Tax consequences follow every decision made in a divorce, settlement agreement, or marital dispute resolution, often for many years. Whether there is a divorce, annulment, separate maintenance agreement, or dissolution, taxes need to be considered in making informed choices. Even when the choices are limited, knowledge of the tax problems created by the divorce may help achieve a better settlement.
Introduction:Residential parental status generally affects who can claim the children’s dependency exemptions, favorable filing status, and many other tax benefits related to children.
The following information has been prepared solely for general information purposes and is not intended to be used in the place of competent professional advice to any particular individual. The subject matter presents general guidance and may omit positions favorable or unfavorable to the taxpayer or government. The topics presented are not exhaustive of all possible tax aspects of a marital dispute, but cover the most common problems encountered in the process of resolution.
Whether to File a Joint Return, Separate Returns, or No Return?: It is one of the first questions that needs to be addressed, often in an atmosphere of mistrust, hurt and hostility. Nonetheless, a decision must be made. Avoiding the issue will only make the government richer at the expense of the couple.
Doctrine of Tacit Consent: Under the judicial doctrine of Tacit Consent the presence or absence of the spouse’s signature is not determinative of whether a valid joint return was filed.
Innocent Spouse Relief: Congress has recently revised protection for innocent spouses when filing a joint return. These new rules apply to both married and separated or divorced spouses who file a joint return.
Requirements for Head of Household Filing Status: For an individual to be considered head of a household for tax filing purposes, that individual must meet a marital filing status test and a household maintenance test.
Dependents: Dependency is defined in the Internal Revenue Code as having two components: 1) those individuals that are defined as dependents, and 2) the right to claim the dependency exemption for those individuals.
Special Rules for Divorced or Separated Individuals: There are two code sections that specifically address the problems of filing status and dependency for persons who are separated or divorced by providing special rules in these situations that will override the general code provisions.
Support Requirements for Dependents: When an individual does not qualify under the special rules for divorce or separated individuals, the general support tests apply. Generally, one must provide more than half the support of an individual to meet one of the tests for dependency. However the Courts and the I. R. S. maintain certain special rules in the case of lodging expenses for married and divorce or separated spouses.
Tax Attributes of Children: Several important tax credits as well as the taxation of minor children depend upon the status of the spouse as residential (custodial) parent and whether the dependency exemption is claimed. In some circumstances, these benefits are denied if one spouse’s income exceeds certain limits. In those cases, it is often futile to argue over who can claim the exemption. Some other form of compensation can be made to the spouse unable to claim the benefits.
Tax Considerations for Adopted and Foster Children: A child is defined, for purposes of claiming the dependency exemption, as a son, daughter, step-son, or step-daughter. However, certain requirements and qualifications are imposed on adopted and foster children for purposes of claiming the tax attributes of these children.
Property Transfers Incident to a Divorce: Section 1041 specifies that in general, transfers of property between spouses or former spouses made incident to a divorce, can be made without income tax consequence, unless property is transferred to a trust and liability transferred exceeds the basis of the property transferred. Property may be transferred to a third party by one spouse, on behalf of the other spouse, but recognition of gain is possible where the transfer is made to satisfy the obligation or liability of one spouse. Gain may be triggered if the property transferred is not used in the same purpose or manner as held before the transfer. Thus, an automobile used in an unincorporated business transferred to a nonowner spouse will cause depreciation recapture unless it is also used by the recipient spouse in a business.
Transfers and Redemptions of Stock "On Behalf of" a Spouse: Under Section 1041 property may be transferred directly to a third party as if it were first transferred to the spouse who then transferred it to the third party on behalf of the spouse who would have transferred it, also though it is not always easy to determine which spouse the transfer is on behalf of. The distinction is critical because the spouse on whose behalf the property is transferred will bear any tax realized upon the transfer. This most often arises when a privately-held business is involved in the property division.
Sales and Exchanges of Personal Residences: Generally a spouse who retains an interest in, but does not use the family residence after separation or divorce, will not lose the benefits of the exclusion of gain on the eventual sale of the personal residence.
Transfers of Individual Retirement Accounts: If cash is withdrawn from an IRA, it will be taxable to the owner of the IRA and subject to the penalty provisions of section 72(t).
Interest Considerations: The rules for deductibility of interest apply to notes given in property settlements. However, the rules for below market loan rules, original issue discounts and imputed interest will not apply.
Alimony: Gross income includes amounts received as alimony or separate maintenance payments. Amounts paid that qualify as alimony, will be deductible from gross income without itemizing by the payer. Any amounts paid that qualify as alimony will be treated as alimony unless it consists of an unallocated amount which includes child support, or is designated as a property transfer. Alimony does not have to be paid over a fixed period of time or a constant amount each period. However, front loading of payments as alimony can cause such excess to be treated as a property transfer by recapturing the excess amounts in the third year.
Life Insurance: Life insurance premiums can be treated as alimony in some circumstances. Ordinarily, life insurance proceed received by the ex-spouse are tax-free, even if used to provide a substitute for alimony upon the death of the payee spouse, unless alimony amounts are in arrears.
Expenses of a Residence as Alimony: Generally, one cannot deduct one’s utilities and maintenance expenses for a residence that is jointly owned. The deductibility of the mortgage interest and real estate taxes depend upon both the terms of the separation agreement and the form of ownership under local law.
Marital Obligations and Debts as Alimony: Payment of debts of one spouse by the other are payments made on behalf of the payee spouse to a third party if paid pursuant to the terms of a divorce or separation agreement (Temp. Reg. Sec. 1.71-1T Q&A 6). These would qualify under Section 71(b)(1)(A) as alimony (assuming all the requirements are met). It can be a very difficult to structure the payments to qualify.
Qualified Domestic Relations Orders: The Retirement Equity Act of 1984 (REA) amended ERISA to permit accrued pension benefits to be taken into account in divorce settlements. REA specifically pre-empts state domestic relations laws insofar as they pertain to qualified plan
s. Federal law is a permissive statute. It permits a broader assignment of the interests than state law. Thus, although state law may restrict the alternate payee spouse’s interests to benefits accrued during marriage, federal law will accept a broader assignment if the Qualified Domestic Relations Order (QDRO) is poorly drafted or if the parties intend to convey a larger interest to the alternate payee spouse than is otherwise required under state law. REA amended the Internal Revenue Code by adding section 414(p).
Tax-Adjusted Balance Sheet for Property Settlements: The tax-adjusted balance sheet represents the after-tax value of marital assets and liabilities as if the assets and liabilities of the marriage were liquidated and the remaining cash were distributed to each spouse. The tax-adjusted balance recognizes the embedded tax liability or savings in assets whose value at the date of divorce differs from its tax basis (usually its cost). The economic value of the assets is the fair market value of the asset, reduced by the associated deferred tax liability or increased by the deferred tax benefit (savings).
Taxes and Business Valuations: In many marriages, a privately-held business is the major marital asset. It is usually impracticable for the couple to jointly run a business when they could not solve the problems of marriage. Courts are reluctant to order the business sold. It may be possible to divide the business, but usually not. If one party receives property that has appreciated while another receives property that has not, the values are not equal. The potential tax to be incurred upon the eventual sale of the appreciated asset cannot be avoided. In order to equalize the values the embedded tax liability should be considered to reduce value of the appreciated marital asset (the family business) for purposes of equitable division.