Unfortunately, in addition to the difficult personal issues associated
with divorce, there are several tax concerns that need to be addressed in
order to keep tax costs to a minimum.
Support provisions. Where one spouse is to be making
support payments to the other upon divorce or separation, the payments are
deductible by the payor and taxable to the payee if they qualify under the
tax rules for “alimony.” To qualify, the payments must (1) be required
under the divorce decree or separation agreement (i.e., voluntary or “extra”
payments won't qualify), (2) be in cash only (not goods or services), and
(3) be required to end at the death of the recipient spouse. Also, (4) the
parties must be living in separate households. The parties can elect to
have payments that qualify be treated as not qualifying (but not vice
versa).
Support payments for children (“child support”) aren't deductible by the
paying spouse (or taxable to the recipient). These include payments
specifically designated as child support as well as payments which otherwise
might look like alimony but are linked to an event or date related to a
child. For example, say a spouse is to pay “alimony” of $3,000 a month,
dropping to $2,000 a month at a specified date. If the date coincides with
a child's 18th or 21st birthday, the “extra” $1,000 will be characterized as
child support and not be deductible by the paying spouse (or taxable to the
recipient spouse).
Tax planning for support payments generally seeks to make them deductible
if the paying spouse is in a higher tax bracket than the recipient, as is
often the case. The tax savings for the paying spouse can be shared with
the recipient through higher payment amounts or other benefit provisions.
For example, if having payments qualify as alimony will save the paying
spouse $5,000 in tax and will cost the receiving spouse only $2,000
(determined by multiplying the alimony amount by the individual's marginal
income tax bracket), the paying spouse can offer additional payments in the
divorce negotiations to cover the recipient's tax cost and a share of the
additional tax savings.
Since alimony payments are required to end at the death of the receiving
spouse, as noted above, the parties may wish to provide for life insurance
for that spouse as part of the arrangement.
Dependency exemptions. To some extent, the parties can
determine who is entitled to claim the dependency exemption for their
dependent children. The exemption for the child goes to the spouse who has
legal custody of the child. However, that spouse can waive his or her right
to the exemption, thus allowing the noncustodial spouse to claim it. In
general, tax planning calls for the spouses to agree to have the exemption
go to the spouse who can extract the greater tax benefit from it. As
discussed above in connection with tax savings from support arrangements,
the tax benefit can then be “shared” with the other spouse via increased
support payments or in some other fashion.
The dependency exemption entitles the spouse who claims it to more than
just the exemption. For example, the child tax and the higher education
(Hope and Lifetime learning) credits are only available to the spouse who
claims the child as a dependent. (Note, however, if the custodial parent
waives the right to the exemption, the custodial parent can still claim the
child care credit for qualifying expenses if the child is under 13.)
If a custodial spouse is waiving the right to the dependency exemption
for a child, it's done on Form 8332. This can be done on an annual basis or
one time to cover future years. Where the waiving spouse will be receiving
support payments from the other spouse, the waiving spouse often prefers the
annual approach so he or she can refuse to grant the waiver if support
payments are late or have been missed.
Property settlements. When property is split up in
connection with a divorce, there are usually no immediate tax consequences.
Thus, property transferred between the spouses won't result in taxable gain
or loss to the transferring spouse. Instead, the receiving spouse takes the
same basis (cost) in the property that the transferring spouse had. (The
receiving spouse may have to pay tax later, however, when the recipient
spouse sells the property. For example, if a spouse receives a $300,000
vacation home, but the transferring spouse's basis was only $150,000, the
recipient spouse will have a taxable gain if he or she later sells the house
for more than $150,000, unless the spouse qualifies to exclude part or all
of the gain by first making the house his or her principal residence). This
“nonrecognition rule” also applies to certain transfers, incident to
divorce, to a spouse or former spouse, of so-called nonstatutory stock
options and/or rights to nonqualified deferred compensation that an
individual has received as compensation for employment and that haven't yet
been recognized for income tax purposes. Moreover, the transferee spouse or
former spouse, rather than the transferor, is taxed on the income
attributable to these transferred options or deferred compensation rights.
Special tax rules apply to certain categories of property. In
particular, please call me to make sure the arrangements for your home,
pension benefits, and certain business interests, discussed below, are
properly structured to minimize potential tax costs.
Personal residence. In general, 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 (as long as they owned and used the
residence as their principal residence for two of the previous five years).
If one spouse continues to live in the home and the other moves out (but
they remain owners of the home), they may still be able to avoid gain on the
future sale of the home (up to $250,000 each), but special language may have
to be included in the divorce decree or separation agreement to protect the
exclusion for the spouse who moves out. If the couple doesn't meet the two
year ownership and use tests, any gain from the sale may qualify for a
reduced exclusion by reason of unforeseen circumstances.
Pension benefits. A spouse's pension benefits are often part of a
property settlement. When this is the case, the commonly preferred method
to handle the benefits is to get a “qualified domestic relations order (QDRO).”
A QDRO gives one spouse the right to share in the pension benefits of the
other and taxes the spouse who receives the benefits. Without a QDRO the
spouse who earned the benefits will still be taxed on them even though they
are paid out to the other spouse.
A QDRO isn't needed to split up an IRA, but special care must be taken to
avoid unfavorable tax consequences. For example, if an IRA owner were to
cash out his IRA and then pay his ex-spouse her share of the IRA as
stipulated in a divorce decree, the transaction could be treated as a
taxable distribution (possibly also triggering penalties), for which the IRA
owner would be solely responsible. However, the taxes and penalties can be
avoided, if specific IRS-approved methods for transferring the IRA from one
spouse to the other are used. For example, money can be transferred
tax-free from one spouse's IRA to the other spouse's IRA in a
trustee-to-trustee transfer, as long as the transfer is required by a
divorce decree or separation agreement. Also, the transfer shouldn't take
place before the divorce or separation is final, or it may be treated as a
taxable distribution.
