ARTICLES

Divorce and Taxes

Taxes impact nearly every aspect of American life – and divorce is no exception.¹ To maximize your financial settlement, your attorney must be familiar with not just family law -- but tax law as well. Failure to take into account the tax consequences of a settlement may render what seemed to be a favorable resolution into a financial disaster. Your settlement agreement or judgment must be carefully worded to ensure that the tax consequences happen as intended.

Our lawyers are often hired to undo the damage of settlement agreements that looked fine at the time of the divorce, but by the time April 15th rolled around, all of the benefit – and then some – was lost to the I.R.S. A good working knowledge of current tax law also helps to open up otherwise unavailable and creative avenues to settlement. Shifting assets and income streams between divorcing spouses shifts the tax burden – and the tax code can be used to your advantage. Divorcing husbands and wives can prosper, while the I.R.S. suffers. Call our offices today and get your settlement done right the first time – we can help you take advantage of the many, many tax advantages available to divorcing couples, and help you avoid the pitfalls.

MINIMIZING TAXES WHILE YOUR CASE IS STILL PENDING: Spouses are married until the divorce is final – when the judge bangs the gavel and says “you’re divorced.” Most cases (at least most cases where the tax ramifications should be considered) take several months or even more than a year to work their way through the divorce courts. That means that husbands and wives should work together while their case is going through court to keep taxes to a minimum.

If your case is truly acrimonious – to the point where your spouse would rather throw good money at the I.R.S. than let you enjoy a part of the tax relief it might represent – you must work with a capable and experienced attorney. The divorce judge can step in and help preserve the marital estate from being wiped out by your spouse’s poor tax strategies.

Generally speaking, fewer tax dollars will be handed over to Uncle Sam when a married couple files a joint return as opposed to filing two, “married but separate” returns. This isn’t always the case, however, and determining whether to file taxes jointly or separate depends on a lot of factors in the divorce case. Be careful when deciding how to file. When filing separately, estimated payments previously made jointly may be divided by agreement between the spouses and, if the spouses cannot come to an agreement, the I.R.S. will divide the payments proportionally based on each spouse’s income reported on their respective returns. Similarly, the carry forward credit for overpayments from previous years will be allocated by the I.R.S. based on the parties’ proportional income in the current year (not in the previous years when the overpayment occurred). This can work gross inequities where the parties’ incomes have recently changed.

One problem that often arises in divorce cases is that one spouse underestimates income in an ill-conceived effort to reduce his or her exposure to an unfavorable property award. Underestimating income results in underpaid taxes and subsequent tax deficiencies along with interest and penalties. Because both spouses are jointly and severally liable for all tax on a joint return, a spouse may become liable for the other spouse’s tax liability.²

WHO GETS THE ITEMIZED DEDUCTIONS DURING THE PENDING CASE?: Generally speaking, when the spouses file “married but separate” returns while their divorce case is working its way through the system, the spouse who pays for a particular item gets to claim the deduction for the payment. Where a home is titled in both names, the spouse making the mortgage or tax payments gets to claim the deductions.

An exception is sometimes made when the asset receiving the payment is specifically tied to one spouse. For example, contributions to an I.R.A are deductible to the spouse owning the I.R.A. regardless of which spouse made the contributions. Similarly, where a house is titled and the mortgage is in the name of one spouse only, the tax payments and interest payments may not be claimed as deductions by the non-owning spouse – regardless of who made the payments. On the other hand, courts have held that the spouse owning the real estate may not be able to claim the payments as deductions either.³

WHO GETS THE CARRYFORWARD?: The division between divorcing spouses of carryforwards for charitable contributions, S-corporations, net operating losses, and passive activity-losses are all addressed by the Internal Revenue Code or various Treasury Regulations. Handling the division of capital loss carryforwards, tax credits, and investment interest expenses are not so clear.

Net operating losses and charitable contributions that are carried forward from a joint return for spouses who subsequently divorce should be divided between the spouses as though the amounts are being carried forward from separately filed prior returns. Each spouse claims a share of the carryforward that reflects what his or her separate carryforward would have been had they previously filed separate returns.

