Tsai Law Company, PLLC

September, 2012

Tax Consequences in

Divorce

Disclaimer: This presentation is from a Family Law Attorney Perspective and Washington State is a Community Property State. There may be other provisions for a non community property state.

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

Filing Status-Divorce

Taxes and Divorce in Washington State in Seattle, Washington

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 parties

Married filing Jointly

High Asset Divorce Lawyers in Seattle, Washington

1. A spouse in divorce can file separately

2. “Usually” not tax advantageous to do so

3. May want to avoid filing a fraudulent tax return

4. May want to avoid late filing

5. Accountant can calculate the taxes for client and run the two separate returns

6. 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.

Married Filing Separately

High Asset Divorce Lawyers in Seattle, Washington

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 care credit and earned income credit.

D. ) Need to know these issues regarding whether client can receive the tax benefit associated with children-impact on overall settlement if maintenance is also included

Head of Household

Common Tax Issues When Divorcing in Seattle, Washington

Unmarried or “considered unmarried” on last day of the year Cannot claim this status if still married. Be careful when entering the Decree of Dissolution. If it either benefits or has a detriment to your client. Negotiate when Decree will be entered.

Paid more than half the cost of keeping up a home for the year; - This can impact whether client qualifies for the status. Some considerations including whether receiving maintenance and paying, or whether other party was ordered to pay during the pendency of the case.

A “qualifying person” lived in their home for more than half of the year.

Requirements to Head of Household Status

High Net Worth Divorce in Washington

Taxes are considered when calculating child support to determine net income

Taxes are considered when calculating spousal maintenance to determine net income

Whether a party receives the tax exemption for a child impacts income for living expenses

Tax Implications of Filing Status on Case

Child Support and Income in Washington

Need to advise client of possible liability associated with filing of joint return

Example- one spouse not involved in business, has signed joint returns in 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 is accurate.

IRS can go after either spouse for tax, interest and/or penalties associated with incorrect filing.

Client may have a claim for innocent spouse, will talk about later in presentation.

Joint and Individual Liability for Married Filing Jointly

Joint Returns and Business Assets in Divorce in Seattle, Washington

IRS can hold a divorced spouse liable for unpaid tax, interest and penalty for a tax return filed during the marriage. Should have this discussion with your client so they are aware of this possible future liability.

May want to include a hold harmless clause in the Decree for prior tax years if have concerns about inaccurate taxes being filed.

A hold harmless does not prevent the IRS from collecting jointly and severally from client, but at least client has a remedy in divorce court should this happen.

I have included language in Property Settlement Agreement that provides what the liability is to the client in the future should the IRS perform an audit and claim taxes interest and penalties are owed.

May also want to include a provision that states if an amended return is filed, that any tax refund 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 the IRS, that my client is entitled to a portion of the refund.

Divorced Taxpayers

Property Settlement Agreements in Washington

First concept- Property Settlement or Award or Transfer of Property between spouses 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 year of 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 more broad.

Related to the end of your marriage includes whether the transfer is made under the original or modified divorce or separation instrument and the transfer occurs within 6 years after the date the marriage ends.

Tax Basis of the property received from your spouse is the same as the spouses adjusted basis.

Tax Impact of Division of Assets

High Asset Divorce Lawyers in Seattle, Washington

Most people are not realizing gain from sale of personal residence. Many short sales and foreclosures- also touch on those later

If there is a gain however, IRC Section 121(b) provides that an individual may exclude from 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 years and cannot have more than one sale within the past 2 years.

If one spouse moved out of residence, for example, during pendency of proceeding, still able 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 of possible tax ramifications of the sale of property.

Do not want client thinking they will be realizing a specific amount of income-only to have to pay in tax.

Gains from Sale of Personal Residence

Division of Assets in Divorce in Washington

Other Exceptions to Sale of Primary Residence

The two out of five rule also has an exception to activity duty military personnel in IRC 121(d)(9).

Also, If there is a separate dwelling unit, in addition to the primary residence, the sale of the dwelling may be subject to taxation as it is not lumped in with the primary residence.

Primary Residence in Divorce in Seattle, Washington

Alimony is taxable to payee and tax deductible to the payor, child support is not taxable to the payee nor deductible to the payor.

Maintenance is an important tool for court to use to level the playing field regarding income between the parties.

Very important to be sure that alimony is clearly identified so that each party is receiving the benefit of the bargain or ruling.

When drafting language in a property settlement, decree or order, be sure and identify what portion of a possible transfer payment is maintenance/alimony versus child support.

Otherwise, client may end up paying tax on support that was supposed to be child 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 a specific child support amount to be part of the overall transfer payment so your client does not end up paying tax on the whole.