Business interests. When certain types of business interests are
transferred in connection with divorce or separation, care must be taken to
make sure “tax attributes” aren't forfeited. In particular, interests in S
corporations may result in “suspended” losses, i.e., losses that are carried
into future years instead of being deducted in the year they are incurred.
Where these interests change hands in connection with a divorce, the
suspended losses may be forfeited. If a partnership interest is transferred
a variety of more complex issues may arise involving partners' shares of
partnership debt, capital accounts, built-in gains on contributed property,
and other complex issues.
I'm not suggesting that the interests discussed above shouldn't be part
of property settlement negotiations: only that the parties be aware of the
tax consequences that their transfer may generate.
Estate planning considerations. The upheaval a divorce
causes in family relations and property holdings makes it imperative for the
parties to reassess their wills and estate plans in connection with the
divorce. First, the typical will in which all property is left to a
surviving spouse is no longer likely to reflect the testator's wishes.
Mutual family goals, often incorporated in reciprocal wills, are likely to
have changed substantially. Second, the property to be left by the spouses
may have changed hands via a property settlement. One spouse may be getting
substantial holdings he or she didn't previously possess, making it
necessary to devise a new estate plan. Finally, guardianship and trustee
issues for surviving minor children must be addressed. That is, who will
manage the assets of, and serve as guardian for, minor children in the event
of the death of the parents.
Medical insurance. If your spouse participates in an
employee group health plan that is subject to COBRA, you should know that
the plan has the obligation to make COBRA health care continuation coverage
available to you, as a qualified beneficiary, if there is a divorce or legal
separation. This availability of health coverage extends for 36 months,
beginning on the date of the divorce or legal separation. You, however,
would have to pay for the coverage (unless, of course, the divorce court
orders your spouse to pay for it). This option to buy COBRA health care
coverage is available to you even if your spouse discontinued your coverage
while the divorce was pending.
Tax records. Make sure you get copies of, or access to,
any records or documents that can have an impact on your tax situation. You
need copies of joint returns filed with your spouse along with supporting
documentation. Also, records relating to the cost of jointly owned property
or property transferred to you in connection with the divorce are essential.
You will need to establish cost when these assets are eventually sold.
And, of course, all documents relating to the divorce or separation itself
should be retained for tax (and other legal) purposes.
Filing status. The timing of your divorce or separation
can have an impact on how you file your tax return. If a “final” decree or
divorce or, in the case of separation, decree of separate maintenance, is
issued by the end of the year, then you can't file your tax return for the
year as a married person. Your filing status will be “single.” However, if
you cover more than half the costs of a household in which a child of yours
lives, you may qualify for more favorable “head of household” rates.
If an above-described decree hasn't been issued by year-end, you are
treated as still married even if you are separated from your spouse under a
separation agreement or “nonfinal” decree. In this case, you may still file
jointly with your spouse. This filing status may result in lower overall
tax for you and your ex-spouse, but may put you at risk for an unpaid tax
obligation of your spouse's (although you may be protected under “innocent
spouse”rules, and an election to limit your liability may be available in
certain circumstances). It also requires contact between the parties to
prepare the joint return, which may not be desirable in some circumstances.
Further, the alimony deduction discussed above can't be taken on a joint
return.
The other available filing status is “married filing separately,” which
is the least favorable status. However, again, if you cover more than half
the costs of a household in which a child of yours lives, and your spouse
hasn't been a member of the household during the last six months of the
year, you may qualify for a more favorable filing status.
Providing income data to spouse who has custody of child under
14. Be aware that if while you and your spouse are still
considered married, you and your spouse decide to file separate returns, and
your spouse has custody of your child under age 14 who has investment
income, you may have to provide to your spouse any information about your
taxable income that's needed to properly figure the child's income tax under
the kiddie tax rules (which tax the child's investment income at the
parent's highest rate). If you will have custody of the child, you may be
in the position of having to get income information from your spouse.
Adjusting income tax withholding. The changes caused by
divorce may require you to adjust the amount of income tax that your
employer withholds from your paycheck. The calculation of your withholding
on the Form W-4, Employee's Holding Allowance Certificate, that you gave to
your employer is based on your married status and on the earnings of both
spouses. When you get divorced, you should submit a new Form W-4 with the
revised information. The fact that deductible alimony payments will be made
(or taxable alimony received) should also be taken into account. This will
ensure that the correct amount of tax is withheld.
Notifying IRS of a new address or name change. If you
will be moving, or if you are changing your name because of divorce, file
Form 8822 with IRS so you will receive any notices or correspondence from
IRS promptly.
Deducting legal fees. Finally, to what extent can you
deduct the legal fees incurred in connection with the divorce? In general,
since a divorce is a “personal” undertaking, the legal fees are
nondeductible. However, as you can readily see from this discussion, many
complex tax issues can be involved in a divorce. And a fee paid for tax
advice (including setting up the support arrangement), is deductible as a
miscellaneous itemized deduction. (This means it's added to other items in
this category, if any, e.g., investment expenses, and is deductible to the
extent the total exceeds 2% of adjusted gross income.)
To get a tax deduction for the part of your legal fee that represents tax
advice, it's important to have your attorney indicate on his or her bill to
you what portion represents tax-related service. If your attorney merely
submits a bill “for legal services rendered” you may have difficulty
convincing IRS how much, if any, is deductible.
Other legal fees in connection with divorce that may save you taxes
include costs to collect alimony payments (but not costs to resist
collection). Also, if legal work is involved in getting marital assets, the
part of fee allocable to the property can be added to its basis. This can
save you tax when the property is disposed of.
