Introduction: Tax planning done properly is process that will help your clients reach an amicable result. Taxes can also be adversarial, especially if one spouse has committed fraud. The IRS Whistleblower Informant Award is an active program where informants (in some cases ex-spouses) have collected up to 30% of IRS collections. This presentation assumes this situation does not apply. If tax fraud is known to exist, tax attorneys should be consulted.
Many times divorcing couples have competing interests and those factors must be considered when advising the options available as a financial neutral.
A. What Tax Filing Status is most advantageous?
The IRS has established guidelines which limit options. The individual’s status on December 31 of that year determines their marital status.
Married Filing Jointly vs. Separately. Taxpayer is considered Married if it is a common law marriage (state law) or if living apart without a separation maintenance agreement or divorce decree. Some exceptions apply. Typically filing jointly results in a lower tax calculation. Other factors must be considered such as both parties are individually liable for tax shortfalls in the event of an audit.
When returns are filed jointly, both parties have potential liability not only for the current year’s return but for prior years filed jointly as well. Some remedies may apply such as innocent spousal relief or equitable relief, depending on the individual circumstances.
Single. Must file single if the maintenance agreement, divorce, or annulment decree is executed by last day of the year. Exception: Filer is considered married even if divorced if done solely for tax savings reasons and re-marries the same person the following year. Filer is considered married even if there is an interlocutory decree i.e. no final decree by last day of year. Interlocutory decree is not considered a final decree.
Married Filing Separately – usually results in the highest cumulative taxes. MFS lowers IRA contributions and eliminates child tax breaks. This filing method is sometimes beneficial for example, when both spouses earn similar wages or when one has high miscellaneous deductions or excessive healthcare costs. Another reason for filing separately is if divorcing couples have concerns about their spouse’s ethics.
Head of Household - Must be unmarried and living apart for six months or more. Usually yields a lower tax liability than filing as single. It requires a child or relative living in the household. That person does not need to be a dependent.
B. Alimony vs. Child Support
Requires a divorce or separation agreement, temporary decree or any type of court order requiring an ex-spouse to make cash payments for the support.
Alimony is tax deductible while child support is not. Includes temporary maintenance and spousal support.
Alimony examples: housing costs including payments to third parties on behalf of the ex-spouse, as long as payee owns property under the terms of the divorce and/or separation agreement. Payee reports alimony income and deducts mortgage interest. If home is owned jointly, only half of payments qualifies as alimony and deductions are shared based on ownership percentages. If payer owns home, then none qualifies as alimony and payer gets full deductions.
Other alimony examples are spouses medical expenses, tuition, and life insurance if on payer’s life and only if the ex-spouse owns the policy.
Use of Payer’s property
Payments for upkeep of Payer’s property including property taxes and mortgage interest
Lump sum payments as settlement if less than 3 years after divorce. After 3 years is usually OK but there are exceptions and care must be exercised. IRS Sec. 719 (f) prohibits front end loading of alimony payments. If so, the payments will be re-characterized as asset transfers and possibly subject to gift taxes.
Payments that normally qualify as alimony will get disqualified when both parties live in the same household. Exception: One-month rule.
Planning Point: If payee received substantial alimony payments, discuss the need for payer to make Estimated Federal and State tax payments to avoid a surprise tax liability and underpayment penalties.
C. Division of Marital Assets Unless the parties meet the requirements of Section 1041 or Section 2516, property transfers included in divorce decree are subject to income or gift taxes respectively. IRS Section 1041 in general states that no gain or loss shall be recognized on a transfer of property between a former spouse but only if the transfer is incident to the divorce. Agreement must be reached up to 2 years before and no later than 1 year after divorce, otherwise the transaction will be deemed a taxable gift. The transferee’s basis and holding period carries over from the transferor. The property value or debt assumed at the time has no bearing on the calculation of basis. The tax advisor should consider any built it gain/loss at the time of transfer and its impact on the transferee’s future taxes.
If instead it is a cessation of a marriage (annulment, voided marriages) then the period is extended from one year to six years.
Planning Point: Marital assets can be significant and it is crucial that the settlement agreement be properly drafted to consider the ramifications of IRS section 1041.
If there is a third party involved in a transaction, the property is not subject to Section 1041 and it becomes a taxable event. Example: a sculpture owned jointly is sold to a studio. The transaction is a taxable event because the studio is the third party. Any gain or loss must then be reported equally by the parties.
