Going through a divorce can be a difficult and stressful time. To make matters worse, a divorce can have significant tax implications to the parties. The attorneys at Allison & Mosby-Scott can help clients navigate the complexity of a divorce, including the tax issues that arise out of a divorce. To find out more, please visit our web-site or call us at 309-662-5084.
Tax Filing Status Considerations in a Divorce
Under the Internal Revenue Code, there are five tax rate schedules for taxpayers:
- head of household;
- married filing separately;
- married filing jointly; and,
- qualified widow(er) with dependent child.
Parties to a divorce need to determine the best filing status. While filing jointly will generally result in the lowest overall tax liability, this can vary depending on a number of factors such as:
- the assets owned by each spouse;
- the income earned by each spouse;
- whether one or both of the spouses have made or failed to make estimated tax payments;
- whether one spouse is likely to incur future tax liability for taxes owed during the marriage; and
- whether one spouse would qualify for head of household status.
To file jointly, the parties must be legally married on December 31 of the tax-year. Spouses who file married filing separate returns usually have the option to amend their returns to file a joint return with his or her spouse within three years of the original tax return due date. Spouses who file a joint return may not later amend their returns to file separately. Therefore, if the parties cannot initially agree how to file, the best approach is to initially file separate returns as they can later amend to file jointly.
Filing jointly does have risks, though. For example, both spouses have joint and several liability for all tax due on the return, including interest and penalties. If one spouse fails to pay the tax due on the return, the other spouse may be required to pay the full amount of the joint tax liability. The IRS may also levy and seize a spouse’s non-marital assets to pay the tax debt of the other spouse. On the other hand, if the parties file separately, each spouse’s tax liability is determined separately, and a spouse is not responsible for paying the other spouse’s tax debt.
Even if a spouse files jointly, he or she may be entitled to “innocent spouse relief” under IRC §6015(b). In order to receive innocent spouse relief, a spouse must meet all of the following:
- He or she must have filed a joint return which has an understatement of tax;
- The understatement of tax must be due to erroneous items of the other spouse; and
- He or she must establish that at the time he or she signed the joint return, he or she did not know, and had no reason to know, that there was an understatement of tax;
Innocent spouse relief must be requested within 2 years after the date on which the IRS first began collection activity against him or her. Even if a spouse had actual knowledge, the spouse may be entitled to innocent spouse relief if he or she did not challenge the other spouse due to fear of domestic abuse.
Even if a spouse does not qualify for innocent spouse relief, he or she may qualify for “separation of liability” under IRC §6015(c) or “equitable relief” under I.R.C. §6015(f). To qualify for separation of liability, the spouse must have filed a joint return and meet either of the following requirements:
- The parties are no longer married or are legally separated;
- The parties are not members of the same household at any time during the 12-month period ending on the date of filing Form 8857.
To qualify for equitable relief, all of the following conditions must be met:
- The party is not eligible for innocent spouse relief, relief by separation of liability, or relief from liability arising from community property law;
- The parties did not transfer assets to one another as a part of a fraudulent scheme.
- The parties did not transfer property for the main purpose of avoiding tax or the payment of tax.
- The spouse seeking relief did not file or fail to file your return with the intent to commit fraud.
- The spouse seeking relief did not pay the tax (although the spouse may be entitled to a refund).
- The spouse seeking relief can establish that, taking into account all the facts and circumstances, it would be unfair to hold him or her liable for the understatement or underpayment of tax.
- The income tax liability from which the party seeks relief must be attributable to an item of the spouse (or former spouse) with whom the party filed the joint return, unless one of the following exceptions applies:
- The item is attributable or partially attributable to the spouse seeking relief solely due to the operation of community property law. If you meet this exception, that item will be considered attributable to the other spouse (or former spouse) for purposes of equitable relief.
- If the item is titled in the spouse’s name who is seeking relief, the item is presumed to be attributable to him or her. However, the spouse seeking relief can rebut this presumption based on the facts and circumstances.
- The spouse seeking relief did not know, and had no reason to know, that funds intended for the payment of tax were misappropriated by his or her spouse (or former spouse) for his or her benefit.
- The spouse seeking relief can establish that he or she was the victim of abuse before signing the return and that, as a result of the prior abuse, he or she did not challenge the treatment of any items on the return for fear of retaliation.
- The spouse seeking relief establishes that his or her spouse’s (or former spouse’s) fraud is the reason for the erroneous item causing the understatement of tax.
If the parties have children, one or both of the spouses could be eligible to file as head of household. Head of household generally results in a lower tax liability than filing single. Generally, the party who has the children more than one-half of the year may claim head of household filing status. If the parties have more than one child and each party has at least one different child living with him or her for more than one half of the year, both parties can file as head of household. Filing as head of household may also qualify the tax-payer for other tax benefits such as the Dependent Care Credit and the Earned Income Tax Credit.
In some situations, a spouse who is not yet legally divorced can qualify for head of household. This can occur is the party has lived apart from his or her spouse for the last six months of the taxable year and provides more than half the cost of maintaining a household that is the principal place of abode of the dependent child for more than half the year.
Child Support and Maintenance Deductibility
Generally, child support payments are not deductible to the payor and are not included in the payee’s gross income. The Tax Cuts and Jobs Act repeals the deduction for maintenance (alimony) for divorces finalized January 1, 2019 and after. For divorces concluded before January 1, 2019, maintenance payments are deductible to the payor spouse and included in the recipient spouse’s taxable income. Be aware that for divorces concluded before January 1, 2019 the various recapture rules also still apply.
