February 9, 2016

Divorce and Taxes

Divorce and Taxes 

Divorce and taxes can be complicated and every divorce has tax implications.  Unfortunately, many lawyers never consider the tax consequences of a property settlement, alimony award or custody award and the financial impact can be significant.   

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Divorce and taxes explained

Disclaimer:   The information provided below should be used as a reference of things to think about when discussing a divorce with your tax professional.  We are lawyers, not accountants.  Do not rely on this information as tax advice.  When appropriate, we hire independent tax experts to resolve tax issues for our clients in the cases we handle.  

Divorce and taxes practice tip #1 – Tax refunds.

In this example, the parties divorce in November of the tax year and the husband receives a large income tax refund in April of the following year.

Under Michigan divorce law, property acquired during the marriage but received after divorce is generally considered marital property subject to division.  Therefore, the wife would be entitled to a share of husband’s income tax refund.  However, the award of the asset is not automatic.  It is not uncommon for lawyers or parties to misunderstand this rule and not award the income tax refund.

Divorce and taxes practice tip #2 – Joint or separate tax return?

What happens if you are divorced in November of a tax year.  Can you file a joint return?  The Internal Revenue Service provides that if you are divorced under a final decree before December 31 of a tax year, you are considered unmarried for the whole year (See IRS Publication 17).   For most taxpayers, filing a joint tax return saves you money.  However, for others, it may cost you more money.  Therefore, consider the timing of the entry of the Judgment of Divorce to maximize your tax savings.

Divorce and taxes practice tip #3 – Dependency exemptions

For many taxpayers, the child dependency tax credit reduces a taxpayers adjusted gross income.  For tax year 2015, the dependent tax exemption reduces a persons adjusted gross income by $4,000.00 (See:  IRS publication 501 ) Michigan courts can award a non-custodial parent the dependent child exemption in a divorce, custody and support case even if it is contrary to the IRS rules.  (See:  Dependent child exemption and child support – Is it worth the fight over?)  Therefore, consider who is awarded the dependency exemption in the divorce settlement.

Divorce and taxes practice tip #4 – Alimony or Spousal Support

As a general rule, alimony payments are taxable to the recipient and tax deductible to the payer.  (See 26 U.S. Code Section 215 – Alimony etc., payments and 26 U.S. Code Section 71 – Alimony and Separate Maintenance payments)

Therefore, consideration should be given to the tax effect of an alimony or spousal support payment in negotiating an award.

Divorce and taxes practice tip #5 – Dealing with tax fraud 

Imagine you discover before, during or shortly after your divorce that you have a large outstanding tax liability.  You may have known nothing about it.  Unfortunately, the IRS will likely hold you equally responsible for all tax due even if the income or improper deduction was the fault of only one party.  Fortunately, the IRS has created a mechanism to provide relief under certain circumstances.  The mechanism is called innocent spouse relief.

Divorce and taxes practice tip #6 – beware of assets that are taxed differently.

In this example, the parties have two assets.   The husband’s 401(k) valued at $100,000.00 and a home valued at $100,000.00 without a mortgage.  Both assets are marital property.

The parties agree that the wife will be awarded husbands $100,000.00 401(k) and the husband will keep the $100,000.00 house.  A 50/50 division of  assets.

A closer look at the taxes and divorce suggest that the settlement is far from fair.

The husband’s 401(k) contains pre-tax dollars.   When the wife converts the asset to cash she is not subject to an early withdraw penalty. (26 U.S. Code Section 72 of the Internal Revenue Code), however she is subject to ordinary income tax on the withdraw.  (As an aside, the wife’s income just increased by $100,000.00 so the tax on the withdraw (2015) is $17,060 and puts her in a 25% tax bracket without consideration of any other sources income.)  Therefore, converting the $100,000.00 401(k) to cash suggests it may actually be worth  less than $75,000.00.

The equity in the home is post-tax dollars.  The value of the home likely not-taxable (See IRS publication 523).  Therefore, converting the home to cash is subject to a 6% real estate commission.  Therefore, converting the home to cash suggests the home is worth $96,000.00.   ($100,000 – 6% real estate commission)

So in this example, what first appeared to be a 50-50 division of an asset is more like 57% to husband and 43% to wife and thousands of dollars.

The Law – Cases and statutes Divorce and taxes

The following resources are provided for your reference on taxes and divorce.

26 U.S. Code Section 72 of the Internal Revenue Code:  Tax rules for Annuities and proceeds of endowment and life insurance contracts.

IRS publication 523 – Selling your home.

IRS publication 501:  Exemptions, standard deduction and filing Information

IRS publication 502:  Medical and Dental Expenses

IRS publication 503:  Child and Dependent Care Expenses

IRS publication 504:  Divorced or Separated Individuals

IRS publication 521:  Moving expenses

IRS publication 523:  Selling your home

IRS publication 551:  Basis of Assets

IRS publication 575:  Pension and Annuity income

IRS publication 939:  General Rules Pension and Annuities

IRS publication 972:  Child tax credit

26 U.S. Code section 215:  Alimony payments

26 U.S. Code section 71: Alimony and separate maintenance

IRS tax topic 205:  Innocent Spouse Relief

Articles – Divorce and taxes

Child tax exemption and Michigan law.

Child tax exemption and Michigan law.

Tax exemptions, tax deductions and Michigan divorce

Michigan divorce law update: Alimony and tax considerations.

Taxes and divorce

Taxes and Innocent Spouse Relief – Lindsay Lohan, Pamela Anderson, Nicolas Cage, Wesley Snipes and You.

Michigan Divorce and Innocent Spouse Relief

Michigan Divorce and Innocent Spouse Relief

Dependent child exemption and support – Is it worth fight over?

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Taxes and Innocent Spouse Relief – Lindsay Lohan, Pamela Anderson, Nicolas Cage, Wesley Snipes and You.

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