Divorce is tough. Even amicable divorces are financially and emotionally draining. The last thing you need is to have tax problems pop up as a result of divorce proceedings. To avoid such problems here’s a list of some top tax considerations to keep in mind:
If you itemize your deductions on Schedule A, you may be in luck. While your legal and court fees are not deductible, other fees related to your divorce may be deductible. Importantly, deductions may be taken for divorce-related tax advice. The advice can pertain to federal, state, and/or local taxes. Also, the advice is not limited to income tax; it may pertain to advice on estate, gift, inheritance and property taxes as well.
Another deductible fee is that paid for services specifically related to getting or collecting alimony. Look to see if you are charge a handling fee for this service.
Alimony has a “two-sides of the same coin” aspect. On the one side, alimony must be included in the gross income of the former spouse receiving the alimony payment and it is taxable to that spouse. On the other side, that same alimony is deductible to the former spouse making the alimony payment. It sounds straightforward, but the devil is in the details.
To avoid mistakes, be clear on the IRS definition of alimony. Generally, alimony must be:
- A payment made under a written divorce or separation instrument, and
- A payment made in cash.
It’s not considered alimony if:
- The divorce or separation agreement doesn’t designate the payment as alimony,
- The spouses are members of the same household (this applies only to spouses who are legally separated under a decree of divorce or separate maintenance), or
- The payments are required to be made after the death of the recipient spouse.
Alimony recipients should also take care to make quarterly estimated tax payments on their alimony. Not making these payments can result in penalties, which often surprise taxpayers, especially if they are on a tight budget. To avoid these penalties, the other option is for the recipient to increase their withholding amount through their employer.
Child support is not taxable to the recipient, nor is it tax-deductible by the payer. Again it sounds straightforward. Where people get tripped up is when the payer is required to pay both alimony and child support, but only partially meets the payment requirements in a taxable year. In those cases, the payments first apply as child support, and then as alimony.
For the payer, this means that only the excess over the amount of child support required to have been paid can count as alimony, and therefore be deductible. So if the payer made total payments of $2,000, but was supposed to have paid $1,500 in child support and $1,000 in alimony, only $500 would be deductible as alimony and the rest would count as child support.
As for the recipient, they only include in gross income the alimony actually received in a taxable year. In the situation described above, only $500 is taxable as alimony. Recipients should be careful not to include any unnecessary amounts into income.
Non-Recognition: Generally, property settlements between divorcing spouses are not taxable. Unlike other exchanges of property, no gain or loss will be recognized. We have Code Section 1041 – Transfers of Property between Spouses or Incident to Divorce – to thank for that. This applies broadly to real or personal, tangible or intangible property. Property eligible for this treatment extends beyond real estate or brokerage accounts and may include interests in a Health Savings Account or an IRA.
To qualify, property settlement transfers must either:
- Occur within one year after that date your marriage ends, or
- Be related to the end of your marriage. This means:
- The transfer must be made under the original or modified divorce or separation agreement, and
- The transfer must occur within six years after the date your marriage ends.
There are some exceptions, such as when your soon-to-be former spouse is a non-resident alien, when there are transfers in trust, and when there are transfers of certain stock redemptions.
Gift Tax: Most divorcing couples won’t be affected by this, but divorces where the stakes are high may be impacted by gift tax consequence. This could occur if the transfer wasn’t considered “incident to divorce.”
Deciding on Filing Status
While you are still married, you and your soon-to-be-former spouse can decide whether you want to file your taxes as married, filing jointly or as married, filing separately. Married filing jointly status provides you with the more preferred tax rates, exemption amounts and tax credits. This status is more likely to reduce your tax liability. If you choose married, filing separately, you won’t get the same filing benefits.
However, if you file married filing jointly, both spouses become jointly and individually liable for taxes, penalties, and interest due on that return. This means that if your former spouse can’t pay, you may be held liable for the full amount. There are some situations in which relief from joint liability is granted, but, it can be difficult to attain.
Think carefully about this decision before you sign. This can be especially true if your spouse is reporting income from a business they own or deductions lacking adequate documentation. Even if your divorce decree has a clause stating your spouse is liable, the IRS may still pursue you for payment if your spouse is unreachable.
