Unfortunately, in addition to the difficult personal issues the
process entails, several tax concerns need to be addressed when facing a
divorce or legal separation to ensure that tax costs are kept to a minimum and
that important tax-related decisions are properly made.
Support Provisions: Support payments required to be made from one spouse to
another upon divorce or separation are deductible by the payor and taxable to
the recipient if they qualify under the tax rules for "alimony." There
are several factors that are used to determine if support payments qualify as
alimony.
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.
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.
Dependency exemptions: To some extent, the parties can determine who's 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.
The dependency exemption entitles the spouse who claims it to
more than just the exemption. For example, the child tax and the higher
education credits are only available to the spouse who claims the child as a
dependent.
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).
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.
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. If a specific IRS-approved method
for transferring the IRA from one spouse to the other is not used, the
transaction could be treated as a taxable distribution (possibly also
triggering penalties).
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; 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 complex issues
may arise involving partners' shares of partnership debt, capital accounts,
built-in gains on contributed property, and other complex issues. The parties
involved should 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. Second, the property to be left by the spouses may have
changed hands via a property settlement. 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.
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'll need to establish cost when these assets
are eventually sold.
Filing status: 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're treated as still married even if you're separated from your spouse under
a separation agreement or "nonfinal" decree. In this case, you may
still file jointly with your spouse, which 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. It also requires contact between the parties to prepare the
joint return, which may not be desirable in some circumstances. The other
available filing status is "married filing separately," which is the
least favorable status.
Adjusting income tax withholding: 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'll be moving, or if you're changing your
name because of divorce, file Form 8822 with IRS so you'll receive any notices
or correspondence from IRS promptly.
We hope this overview of a complex area has been helpful to you.
Please contact
us if we can be of assistance
regarding any of these matters.