Undifferentiated Support

Child Support versus Alimony

Child Support and Alimony in Divorce in Seattle, Washington

In this case, tax court addressed a Pennsylvania temporary order that provided support for support of spouse and one child. Wife argued that because the state 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 the amount of child support must be fixed by the terms of the divorce or separation instrument, not outside the instrument. The Court also pointed out that the wife should have had the divorce court characterize the payment as child support.

You can bet that the wife specifically went back to her divorce lawyer and asked why the support she received was not segregated between child support and alimony.

The safest thing to do is have it broken out so there is no question.

Lawton v. Commissioner

High Asset Divorce Lawyers in Seattle, Washington

The child dependency exemption is usually something that needs to be addressed in divorce.

If you represent the non primary parent or non custodial parent and that parent is paying support, be sure to address the dependency exemption.

If you are solely applying the Code, the parent who has the child or children for more overnights in the year gets the exemption.

If the parents have an equal number of overnights, the exemption goes to the parent who has the higher adjusted gross income.

Examples-(1) Absences (2) child goes to camp for 6 weeks during summer,(3) parent works at night

Dependency Exemption and Credits

Dependency Exemption in Divorce in Washington State

(1) child must be designated as the child of the taxpayer in the return

(2) Child must not have reached age 19 during calendar year or must be enrolled as full time student and not reached age 24 in calendar year

(3) child must have the same principle place of abode for more than half year

(4) child must not have provided more than one half of his or her own support for the year.

Qualifications of Dependent Child

High Asset Divorce Lawyers in Seattle, Washington

If represent non custodial parent, may still claim exemption as long as divorce court grants you the exemption.

Divorce court cannot preempt IRC. Supremacy clause clearly trumps that specific argument.

However, divorce court has jurisdiction over ordering client to sign form 8332.

Important to be sure that the Order of Child Support specifically grants the non custodial parent the exemption and requires the custodial parent to sign Form 8332.

For Orders entered prior to 2009, the order has to state: (1) that the non custodial parent can claim the child without regard to any condition (2) the other parent will not claim the child; and (3) specify the years for which the claim is released.

Release of Exemption FORM 8332

Dependency Exemption in Divorce in Seattle, Washington

While most costs incurred for a divorce proceeding are not deductible, some costs of divorce are deductible.

1. Fees for Tax Advice

2. Fees to obtain or collect alimony

Deductible Costs of Divorce

Deductible Costs in Divorce in Seattle, Washington

As part of the advice an attorney provides to a divorcing client, the client may receive the tax benefit of deducting those costs on their income tax return.

This includes advice for federal, state, local taxes, income, estate, gift, inheritance, and property taxes., but is subject to the 2% limit

The trick is to be sure that these costs are itemized on the attorney billing statements.

If audited, want to be sure that the client has the billing statements that can be produced to prove that the amount deducted can be clearly quantified.

Do not want a client coming back to you years after the divorce is final, and asking you to provide an itemized billing statement with the breakdown regarding the tax advice that was provided.

It is not a difficult thing to do at the time you are doing it. But could be a very difficult thing to do years later.

Tax Advice-Deductible

Inheritance and Divorce in Seattle, Washington

Because Alimony is included in the recipient’s income for tax purposes, the attorney’s fees incurred in establishing and collecting alimony is tax deductible.

Once again, important for the family law practitioner to itemize these costs on the client invoice.

Usually the issues that we address are custody, child support, property and debt division and alimony. It is advisable to have separate time entries for the alimony on the client statements so they receive the benefit associated with those payments.

Something easy attorney can do to be sure the client receives the financial benefit.

Fees Incurred Establishing or Collecting Alimony-Tax Deductible

Save Money in Divorce in Seattle, Washington

Earlier discussing that many client’s going through divorce do not have equity to divide.

After the housing bubble burst, many people were forced into foreclosure and/or having to do a short sale of their home.

A short sale is when the bank is agreeable to accept a reduced amount of the mortgage to transfer title to a buyer so they receive something other than the residence.

Generally, banks do not like to be in the position of having to own and maintain residential real estate.

So what happens is the bank forgives a portion of the debt associated with the loan just so they get something and do not have to foreclose and possibly get less than what a willing buyer would pay.

Short Sales, Mortgage Debt Relief Act of 2007

Real Estate and Divorce in Seattle, Washington

When the bank forgives a portion of the debt associated with the loan, that forgiveness now becomes taxable income.

Due to an outcry of homeowners who were losing their homes, and also then having to pay an additional tax on the forgiveness, a double whammy, the Mortgage Debt Relief Act was passed into law.

What that law provides is that tax payers can exclude from their income cancelled debt owed on their principle residence as long as the mortgage was to buy, build or substantially improve the persons main home.

That does not mean that a person can refinance their residence, pay off their credit cards, then do a short sale and have the debt forgiven along with the tax owed.

Publication No. 4681 Canceled Debts, Foreclosures, Repossessions and Abandonments provides some specific examples of what situations are covered and what situations are not covered.

Short Sales in Washington

Short Sales in Divorce in Seattle, Washington