10 Tax Issues You Should Address in a Divorce
Divorces are usually messy. One spouse is usually angry and many times both spouses are very emotional. Not the best setting for talking about taxes, but here are ten issues that will affect income taxes for years to come and addressing them now can save thousands of dollars.
1) Determining who gets the tax benefits relating to the children. Generally, the person who gets to claim a child as a dependent gets an exemption and the ability to claim Head of Household status. With the exemption comes the right to the child credit, the earned income credit, the child care credit, and other benefits. If there is more than one child, there are usually tax savings in splitting exemptions relating to the children. This allows both parents to claim Head of Household status, saving taxes on both returns. When there is a large discrepancy in incomes, many times the second child will not benefit the parent with the higher income, because of phase-outs and Alternative Minimum Tax. If this sounds complicated, it is. Do not guess. Have a tax professional compute the different scenarios and get the tax implications.
In Missouri, it is presumed that the parent receiving the child support will also receive the right to claim the child for whom support is being received will receive the exemption for that child.
The parents can agree that one parent may “buy” the right to claim an exemption by paying the parent who is otherwise entitled to the exemption what that parent would save in taxes by claiming the exemption. The Judge can only order this if the parties agree.
2) Locking down the agreement on the children. Believe it or not, this is a different issue. Just because the dissolution judgment gives the dependency deduction to a parent, does not mean that the IRS will honor the judgment. In one case where both parents claimed the same child, the IRS sued both parents and lost both cases. Each trial was separate and each court gave the exemption to a different parent. Now, the IRS only considers 1) an unconditional grant of the exemption, 2) the actual custodial parent, and 3) Form 8332.
If the judgment gives the exemption to a parent regardless of the payment of child support, then the IRS will accept it. After that, the IRS looks for a Form 8332 in which one parent grants the exemption to the other parent. Absent that, the IRS awards the exemption and ancillary benefits to the custodial parent.
There is no way to guarantee the result you want. First, the custodial parent will normally not sign away an exemption, either in the divorce settlement or on the Form 8332, until after the child support is paid. Second, the custodial parent can revoke the Form 8332 by notifying the noncustodial parent in writing before the beginning of the year the exemption is to be taken. The only provision you can make is for some penalty in the divorce judgment if the custodial parent violates the judgment so that the cost of violating the judgment exceeds the tax benefit.
Form 8332 can be found at:
3) Form of Maintenance (Spousal Support, called Alimony by the IRS). Sometimes the spouse paying alimony wants to designate what some of the alimony is spent on, such as the mortgage payment on the home. This is possible for tax purposes, but it has to meet certain requirements to be deductible as alimony. Sometimes an ex-spouse is willing to pay more money or prepay money to an ex-spouse in need, but wants to call it alimony. This is much more difficult.
Alimony, for tax purposes:
a) Must be in cash to the spouse or third parties at the written request of the spouse,
b) Must be pursuant to a divorce or separation agreement,
c) Must stop at the death of either the payor or the payee,
d) Cannot be paid to a cohabitating ex-spouse, and
e) Cannot be tied to child support. (You cannot increase child support after the termination of alimony and call all of the money paid for spousal support the payment of alimony.)
So, in the case of specifying the payment of alimony by paying the mortgage payment, either the divorce judgment must require the payment or the ex-spouse must give the paying spouse a written request. In the case of trying to prepay alimony, a payment is not alimony until it is due under the divorce judgment. Prepayment will not work without a provision allowing the same in the judgment.
4) Alimony versus Child Support. Alimony and child support are treated differently for tax purposes. Alimony is deductible by the paying spouse and taxable to the receiving spouse. Child support is not deductible or taxable. So there are significant tax ramifications in setting the different amounts. For tax optimization, alimony is the way to transfer income from a taxpayer in a high tax bracket to a taxpayer in a lower tax bracket. This is, again, not as easy as it seems. First, you must get projected tax liabilities for both parties based on different levels of alimony. Second, you must remember item (e) above: you cannot arbitrarily increase child support after fixed term alimony ends, or the IRS can recast some of the alimony to child support.