Passive activity losses carryforward with the entity that caused the loss. For example, where a spouse separately owns property that produces a passive activity loss, and that spouse retains the property, that spouse keeps all of the passive activity loss carryforward. Where, however, the property is jointly owned and then transferred to one spouse incident to the divorce, that spouse must add the unused passive losses to his or her basis and lose out on the carryover tied to the other spouse’s, pre-transfer, share of the property.

S-corporation losses for years prior to 2004 remain with the corporation shareholder. S-corporation losses, however, can only be carried forward against income from the same S-corporation. So, if shares of an S-corporation are transferred in a divorce, any losses that were to be carried forward will be lost for the shares that are transferred to the other spouse. If the shares were jointly owned prior to the transfer, one half of the losses to be carried forward will be lost as the shares are, essentially, being transferred from two owners to only one. S-corporation losses for years after 2004 are transferable with the S-corporation shares.⁴

Capital loss carryforwards follow the ownership of the property that caused the loss where the property is held in the name of only one spouse. Where the property that caused the loss is jointly owned prior to the transfer, the carryforward is divided equally between the spouses.

UNCOOPERATIVE SPOUSES AND INCREASED TAX LIABILITY: Oftentimes in a divorce case a non-income earning spouse will (often acting on a lawyer’s advice) attempt to leverage a settlement by refusing to sign off on a joint return. The result, she believes, will be to cause the income-earner to have to file a separate return – and thereby incur a significantly higher tax liability. She demands “give me what I want in the divorce settlement and I’ll sign the joint return.” If you face a situation like this, talk with our lawyers. There are several effective ways to respond to the tactics of the recalcitrant spouse.⁵

On the other hand, sometimes the monied spouse is the one who has, for years or decades, been the spouse to oversee the preparation and filing of the joint tax return and, in the acrimony of the divorce, fails to obtain an extension for both spouses or – worse – files a separate return without notifying or obtaining an extension for the non-monied spouse. Again, call our offices, there are several effective ways to respond to the tactics of the monied, shirking, spouse.⁶

Be forewarned: if your spouse doesn’t fully cooperate in the preparation and filing of taxes, contact one of our attorneys immediately. The penalty for late filing is 5% of the net tax due for each month (or portion of a month) the return is not filed.

An additional penalty applies to late payments (as opposed to late filings).⁷ Interest also is assessed in addition to the penalties. In a case where taxes are a significant issue, the cost of hiring a competent, experienced attorney will almost certainly pay for itself almost immediately. If you’re involved in such a case, you really can’t afford not to hire a very good, experienced, divorce lawyer.

DEDUCTIBILITY OF ATTORNEY FEES: Like the fees you pay to your accountant for tax-related work, the fees you pay to your attorney can – in some circumstances – be claimed as deductions on Schedule A. Generally, fees for legal advice related to collecting maintenance or for tax advice related to the divorce are deductible. Attorneys’ fees related to other matters, including obtaining child support and defending against claims of alimony and child support are not deductible. Attorney fees that are not otherwise deductible can still bring a tax benefit, however: attorney fees incurred for the management, conservation, or maintenance of income-producing property may be added to the basis of the property at issue. In other words, the attorneys’ fees you spend to protect certain assets may be added to the basis of those assets – reducing your capital gains tax liability years down the road.

TEMPORARY MAINTENANCE: Temporary maintenance (alimony) payments made pursuant to a court order should be taxable income to the recipient and a tax deduction to the payor, notwithstanding the fact that the divorce is not yet final.⁸ Talk with a lawyer to find out if a temporary maintenance arrangement and filing separate returns might benefit you. There are, however, a few technical hurdles that must be satisfied for the payment to fully qualify under I.R.S. guidelines.⁹

EFFECT OF PROPERTY SETTLEMENTS: Under the Internal Revenue Code,¹⁰ property settlements between spouses incident to a divorce are supposed to be treated as nontaxable events.¹¹ When there is a transfer of property between spouses or a transfer of property to a former spouse made incident to the divorce no gain or loss is recognized for either party. That’s the simple part. Things start to get interesting, however, when one begins to consider the transfer of the “basis” of the assets involved. The transferee spouse (the spouse receiving the property) takes property with the basis held by the transferor spouse (or the couple, if previously held jointly) at the time of transfer.