Informing the IRS of Your New Address
If the IRS is trying to contact you, you’re going to want to know about it before the penalties and interest start adding up. So, during the divorce and after, make sure you have informed the IRS of any new address you might have. You’ll be in a better position to resolve problems the sooner you hear about them.
The easiest way to do this is by filing your tax own return with your new address. If your address changes between filing timeframes, submit IRS Form 8822. Don’t rely on your estranged or former spouse to forward IRS notices. If you don’t receive the notices on a timely basis, the fact that your estranged or former spouse withheld them typically will not provide an excuse of any merit to the IRS.
The world is becoming a smaller and smaller place. In the past, you often heard stories of the moneyed-spouse sneaking assets into secret accounts overseas. Anyone thinking of doing that should re-think their plan. And quickly. With FATCA (Foreign Account Tax Compliance Act), foreign banks and other foreign financial institutions are now reporting foreign assets held by their U.S. account holders to the IRS.
In fact, in November 2015, a plastic surgeon in Alaska was convicted in federal court of wire fraud and tax evasion for hiding about $5 million in accounts in Panama and Costa Rica. In addition to being sentenced to 48 months in prison, he was assessed with $500,000 in additional taxes, $26,000 in court costs, and restitution for the doctor’s ex-wife was under consideration.
Separately, sometimes people set up foreign financial accounts for good reasons. They may have been working on a foreign assignment or they set up a foreign account before they moved to the U.S. If these accounts meet the reporting requirements under FATCA or for an FBAR (Report of Foreign Bank and Financial Accounts), the owners or owner should come into compliance before the divorce proceedings take place. Depending on the situation, taxpayers have a few different options to become compliant, especially if the non-reporting of these accounts or assets was unintentional – or non-willful conduct, in IRS terms.
Not reporting such accounts and assets before a divorce may make it harder for taxpayers to be eligible for reduced penalties under the non-willful conduct regime by creating a perception that the delay was intentional. If failure to file an FBAR is determined to have been willful, the penalty may potentially be “equal to the greater of $100,000 or 50% of the balance of the account at the time of the violation.”[i] Also, if the IRS can interpret the conduct to be willful, they may pass the case onto the Department of Justice for criminal prosecution. Divorce is stressful enough without these types of issues lurking in the background.
A Word About IRAs and Pension Plans
A lot of tax headaches result when account holders of pension plans and IRAs try to transfer assets in these type of accounts without having the proper written documentation in place.
First, interests in a pension or profit-sharing plan should only be transferred to an estranged or former spouse, child or other dependent when there is a QDRO in place. A QDRO is a “qualified domestic relations order” which “creates or recognizes the existence of an alternate payee’s right to receive, or assigns to an alternate payee the right to receive, all or a portion of the benefits payable with respect to a participant under a retirement plan…” A property settlement agreement is not an adequate document to transfer interests and without a QDRO a taxable distribution may be triggered.
On the other hand, transferring interests in an IRA does not require a QDRO. Transfers can be made if they are pursuant to a divorce decree or separate maintenance or written instrument incident to the divorce decree. If one of these documents instructs the transfer, the transfer will not be taxable.
In either case if the requirements aren’t properly followed, a transfer can be considered an early distribution and subject not only to tax but also to early distribution penalties.
The above provides a brief overview of some of the tax issues which can be encountered as a result of divorce. While it’s not a complete how-to when it comes to taxes and divorce, it touches on some important points to be aware of. Divorce is overwhelming and exhausting, but the last thing you want are ongoing problems, post-divorce, with an ex-spouse. Before the divorce decree, or any other written instruments related to the divorce, is final, make sure you fully understand how taxes will impact you, both presently and in the future.
[i] This is the statutory ceiling and, according to the Internal Revenue Manual, the IRS examiner has some discretion in applying penalties. For more on this see, I.R.M. 22.214.171.124.5.3.
The material in this publication does not constitute legal advice. It is intended for general information purposes only. If you have questions or need assistance with taxes related to a divorce, the attorneys at M. Robinson & Company may be able to assist you. Please feel free to contact us at 617-428-6900.
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