What Are Some Tax Consequences That Should Be Considered In A Divorce?
The following is an article written for the California Society of CPAs, written by Beverly Brautigam, CPA/PFS – www.divorcetaxcpa.com
Tax Aspects of Divorce for the California Practitioner
Whether to file a joint return or not:
If married on the last day of the year, the parties have the option of filing a joint return or married filing separately. There might also be the possibility of one or both of the spouses qualifying as head of household. They must be separated for more than half the year and provide a principal place of abode for a qualifying child, to qualify as head of household.
Often, two married filing separate returns result in more income tax due than would be due on a joint return. This is, however, not always the case.
If there is other than a joint return for the year in which separation occurred, care must be taken to determine who reports what income and withholding. Absent a prenuptial agreement to the contrary, earned income until separation is community (reportable 50/50 by each spouse) and earned income after separation is the separate income of the spouse who earned it. Keep in mind that self-employment tax is assessed without regard to community-property laws.
For example: Wife earned $70,000 of SE income, consisting of $20,000 of community income. Husband would report $10,000 of ordinary income not subject to SE tax, wife would report $60,000 of ordinary income but $70,000 would be on her SE form.
Income from a community-property asset is reported 50/50 until the asset is awarded to one spouse.
For example: The parties’ rental property generated $10,000 of taxable income for the year in which the parties separated on July 1. Their marital settlement agreement (MSA) was finally signed on March 1 of the following year and awarded the rental property to husband. It did not have an effective date of the division of the rental property stated in the agreement. They would each report $5,000 of taxable income in the year of separation and they would each report half of the taxable income the next year through March 1. Husband would report the balance of the income received after March 1st.
If withholding, estimated income tax payments or the overpayment from the prior year applied to this year is going to be claimed by a spouse whose social security number it is not under, be sure to write to the IRS and FTB and have them apportion the taxes between the spouses prior to filing tax returns. Both spouses should sign these letters of instruction. The address to use for the FTB is:
Joint Estimate Credit Allocation
Taxpayer Services Center
Franchise Tax Board
P.O. Box 942840
Sacramento, CA 94240-0040
Date of separation:
Generally, the date of separation is the date that earned income ceases to be community (Poe v. Seaborn, 282 U.S. 101 (1930).) This date is very important. Confirm this date with your client’s attorney! Prior to the date of separation the earned income and withholding would be reported 50/50 by each spouse.
Marriage Tax Penalty & Decree of Legal Separation:
Two single returns often result in less overall tax than the tax on a joint return. The reasons for this are several fold. Generally, the reason is that the joint return is considered to be one taxpayer and two single returns are considered to be two taxpayers and there are many, many items in the Internal Revenue Code that have an allowance or a limit PER TAXPAYER. One of the most common examples of this is the capital loss deduction of $3,000 PER TAXPAYER.
The ability to file a single return is available if the parties are divorced on December 31st or if they have obtained a decree of legal separation by December 31st. If they have a decree of legal separation, they are considered unmarried for tax purposes; they cannot file a joint return. You would want to actually see the judgment and not take your clients’ word for it. Many people think they are legally separated because they are, in fact, separated and they know it is not illegal!
Interestingly, there is no waiting period to obtain a decree of legal separation (and there is a 6-month waiting period to obtain a dissolution of marriage in California.)
Coordinating with divorce attorney:
If filing other than a joint return, be certain to ask your client’s attorney if there are any separate-property issues. You wouldn’t want to report, for example, 50% of the taxable income from rental property if it is your client’s position that the rental property is his separate property (you would, instead, report 100% of the income for the year; a tax position consistent with your client’s legal position.)
If the parties do not agree on the date of separation, the character of income (community or separate), the allocation of tax payments, or any other items you need to know in order to prepare income tax returns (or are refusing to provide tax documents), let your client’s attorney know in writing as soon as you discover the problem. The cover letter should refer to an attached list of items (this makes it simple for the attorney to write to opposing counsel and attach your list.)
Type of process:
Most people are familiar with the adversarial process for divorce. This is where each spouse is represented by an attorney and they proceed with the expectation of going to court if they don’t settle the case.
Mediation, as an alternative, has been the most prevalent form of alternative dispute resolution. This is where one attorney acts as a neutral to facilitate, through a series of meetings with the couple, achieving an agreement.
A relatively new process to California is Collaborative Divorce. This is where each spouse is represented by an attorney and all four people have signed a contract that indicates that should the process fail (they don’t reach an agreement), then the two attorneys are out of the case; they cannot continue to represent their client. So, everyone is committed to reaching an agreement and the, “I’ll see you in court” threat doesn’t exist. This is becoming more and more popular. The process typically uses the services of neutral experts.
Out-spouse’s ability to exclude gain from the sale of the residence:
This article assumes the reader understands the basics of Section 121 regarding the exclusion of gain from the sale of one’s personal residence.
Interestingly enough, when this legislation passed, divorcing couples were considered. One is deemed to be using a residence as one’s residence during any period of time that one’s spouse, or former spouse, is granted the use of the home. In other words, if husband moves out and even buys a new principal residence and the wife is granted the use of the home in the divorce agreement and the parties both stay on title and the house sells 10 years later, husband will be deemed to have lived in the home and, as long as he hasn’t sold a different principal residence within two years, will qualify to exclude $250,000 of gain on the sale of his half of the house. Obviously this assumes that the tax law remains the same.