CONSIDER THIS EXAMPLE: A couple owns 10 shares of Company A stock bought at $80.00 / share and 50 shares of Company B stock bought at $1.00 / share. Each investment has been held for more than one year (they’re both long-term capital) and each is valued at $1,000 at the time of the divorce.

Without considering the tax ramifications, a 50/50 division would seem to be fair: Husband takes the shares of Company A, and wife takes the shares of Company B – each gets stock valued at $1,000. After considering taxes, however, we see that the Husband’s attorney saved him $105.¹² 

	Less Value	Less Basis	Gain	15% tax	Yield
Husband / Co. A:	$1,000	$800	$200	$30	$970
Wife / Co. B:	$1,000	$100	$900	$135	$865
Dispartiy:					$105

If you apply the above example to a typical case involving tens or hundreds of thousands of dollars in retirement investments, and real estate worth hundreds of thousands of dollars, you can see the potential for significant losses, savings, and unfairness. Do yourself a favor: call our offices today to find an attorney experienced with, and capable of considering and incorporating the tax ramifications into your divorce settlement – you’ll be glad you did.

The transferred-basis rule also applies to transfers made by a spouse (or former spouse) to a third party on behalf of the other spouse – provided a few additional technical requirements are met.¹³ The transferred basis rule does not apply, however, where the recipient spouse is a non-resident alien.¹⁴

Although a transferee spouse must take the basis held by the transferor, the recipient spouse may benefit from the tax code’s lenience regarding the application of the transferor’s holding period. The transferee spouse may sell the acquired asset within one year and claim the transaction was the sale of short-term capital.¹⁵ If however, the transferee wants to quickly sell the asset but take advantage of the long-term capital gains tax rate, the transferee spouse may tack on the transferor’s holding period to satisfy the long-term holding period.¹⁶

CHILD SUPPORT, DEPENDENCY EXEMPTIONS, AND CHILD TAX CREDITS: Children have been important assets for tax purposes since the mid-1980’s. Smart divorce attorneys can help divorcing couples take advantage of the tax advantages carried by children, Oftentimes they can make or break the financial side of a settlement agreement. Congress changes these laws all the time and even makes retroactive application in some cases. Call our office and learn how child tax entitlements can impact your case.

CHILD SUPPORT: Child Support has no impact on taxes – it is not deductible to the parent paying child support and it is not considered income to the parent receiving it.

DEPENDENCY EXEMPTIONS: Today, a child’s dependency exemption of $3,100 can be worth over $1,000 to a taxpayer in the 33% bracket. Kids are considered minor dependents if they are 17 years old or younger on the last day of the tax year. Generally speaking, the custodial parent may claim the child’s dependency exemption by default.¹⁷ 

Custody is determined by the divorce Judgment. In cases of split custody (one child lives with Mom and one Child lives with Dad) each parent may claim the exemption for the child living in their respective household – provided the parent is identified as the custodial parent in the Judgment. In cases of joint custody, the exemption goes to the parent with whom the child lives for the greater part of the year.

The dependency exemption may be transferred between the parents by agreement¹⁸ or by order of court over the objection of the custodial parent.¹⁹ Such transfers may be for only the current year, specified years (alternating years is popular) or for all future years.

CHILD TAX CREDIT: The parent claiming the child’s dependency exemption will benefit from the Child Tax Credit: a dollar-for-dollar reduction against that parent’s tax liability. The credit phases out with higher incomes²⁰ and the value of the credit for each claimed child dependent varies from year to year.²¹ The Child Tax Credit can easily save a taxpayer a few thousand dollars a year – enough to make it worth thinking about. Talk with one of our attorneys to learn how you may reduce your tax liability and improve your settlement position.

CHILD AND DEPENDENT CARE CREDIT: To help those divorced parents with custody of young or disabled children pay for child care to permit employment, a custodial parent may claim an additional credit against his or her tax liability. This credit varies between 20% and 35% of expenses related to the care of the child. The credit can be a financial boon to the custodial parent and should not be overlooked. Significant restrictions apply²² so be sure to check with a knowledgeable attorney Unlike the dependency exemption and its accompanying Child Tax Credit, the Child and Dependent Care Credit is not transferable between parents.