Taxation of 401(k)s and Traditional IRAs in a Divorce
Divorcing couples will have to address how marital property is divided between them, this includes pensions, 401(k) plans and individual retirement accounts (IRAs). To transfer assets in a retirement plan subject to ERISA, such as pensions and 401(k) plans, it is necessary for the court to issue a Qualified Domestic Relations Order (QDRO). The transfer of 401(k) funds or pension funds in divorce cases are not taxable transfers. Moreover, the transfer of 401(k) funds is not considered an early withdrawal and is not subject to the 10% early withdrawal penalty. Once the 401(k) funds are transferred from the Participant spouse’s account, the recipient spouse has the option to receive the funds in cash or may roll the funds into his or her own IRA or other retirement account. If the recipient spouse elects to receive the funds in cash, there is a mandatory 20% withholding for federal income taxes. Depending on the state of residence, there may also be state withholding. The withdrawal will ultimately be taxed at the recipient spouse’s regular income tax rate. If the funds are rolled directly into the recipient spouse’s retirement account, the transfer is tax free and the funds then become subject to the distribution rules of the 401(k) or IRA. This means that if a recipient spouse wants to access the funds after a roll-over, that the 10% early withdrawal penalty will be assessed. Thus, if the recipient spouse wants to take cash, it should be done before the amounts are rolled over.
A QDRO is not necessary for a spouse to transfer funds in an IRA funds to the other spouse in a divorce. Most financial institutions that sell IRAs have forms that the parties can fill out to accomplish the transfer. Transfers of IRA funds in divorce cases are not taxable transfers as long as long as the recipient spouse rolls the funds into his or her own IRA or other retirement account. Unlike in a 401(k) transfer, the recipient of IRA funds in a divorce does not have the option of receiving the funds in cash without paying the 10% early withdrawal penalty, as the except in the Internal Revenue Code only applies to withdrawals pursuant to a QDRO.
Finally, with some qualified plans, such as pensions, the plan will not distribute assets pursuant to a QDRO until the plan participant experiences a triggering event. A triggering event is usually reaching retirement age or being separated from service. Some plans consider a QDRO a triggering even, but this is not the norm.
Property Distributions in a Divorce
Under the general rule of 26 U.S. Code § 1041(a), a transfer of property to a former spouse incident to divorce will not cause the recognition of gain or loss. A transfer of property is incident to a divorce if the transfer occurs within one year after the date on which the marriage ceases or is “related to the cessation of the marriage” which requires that the transfer:
- Is pursuant to a divorce or separation instrument, and
- Occurs not more than six years after the date on which the marriage ceases.
A divorce or separation instrument includes a modification or an amendment to the decree or instrument under IRS regulations.
If the transfer is not made under a property settlement agreement incorporated into a divorce decree, it may still not be subject to gift tax under 26 U.S. Code § 2516. Sec. 2516 provides that transfers of property or interests in property in settlement of marital property rights are treated as made for full and adequate consideration if the transfers are made pursuant to a written agreement and the divorce occurs within a three-year period beginning one year before the spouses enter into the agreement.
Capital Gain and Loss Considerations in Allocating Assets
In analyzing a divorcing couple’s assets for purposes of dividing those assets in a divorce, it is important to determine if there are any unrealized gains or losses on those assets. In many divorces, assets are divided by fair market value or other equitable manner without consideration of the unrealized capital gains or losses. The problem becomes when one spouse liquidates the assets or transfer the assets to another investment vehicle, it will trigger the capital gain or loss. If it triggers a capital gain, the additional tax owed effectively lowers the share of assets the party received in the divorce settlement. If it triggers a capital loss, that loss can off-set other capital gains and lower the tax liability of the party, effectively providing more assets to that party. An example may help illustrate the issue:
If one party receives an asset worth $200,000 with an unrealized long-term gain of $50,000, and the other party receives a savings account worth $200,000, the party who receives the asset could have a tax consequence of $7,500 (assuming 15% log-term capital tax rate) if he or she liquidates the asset. Thus, one party will receive after tax cash of $200,000 while the other will effectively only receive $192,500 as the additional taxes of $7,500 effectively lower the share of assets the party received in the divorce settlement.
Capital Loss Carry-Forward
A capital loss results when a capital asset is sold for less than the taxpayer’s basis in the asset. If net capital losses in a given tax year exceed net capital gains by more than $3,000, any excess must be carried over to the following tax year. This “capital loss carry-forward” can often have significant value because of future tax savings and should be accounted for when dividing property in a divorce. The IRS allows a capital loss carry created by the sale of jointly owned property to be assigned to a particular spouse or allocated between the parties. If carry forward is a result of solely owned assets, only the spouse who owned the asset can claim the capital loss carry forward. Even in these cases, the capital loss carry-forward asset should still be accounted for when dividing marital assets.
The Marital Home
Generally, the Internal Revenue Code allows the exclusion of a gain of up to $250,000 on a separate return or $500,000 on a joint return on the sale of a principal residence if the residence is owned and used by the taxpayer for two out of five years prior to the sale. If a spouse received the marital home in a divorce, he or she may include the ex-spouse’s ownership period in determining whether the two-year test is met.