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.