CHILD’S MEDICAL EXPENSES: Certain restrictions apply,²³ but a parent who does not claim the child’s dependency exemption can still deduct a child’s medical expenses. The expenses may be deducted only to the extent they exceed 7.5% of adjusted gross income. In some cases, this can be a significant savings as one parent may use the medical expenses to reduce AGI and the other parent may use the dependency exemption – lowering the tax bill for everyone and leaving more money in all the pockets to help care for the child.

TAX IMPLICATIONS IN DIVISION OF INCOME PRODUCING PROPERTY, PARTNERSHIPS, AND S-CORPORATIONS: When a couple owns income-producing property – like commercial buildings or rental property – the “transfer of adjusted basis” game has an added level of complexity. Depreciation reduces an income-producing asset’s basis at a constant rate over a specific period. On the other hand, capital improvements²⁴ made to the property increase the basis.

Partnerships and S-corporations may be viewed like any other asset: the partner or shareholder holds an asset (a partnership “interest” or shares of stock) with a current value and a basis. The basis in a partnership interest and in S-corporation stock can increase and decrease over time.

The most common way for the basis of such an asset to decrease is when a partner, or an S-corporation shareholder, takes a distribution. Distributions cause a partner’s / shareholder’s basis to be reduced by the amount of the distribution. Adjusted bases are also reduced when a partnership or S-corporation passes its losses on to the partners / shareholders by the amount of the passed-on losses. The most common ways for the bases of partnership interests and S-corporation shares to increase is through the partner’s / shareholder’s share of the partnership’s / S-corporation’s retained earnings, and by the making of loans to, or investment in, the partnership / S-corporation.

All of this means that attorney and client must be aware of the fact that the adjusted basis at the time of the divorce may be very different from the business’s basis at the time of the original investment. For example, imagine a business investment (say, a small Bed & Breakfast). Husband invests $100,000 in the B&B during the marriage (it’s marital property). Over the years, he withdraws $2,000 here and $5,000 there to fund small trips with his wife to the B&B. His distributions total $50,000. He doesn’t tell his wife that the money funding the trips reduced his basis in the investment – she thinks the B&B is paying for the trips as part of his compensation – a perk of employment. Wife also likes the area where the B&B is located and, in the course of divorce settlement, agrees to take the Husband’s interest in B&B believing the husband’s share to be worth $120,000. Two years later, she decides she doesn’t like the hotel business and decides to sell her interest for $150,000. She believes she’ll have to pay tax on a $50,000 long term capital gain. Unfortunately for her, she discovers that she took the hotel with an adjusted basis of only $50,000 (she gave her husband a credit of $120,000 in the settlement – meaning she cheated herself out of $70,000) and she’ll have to pay tax on a $100,000 long term capital gain.

INTEREST ON CASH PAYMENTS AS PROPERTY SETTLEMENTS: Property transfers between spouses incident to a divorce are not taxable events. Sometimes, however, those cash payments are made over time – sometimes years. The parties may not want to characterize the payments as maintenance because that would make the payment taxable income to the recipient and deductible to the payor. Cash payouts over time, however, usually earn interest. The interest on such payments is taxable to the recipient, but is not deductible to the payor.²⁵

MAINTENANCE PAYMENTS: “Maintenance” is what we, in Illinois, used to call “alimony.” The I.R.S. calls it “alimony or separate maintenance payments.” As with everything else, the I.R.S. has a very specific definition of “alimony or separate maintenance payments.”²⁶ Caution must be used to not run afoul of the I.R.S.’s definition²⁷ – every year there are numerous appellate cases where one party loses a small fortune in taxes due to a poorly worded settlement agreement that fails to meet the I.R.S. definitions.

The general rule is that maintenance payments are to be included in the payee’s gross income²⁸ and the payor is permitted to claim a deduction for such payments.²⁹ This is important because of the difference in the tax rate between the spouses. Usually, the spouse paying maintenance will be in a higher tax bracket than the spouse receiving the payments. That means that the payor will realize a tax savings that is larger than the tax liability incurred by the recipient – in effect, the I.R.S. is helping to make part of the maintenance payment. Moreover, if the recipient has any sort of tax deductions (like mortgage interest), with smart planning he or she very well may not pay any tax on the maintenance.

RECAPTURE: Recapture is the I.R.S.’s most effective way of preventing divorcing couples from disguising property settlement payments as maintenance. Sometimes divorcing couples will attempt to claim a tax savings by labeling property settlement payments as “maintenance.”

