits through the tuition tax credit programs, but oddly enough, one does not give the money to a child. Rather, one must pay the child.

Bob: That's right. If a person can figure out how to make the transfer of money from the parent to the child a taxable event, then the parent may be able to deduct it. Let's create a hypothetical situation in which you hire your son to work for you, say as a grader, a researcher or in some other fashion that relates to your job or home-based business. Let's then assume you pay him $10,000 for this work. Because his labor is related to your income, the money you pay him becomes a deduction for you. Now you no longer will pay income taxes on the $10,000 at your higher rate (in the 28 percent bracket, that would be $2,800); but your child will pay at his lower rate (in the 15 percent bracket, that would be $1,500). Assuming you pay your son as an "independent contractor" (which allows you to avoid all those nasty payroll taxes!), your child will pay an additional 7.65 percent in self-employment taxes (which, in this hypothetical case, comes to $765). So, at this juncture, you have saved $535 ($2,800 in taxes you saved minus the $2,265 in taxes paid by your son).

Brad: Now that your son has income to report (you have to send him and the IRS a simple Form 1099 to report the payment), he can be the one to file for the tuition tax credits. If his tuition and fees come to $2,000 per year, then as a freshman and sophomore, he can claim Hope Scholarship tax credits of $1,500 for those years. That's a tax savings, all combined of $2,035 ($1,500 in tax credits plus the $535 saved on income taxes). As a junior, senior and beyond, he can claim Lifetime Learning tax credits of 20 percent of up to $5,000 per year (if his tuition is $2,000 as in the previous example, then he claims a tax credit of $400). For these years, the tax savings is $935 ($535 saved in taxes plus a $400 tax credit).

Bob: In this example, we assumed that you would still claim your son as a dependent and that when he filed his tax return, he would not claim the personal exemption (one cannot be a dependent on someone else's 1040 and also claim a personal exemption on one's own 1040). You would have to make sure your son still qualified to be your dependent.