Filing status and divorce, tax implications and divorce, division of assets, gains from residence, child support and alimony, dependency exemption, and deductible costs in divorce.
- 1. Tax Consequences inDivorceSeptember,2012 Tsai Law Company, PLLCDisclaimer: This presentation is from a Family Law Attorney Perspective and Washington State is a Community Property State. There may be other provisionsfor a non community property state.
2. Filing Status-Divorce Clients want to know how to file- or the status:on 1040, 5 different status: Single Married Filing Jointly Head of Household Married filing Separately Qualifying widow(er) with dependent child Taxes and Divorce in Washington State 3. Married filing Jointly Married filing jointly-status on 12/31 determines how must file. Just because opposing party filed wrong, does not mean client can follow along. Example- John is client, signed a Property Settlement Agreement on December 20th resolving all issues in the divorce case. However, Divorce Decree not entered until January 20th. Must file a tax return indicating married status. Does not matter if settled issues in divorce, must enter divorce decree- status of 12/31 determines filing status. May be tax advantages to filing a joint return-timing of when file the Decree of Dissolution Be Aware of this, negotiate a settlement that includes possible benefit to one or both partiesHigh Asset Divorce Lawyers 4. Married Filing Separately1. A spouse in divorce can file separately2. Usually not tax advantageous to do so3. May want to avoid filing a fraudulent tax return4. May want to avoid late filing5. Accountant can calculate the taxes for client and run the two separate returns6. Sometimes, court may be upset if file separately. Court can order party to reimburse other party.7. Had judicial officer rule that they cannot order a spouse to file in a particular manner. But can award other spouse the benefit of most tax advantageous filing.High Asset Divorce Lawyers 5. Head of Household Benefits to the filing status of head of household. A. ) Higher standard deduction B. ) Lower overall tax rate C. ) Ability to claim certain credits such as dependent carecredit and earned income credit. D. ) Need to know these issues regarding whether client canreceive the tax benefit associated with children-impact onoverall settlement if maintenance is also included Common Tax Issues When Divorcing 6. Requirements to Head ofHousehold Status Unmarried or considered unmarried on last day of theyear Cannot claim this status if still married. Be careful whenentering the Decree of Dissolution. If it either benefits or has adetriment to your client. Negotiate when Decree will beentered. Paid more than half the cost of keeping up a home for the year;- This can impact whether client qualifies for the status. Someconsiderations including whether receiving maintenance andpaying, or whether other party was ordered to pay during thependency of the case. A qualifying person lived in their home for more than half ofthe year.High Net Worth Divorce in Washington 7. Tax Implications of FilingStatus on Case Taxes are considered when calculating child support todetermine net income Taxes are considered when calculating spousalmaintenance to determine net income Whether a party receives the tax exemption for a childimpacts income for living expensesChild Support and Income in Washington 8. Joint and Individual Liabilityfor Married Filing Jointly Need to advise client of possible liability associated with filing of jointreturn Example- one spouse not involved in business, has signed joint returnsin the past-is being asked to sign a joint return now. Duty to advise client to have own CPA look at return to be sure it isaccurate. IRS can go after either spouse for tax, interest and/or penaltiesassociated with incorrect filing. Client may have a claim for innocent spouse, will talk about later inpresentation.Joint Returns and Business Assets in Divorce 9. Divorced Taxpayers IRS can hold a divorced spouse liable for unpaid tax, interest and penalty for a tax return filedduring the marriage. Should have this discussion with your client so they are aware of thispossible future liability. May want to include a hold harmless clause in the Decree for prior tax years if have concernsabout inaccurate taxes being filed. A hold harmless does not prevent the IRS from collecting jointly and severally from client, butat least client has a remedy in divorce court should this happen. I have included language in Property Settlement Agreement that provides what the liability isto the client in the future should the IRS perform an audit and claim taxes interest andpenalties are owed. May also want to include a provision that states if an amended return is filed, that any taxrefund shall be shared in a specific proportion. I have also included in a PSA that if an amended return is filed and a refund is due from theIRS, that my client is entitled to a portion of the refund. Property Settlement Agreements in Washington 10. Tax Impact of