5) Alimony versus Property Settlements. Many times, the higher income spouse retains an asset and must pay the lower income spouse over time. Owners of closely-held businesses commonly have this problem. The tendency is for the parties to cast these payments as alimony. The IRS has already seen this and has tools to prevent it. Any alimony payments that are frontloaded into the first two years are treated as a property settlement and not as deductible alimony. This calculation is set in stone and you will need to check with a qualified tax professional before finalizing any settlement with higher payments in the first two years.
6) Basis in Property Settlements. When fairly dividing up investment assets, you cannot simply look at the value of each asset. You must also consider the tax basis of the asset involved. In a divorce, the person receiving the asset retains the original basis and will pay taxes based on that basis. For example, say the marital estate includes $10,000 of AT&T stock and $10,000 of Walmart stock. The AT&T stock was bought recently for $9,500 and the Walmart stock was bought for $1,000 twenty years ago. The spouse receiving the AT&T stock will pay tax on a $500 gain on the sale, whereas the spouse receiving the Walmart stock would have a $9,000 gain to report on the sale. One spouse could have a $75 tax bill while the other could have a $1,350 or higher. In large marital estates, this can be a huge issue.
7) Retirement Accounts. Many times, the largest asset in the marital estate is the 401K plan and the account is split in the divorce. The way to do this is through a QDRO (Qualified Domestic Relations Order) in the divorce judgment. That way, the transfer is not taxable. After the transfer, the spouse receiving a distribution is taxed on the distribution. Plus, the spouse receiving the transfer is exempt from the 10% early withdrawal penalty.
The way not to do it is for the spouse with the account to cash in the transfer amount and give the recipient spouse the money. This distribution is taxed to the spouse with the account, including the 10% penalty, if applicable. In this scenario, the recipient spouse has the income tax paid for by the paying spouse. And the IRS can get a 10% bonus that should not have been necessary.
8) Joint Returns before the Divorce is Final. One of the few tax rights you have is to file separately from your spouse. No one can make you sign a joint return. This leads to two considerations.
First, invariably, one spouse would incur much lower taxes than the other spouse if separate returns were filed. The total tax will almost always be higher, but one spouse would be paying much more. This usually gives the lower income spouse some leverage. The judge may frown on this and balance the tax bill in splitting the marital estate. But the time between filing the tax return and filing the divorce decree can be substantial.
Second, and more important, one spouse may have a good reason not to file jointly. If one spouse is self-employed and does not remit estimated tax payments and the other spouse has taxes withheld on an employee pay check, both taxpayers are liable for the tax due on a jointly filed return. And one spouse has pay check that can be garnished. The spouse with the pay check has a valid concern about filing a joint return. And the IRS will not abide by the divorce judgment and only try to collect from the self-employed spouse. The IRS will go after the low-hanging fruit.
Another valid concern would be potential liabilities under audit, covered in the next issue.
9) Innocent Spouses. Both spouses who file a joint tax return are joint and severally liable for the income tax due, including tax arising from a tax audit. Even if the tax is generated due to improprieties related to only one of the spouses. There are some defenses for innocent spouses, but the process is neither easy nor cheap. The cheapest, easiest defense is usually to file separately. If there is a potential tax that could be assessed against the joint return filed in prior years, the divorce settlement should considered an indemnification process for the innocent spouse. The IRS will not honor the decree, but recovery from the offending spouse by other means should be addressed.
10) Allocation of itemized deductions. Both before and after the divorce, there can be issues on which party is entitled to itemized deductions. This is not as simple as you might think. State law comes into play, as well as where the money comes from. In general, itemized deductions paid from a joint account are split evenly. The only way to not split the deductions is for the party wanting the deduction to show the source of separate funds and the payment through a separate account. This decision must be made at the time of the payment, not when you are getting ready to prepare your tax return.
Divorces are seldom easy. The associated tax planning can make the process more difficult, but the tax savings from proper planning can be substantial.
The information in this article was provided by Mark Wilson, Certified Public Accountant of Martz & Wilson, LLP. He may be reached at (314) 646-1040. The information in this article is general in nature and intended for background information only. Anyone in a divorce should consult an independent professional (like Mark) before making any decisions relating to taxes.