In such cases, the payments are usually “front-loaded” – the months and years with the biggest payments come right after the divorce to help the recipient spouse with payments related to the divorce and to get things going financially. The payments begin to decrease pretty quickly. If “maintenance” payments are reduced by a significant amount³⁰ in too short a period,³¹ the I.R.S. will consider some of the payments deducted by the payor to be taxable (meaning a tax deficiency) and those same payments that were reported as income by the recipient will then be considered as non-taxable (meaning a refund will be due).

The recapture rule does not take effect until the divorce is final – payments of “temporary maintenance” are not considered and cannot throw the calculations askew. Recapture also does not apply when maintenance payments stop due to the death of either party.³² 

TAXES ON GAIN FROM THE SALE OF THE MARITAL RESIDENCE: Each spouse may exclude from his or her income up to $250,000 (married couples enjoy a $500,000 exclusion) of gain on the sale of his or her home under certain circumstances.³³ The taxpayer must live in the residence for two of the five years preceding the date of the sale and must not have exercised the exclusion in the two years preceding the sale. For tax purposes, the two-out-of-five year requirement may be satisfied by only one spouse as long as the arrangement is defined in the divorce judgment or settlement. In many cases, for example, one former spouse will – as approved and specified in the divorce judgment – continue to live in the marital residence for many years after the divorce until the children have graduated from high school. Under those circumstances, the former spouse living away from the former marital residence will still pass the two-out-of-five years test by virtue of the other former spouse’s period of residency.

Similarly, where a taxpayer owning a premarital residence marries and then sells the residence, the exclusion of real estate gain will be limited to only $250,000 unless the new spouse has not used the exclusion in the preceding two years and until the new spouse uses the marital residence as his or her principal residence for at least two years.

MORTGAGE INTEREST AND REAL ESTATE TAXES: Tax deductions for payment of real estate taxes and the interest payments on the mortgage are one of the biggest – if not the biggest – tax benefits available in most divorce cases. The I.R.S., however, has numerous rules that restrict which spouse may claim those benefits. The deductibility of interest and real estate tax payments depends on several factors: how the home is titled,³⁴ whether the home is used as the taxpayer’s residence,  whose name is on the mortgage and, in some cases, the wording of the divorce judgment or Marital Settlement Agreement.³⁵

TAXES AND TIMING OF DIVORCE: You are considered “married” for tax purposes if your divorce is not final by December 31, of the tax year. Whether you get divorced on January 1, or December 31, you’re considered “unmarried” for the whole of that year.

TIMING OF PAYMENTS: Sometimes a spouse who pays maintenance will prepay one or more payments due in January or later and, for example, date them December 31 of the previous year in an attempt to increase the maintenance deduction. The receiving spouse, of course, reports the income in the year it is actually received. If necessary, the I.R.S. may look to the intent of the parties and may consider any schedules or payment sequences that are memorialized in your court papers. When in doubt, it is a good practice to save old correspondence, including post-marked envelopes, to keep from running afoul of maintenance timing problems.

RELIEF FROM THE I.R.S.: The Internal Revenue Code offers relief to an “innocent spouse” who is not responsible for tax liabilities accrued prior to the finalization of the divorce. Where the innocent spouse was unaware, and had no reason to know of, and did not benefit from the under-reporting of a tax liability, the I.R.S. will look only to the guilty spouse for recovery.

Relief may also be available under a “separation of liability” theory … as long as no assets were transferred to the innocent spouse as part of a scheme to avoid payment of taxes and the innocent spouse had no knowledge of the wrongful conduct that resulted in the tax deficiency.

For an “innocent spouse,” proving a lack of knowledge of the origin of the deficiency, and proving no reason to have knowledge of the wrongful items, can present a very difficult burden. The federal tax courts use a “reasonable and prudent taxpayer” standard and ask not what the innocent spouse actually knew, but rather “what should the taxpayer have known?” One can begin to imagine the difficulty of meeting the “innocent spouse” burdens when the spouse claiming “innocence,” has hired accountants as expert witnesses in the preparation of the divorce case and obtained the good counsel of an attorney who, in all likelihood, will have required a “tax liability indemnification” clause in any settlement agreement or judgment.

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