Divisionof Assets First concept- Property Settlement or Award or Transfer of Property betweenspouses incident to divorce is not subject to taxation pursuant to IRC 1041. To avoid the tax, that code provision provides 2 factors: (a) occurs within 1 yearof date of marriage ends, or (b) is related to the ending of your marriage. The specific time factor is pretty simple, the transfer occurs within one year.The second disjunctive provision, related to the end of your marriage is morebroad. Related to the end of your marriage includes whether the transfer is madeunder the original or modified divorce or separation instrument and thetransfer occurs within 6 years after the date the marriage ends. Tax Basis of the property received from your spouse is the same as the spousesadjusted basis.High Asset Divorce Lawyers 11. Gains from Sale of PersonalResidence Most people are not realizing gain from sale of personal residence. Many short sales andforeclosures- also touch on those later If there is a gain however, IRC Section 121(b) provides that an individual may excludefrom income $250,000 of gain or $500,000 if status is married filing jointly. Test: Residence must be used as primary residence for two years over the past five yearsand cannot have more than one sale within the past 2 years. If one spouse moved out of residence, for example, during pendency of proceeding, stillable to count as primary residence as long as other spouse was primarily residing Some people still have substantial equity in their residence and should advise clients ofpossible tax ramifications of the sale of property. Do not want client thinking they will be realizing a specific amount of income-only tohave to pay in tax.Division of Assets in Divorce in Washington 12. Other Exceptions to Sale ofPrimary Residence The two out of five rule also has an exception toactivity duty military personnel in IRC 121(d)(9). Also, If there is a separate dwelling unit, in additionto the primary residence, the sale of the dwellingmay be subject to taxation as it is not lumped inwith the primary residence. Primary Residence in Divorce 13. Undifferentiated SupportChild Support versus Alimony Alimony is taxable to payee and tax deductible to the payor, child support isnot taxable to the payee nor deductible to the payor. Maintenance is an important tool for court to use to level the playing fieldregarding income between the parties. Very important to be sure that alimony is clearly identified so that each party isreceiving the benefit of the bargain or ruling. When drafting language in a property settlement, decree or order, be sure andidentify what portion of a possible transfer payment is maintenance/alimonyversus child support. Otherwise, client may end up paying tax on support that was supposed to bechild support, which generally is not taxed. This is true for an order entered on a temporary basis as well as a final order.So if you represent the primary parent of children, you want to advocate for aspecific child support amount to be part of the overall transfer payment so yourclient does not end up paying tax on the whole. Child Support and Alimony in Divorce 14. Lawton v. Commissioner In this case, tax court addressed a Pennsylvania temporary order that providedsupport for support of spouse and one child. Wife argued that because thestate court was required to adhere to the mandated child support guidelines,that a portion should be deemed non taxable child support. Court disagreed and indicated that IRC Section 71(c)(1) required that theamount of child support must be fixed by the terms of the divorce orseparation instrument, not outside the instrument. The Court also pointed outthat the wife should have had the divorce court characterize the payment aschild support. You can bet that the wife specifically went back to her divorce lawyer and askedwhy the support she received was not segregated between child support andalimony. The safest thing to do is have it broken out so there is no question.High Asset Divorce Lawyers 15. Dependency Exemptionand Credits The child dependency exemption is usually something that needs to beaddressed in divorce. If you represent the non primary parent or non custodial parent and that parentis paying support, be sure to address the dependency exemption. If you are solely applying the Code, the parent who has the child or children formore overnights in the year gets the exemption. If the parents have an equal number of overnights, the exemption goes to theparent who has the higher adjusted gross income. Examples-(1) Absences (2) child goes to camp for 6 weeks during summer,(3)parent works at nightDependency Exemption in Divorce in Washington State 16. Qualifications of DependentChild (1) child must be designated as the child of the taxpayer inthe return (2) Child must not have reached age 19 during calendaryear or must be enrolled as full time student and notreached age 24 in calendar year (3) child must have the same principle place of abode formore than half year (4) child must not have p