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DIVORCE TAX PLANNING

THE TAX CONSEQUENCES OF DIVORCE

While in graduate school, I was assigned a simple sounding tax research project - find all IRS regulations and Internal Revenue Code sections that address or have application to divorce in the state of Texas. Upon reflection, I think my professor was playing a cruel joke on me. I graduated before the research was complete but at last count there were over 143 sections with significant tax implications for divorcing couples.

Why You Need Divorce Tax Planning?  Several years ago, a client mailed in his tax organizer but had apparently neglected to include his wife's information. I remember the phone call went something like "Oh, I thought you knew we were divorced.... she's claming the kids.... we split the partnership 50/50............I might owe something this year"

Undaunted by the sad news, I asked for a copy of the divorce decree and prepared his return accordingly. THEN the phone call came. (I really hate it when my work makes clients cry) YES, he did "owe something" and unfortunately it was an amount he couldn't afford to pay. Later, as he was trying in vain to amend the terms of his divorce, we calculated that his gross six figure plus income netted monthly cash flow (after taxes) of NEGATIVE $450 a month! (Did I mention I don't like to see clients cry?)

The following is a general overview of the more common divorce tax planning issues. If your marital assets include a business, home, pension benefits or investments in flow thru entities such as S corporations, partnerships and LLCs, etc., please call your tax advisor BEFORE the divorce is final to consider the tax implications and possible planning options.

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Filing Status

A divorcing couple’s filing status for tax purposes is determined as of the last day of a tax year. Unless a FINAL decree of divorce has been entered by December 31, the spouses must file as married joint or married filing separately. You are treated as still married even if you are separated from your spouse under a separation agreement or ‘nonfinal’ decree. Married filing jointly may result in lower overall tax for you and your ex-spouse, but remember that the IRS can hold either spouse 100% financially responsible for the tax liabilities reported on the joint return. A non tax consideration is that a married filing jointly return requires contact between the parties to prepare the joint return, which may not be desirable in some circumstances.

If the couple is legally divorced and living apart before December 31, each souse completes a separate income tax return with the filing status of single or head of household. Note: that each spouse may qualify under the favorable head-of-household status if they cover more than half the costs of a household in which qualifying children live and meet other requirements. Give me a call if you would like to review the complete rules for qualifying for this tax filing status.

In special cases a married spouse may qualify as an “abandoned spouse” and file as head of household. Other special situations apply to 'innocent spouses' and may limit your tax liability on jointly filed tax returns in certain circumstances.

Dependency Exemptions

Generally, the dependency exemption for children goes to the spouse who has physical custody of the child. However, the custodial spouse can waive his or her right to the exemption and allow the non custodial spouse to claim the exemption. Agreeing on such tax matters in divorce is always a challenge but from a tax planning perspective, the spouse who can extract the greatest tax benefit from the exemption should receive the deduction. . It is often necessary to show the non claiming spouse that the extra exemption (less total tax paid) will assist them in making child support or other payments to the ex spouse. This is a win-win situation if the parties agree since the tax savings is passed along to the children in the form of child support rather than paid to Uncle Sam.

The waiver of the exemption is done on Form 8332 and may be done on an annual basis or for all future years. Where the waiving spouse will be receiving support payments, the waiving spouse often prefers the annual approach so he or she can refuse to grant the waiver if support payments are late, etc. The custodial parent may still claim the child care credit for qualifying expenses for children under 13 years of age. Other tax areas to consider before waiving the dependency exemption is certain higher education tax credits such as the Hope and Lifetime Learning that are only available to the claiming parent.

Sale of Personal Residence

If a married couple sells their home in connection with divorce or legal separation they should be able to avoid tax on up to $500,000 of gain assuming it was their principal residence for two of the previous five years. Assuming joint ownership of the home, if one spouse continues to live in the home and the other moves out, the gain on the future sale may still be avoided but may require special language may be required in the divorce decree or separation agreement to ensure the move out spouse a gain exclusion. Note: Both divorcing spouses may be eligible for this tax treatment, even if they file independent returns.

Transfers of Business Interests

Divorcing parties should be aware of the tax consequences that their transfers of business interests may generate. Certain types of business interests such as S corporations and partnerships have certain carryover tax attributes that may be lost in a divorce or separation. Partnerships in particular may raise amazing complex tax issues such as partnership debt allocations and built-in gains on contributed property. In cases such as this require careful tax planning in order to avoid unpleasant tax consequences and shift the tax benefits to the spouse who can best utilize them.

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Property Settlements & Qualified Domestic Relations Orders (QDRO)

Generally, when property is transferred between the spouses pursuant to a divorce in does not result in taxable gain or loss to the transferring spouse. The receiving spouse takes the same tax cost basis (carryover basis) in the property that the transferring spouse had. This basis is used to compute taxable gain or loss when the spouse eventually sells the property.

Qualified retirement plans and pension benefits are often part of a property settlement and are generally handled through a court assigned qualified domestic relations order or QDRO. A QDRO gives one spouse the right to share in the pension benefits of the other and ensures that the tax liability falls on the spouse receiving the benefits. Without a properly structured QDRO the spouse who earned the benefits will be taxed on them even though they are paid to the former spouse. Properly structured QDROs can be a welcomed divorce tax planning and liquidity tool.

A qualified domestic relations order isn’t needed to split up an IRA, but require specific IRS-approved methods for transferring the IRA from one spouse to the other. Never just 'cash out' an IRA as part of a property settlement without following the IRS rules. Failure to do so can cause the transaction to treated as a taxable distribution for the owner of the IRA and possibly trigger early withdrawal penalties. The proper tax-free method is a direct trustee-to-trustee transfer from one spouses IRA the other spouses IRA pursuant to divorce decree or separation agreement. This transfer should only be made AFTER the final divorce decree or separation agreement.

Child Support And Alimony

Qualified alimony payments are deductible by the payor and taxable to the payee.

In order to qualify as alimony, the payments must

•  be required under the divorce decree or separation agreement

•  be in cash only

•  be required to end at the death of the recipient spouse and

•  the parties must be living in separate households.

Child support payments are not deductible by the paying spouse nor taxable income to the recipient spouse. Child support includes payments specifically designated as child support as well as payments which otherwise might qualify as alimony but are linked to an event related to a child such as a child turning 18. Such disguised payments are recharacterized as non deductible/non taxable child support. Voluntary or extra payments do not qualify as alimony. However, qualifying alimony payments may be treated as non qualifying if the parties elect.

Proper tax planning for support payments will generally seek to make payments deductible if the paying spouse is in a higher tax bracket than the recipient. Divorce negotiations often center around the split between child support verses alimony. The benefiting spouse is generally asked to share the tax benefits with the ex-spouse through larger payments.

Non tax considerations. Since alimony payments must cease at the death of the receiving spouse a provision for life insurance is often included as part of the divorce agreement.

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