Agreement doesn’t control tax consequences:
Generally, it doesn’t matter if the marital settlement agreement or minute order or judgment states that something is deductible or that something is taxable or that someone can file as head of household or that one of the spouses will report the sale of property, etc. What is controlling is the Internal Revenue Code. Child support and alimony are two areas where we cannot look to the agreement for the tax consequences; we must review the tax rules.
Child Support: There are three ways a payment from one parent to the other can be considered to be child support:
- The payment is called child support. This is called “fixing” the payment as child support.
- There is to be a decrease in the amount of family support or spousal support tied to a contingency of a child of the payor parent.
An example of this is: $5,000 per month until Johnny (child of payor) graduates from high school, when the payment will decrease to $3,000. Here only $3,000 is potentially considered alimony as the $2,000 is child support for tax purposes (not deductible by payor or taxable to recipient.)
- There is to be a decrease in the amount of family support or spousal support associated with a contingency of a child of the payor parent. This rule is a rebuttable presumption that the amount of the decrease is child support.
There are two tests:
a. 6-month rule. If there is a decrease in the amount of support within 6 months of a child of the payor parent turning 18 or 21, the amount of the decrease is presumed to be child support (Temp. Reg. Section 1.71-1T(c) Q & A 18.) The law actually says 18, 21 or age of majority; in some states there are three ages to worry about.)
An example: $5,000 a month until June 1, 2006, when it decreases to $3,000. Johnny’s DOB is 10/27/1988. Since Johnny will be 18 years 7 months and 5 days old (over 18 years and 6 months,) this is an example of how one could successfully draft around this rule.
Note that it is 6 months before and after turning 18 and 21 that are the ages to be considered.
b. 24-month rule. Actually this is called the multiple-reduction rule. If there are two or more reductions at times when the children of the payor parent are not different by more than 24 months, the reduction is presumed to be child support. Here we consider children between the ages of 18 and 24, inclusive.
An example: Alimony is ordered at $6,000 per month, reducing to $4,000 per month on August 1, 2006, and reducing to $2,000 per month on February 1, 2008. The children’s birth dates are July 1, 1983 (Mary) and November 1, 1984 (John.) Mary will be 23 years 1 month old at the first reduction date (8/1/06) and John will be 23 years 3 months old at the next reduction date (2/1/08). Since these two ages are not different by more than 24 months, the reduction of $4,000 per month (from $6,000 to $2,000) will be presumed to be child support.
Alimony: This is a prime example of the agreement not controlling the tax consequences. “Spousal support” is what is awarded in the state of California. “Alimony” is the number on a tax return. They are often different numbers – often to the surprise of the court, the attorneys and the parties.
The rules for alimony include ALL of the following:
- At the time of payment, the payment needs to be pursuant to a written separation agreement or court order (Ali v. Commissioner, T.C. Memo 2004-284 (12/27/04).)
- The payment needs to be made in cash.
- The payment needs to be received (Therefore, a check put in the mail on 12/31 becomes alimony in the next calendar year.
- The payment cannot be considered to be child support (see above.)
- The parties cannot have elected out of alimony treatment pursuant to IRC Code Section 71 (b)(1)(B.)
- The parties do not file a joint return together (however, the payor could be filing a joint return with a new spouse.)
- If the parties are divorced or have a decree of legal separation, they may not be members of the same household.
- The liability to pay must terminate at the death of the payee.
The payments have to meet all the above rules to be considered alimony, even if the MSA states that the payments are deductible to the payor and taxable to the payee!
If alimony pursuant to a permanent order decreases too quickly by too much, there will be alimony recapture. When there is, the amount of the recapture is included in the payor’s income and is an “above-the-line deduction” to the payee in the same amount.
Alimony pursuant to a permanent order is compared in three calendar years beginning with the first calendar year in which there is alimony pursuant to a permanent order. And the amount of alimony in that first year is only the amount paid pursuant to the permanent order (in other words, payments made pursuant to a temporary order are not considered.) If there is recapture it will be in the third year.
The formula compares alimony in year 1 to that in year 2, alimony in year 2 to that in year 3 and alimony in year 1 to that in year 3. A useful quick check is that there is no recapture if Year 2 is greater than or equal to Year 1 minus $7,500 and Year 3 is greater than Year 2 minus $15,000.
The only exceptions are if the decrease is due to death or remarriage or if the order was a percentage of income order and the income decreased.
How to get the stock options to the non-employee spouse:
Revenue Ruling 2004-60 explains how nonqualified stock option (NQ) income is taxed in a divorce. It sets forth how to divide the community options and how the non-employee spouse will receive a Form 1099, reflecting the income and the income tax withholding under that spouse’s social security number. It also explains that the FICA withholding will appear on the employee’s W-2.
Private Letter Ruling 200519011 addresses the division of incentive stock options (ISOs) in a divorce. In essence, the non-employee spouse steps into the shoes of the employee spouse. There is no disqualifying event. All the income tax withholding will be that of the non-employee spouse.
It is the unusual divorce attorney who understands the intricacies of our federal and California income tax laws. As tax professionals, we have the opportunity to help our clients structure their divorce settlements and be in compliance with these laws. At the same time, we can help the parties structure their settlements to pay the least amount of tax and result in the least amount of difficulty in tax return preparation. We need to review our clients’ marital settlement agreements for any tax consequences and explain to them and to their attorneys if the tax consequences are different from what the agreement states they will be.