Sale of Primary Residence The best case scenario is when each spouse can exclude up to $250,000 gain for a total of $500,000. There are two tests that must be met. The time period and ownership requirements must both be satisfied. For the time test, one spouse must have lived in the residence for at least 2 of the previous 5 years. When the parties become divorced, the other spouse meets the time period test even though both are not living in the residence. Refer to IRS Publication 523. One spouse must be granted use of and live in the residence (the key is that a divorce or separation agreement is properly drafted and executed) and the other spouse must have moved out. To satisfy the ownership test, the deed must show both names and one spouse must live in the house in 2 of 5 years following divorce and prior to sale. If so, both meet the ownership test and each can exclude $250k of gain. If only one has ownership it will fail the ownership test and only the person who is listed on the deed can exclude the $250k gain and the other ex-spouse has a $0k exclusion. As part of the divorce agreement, the parties agree on how to split the profits. If not 50-50, then each party calculates their respective gain based on the agreed upon percentages and then applies their respective calculated gains against their respective $250k exclusions. If the total gain on sale is $600k and the settlement agreement specified the wife would get 60% of the gain, the wife’s gain on sale of the house is $90k ($600k gain * 60% = $360k, less $250k exclusion = $90k gain. Husband’s gain would be $0 because his share of gain 40% is less than his $250k exclusion.
Sale of the home can come many years after the divorce, such as when the youngest child reaches 18 years old. As long as the time and ownership tests are met, both parents preserve their individual $250k exclusion.
Other factors to Consider:
Stocks owned individually have a different tax basis and, therefore, different unrealized gains or losses – which may result in significantly different capital gains taxes. It is so important consider the tax impact on each party. It may be necessary to compensate one party to arrive at a tax-neutral basis.
Redemption of Stock in a closely held business Sec 1041, gains must be recognized on the deemed distribution. The one who has a primary interest in stock of business reports the gain.
Stock Options Must be considered in the marital assets. There are various ways of valuing them depending on the type of options and the strike price versus current market value and the time frame for exercising the options.
Accrued Investments owned individually Consider the unrealized gain or loss accrued during the marital period in the divorcing year and adjust to become tax neutral.
The Divorce & Separation Agreement typically specifies who cares for the child/children but it is not always the same for tax purposes.
A dependent is defined as a child under 19, (age 24 if a full time student), who lived with you more than half the year, and did not pay half their own support.
Parent is deemed a Custodial parent if child spends more than 50% of calendar nights (or the greater number of nights if college student living away from home or if other qualified living arrangements apply). If equal nights, the parent with lower income prevails per IRS rules. Another option is custodial parent can release custodial status to other parent by filing form 8332. This is a tax planning option.
E. Who can deduct a child’s medical expenses?
Must be your dependent and payments are made directly to provider.
Child must have lived with parent the entire year and parent provided 50% or more of child’s support.
It is possible that neither parent is qualified to claim a child’s medical expenses so careful tax planning is necessary.
F. Tax Strategies for a Single Parent
If Spouses are not legally separated, or divorced, they can file Married Filing Jointly to minimize taxes. Other options are Married Filing Separately and Head of Household but those filing methods usually result in higher taxes. A tax professional can run the numbers to determine the most advantageous approach. Refer to Section A.
Divorced or Legally Separated spouses may have a choice of filing as single or head of household (if they qualify). See Section A.
Utilize all available child related tax credits:
These credits cannot be assigned by agreement of parties. Only the custodial parent is eligible for these credits as long as the income and other criteria are met.
Child Tax Credit - $1,000 per child. Child must be under 17 years old and lived with parent for at least 6 months and must also be your dependent. The credit is phased out completely when custodial parent’s adjusted gross income exceeds $75,000. Alimony is included in the calculation of AGI.
Credit for Dependent Care Expenses – form 2441, up to $3,000 per child or $6,000 maximum for 2 or more children. The amount of the credit ranges between 20% and35% depending on income.
W-2 Gross Income Exclusion for Dependent Care Benefits – This is provided by your employer to offset dependent and child care expenses. It is limited to a $5,000 reduction to Federal and State wages on the employees W-2. Child must be under age 13. Form 2441 takes this amount into account when calculating the allowable credit for dependent care expenses.
Earned Income Credit - The amount of the credit depends on the number of dependents and adjusted gross income. Generally, taxpayers qualify only if their income is in the lower tier. For example, a parent with one child would need to have AGI (including alimony) less than $45k to qualify.
Higher Education Credits and deductions. The most generous is the American Opportunity Credit followed by the Lifetime Earning Credit and then the Student Tuition and Fees deduction.
Merrill is owner and president of Merrill J. Martin CPA LLC, an accounting/tax services firm which also specializes in collaborative divorce and mediation. Prior to 2013, he was Chief Operations Officer and Chief Financial Officer for various companies in the manufacturing and services industries, specifically for Valid USA, Versatile Card Technology, and Philips Electronics.
Merrill’s expertise is in Budgeting, Strategic Planning, Business Development, Corporate Acquisitions, Bankruptcy and Operation Turnarounds; along with Tax Dispute Resolution. Merrill holds a Master’s degree in Finance and Bachelors in Accounting from Fairleigh Dickinson University and is a Certified Public Accountant.