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Tax Issues in Family Law

|Law Offices of Kathryn Irene Phillips|

Every family law case involves some aspect of tax law. The purpose of this article is to help parties involved in family law cases to be aware of some of the tax issues of their cases. The information in this article is of a general nature and is not intended to apply to any specific case.  The nuances of tax law are too complex to present a definitive presentation here and you are, therefore, advised to seek the advice of your tax professional on all tax aspects of your case.

 Four of the general areas of family law impacted by taxes will be discussed in this article: 

  • Support
  • Dependency Exemptions
  • Property Divisions
  • Deductibility ofAttorneyFee


 SPOUSAL AND CHILD SUPPORT

CHILD SUPPORT: The most common impact of taxes in family law is first seen in the calculation of child support and temporary spousal support.  In California, it is mandatory to first determine child support pursuant to the Guidelines set forth in the Family Code before the court can vary from that amount.  The tax filing status, number of exemptions, and certain deductions allowed from the parties’ gross income are applied to determine the net spendable income available for support. A formula set forth in the Family Code is then used to determine the amount of support. That formula is so complex that it must be performed by a computer program. A common program used by the courts for this is Dissomaster.  The DCSS also has its own program for calculation of Guidelines child support. These same computer programs also calculate an amount that the court may award as temporary spousal support. Spousal and child support are not tax deductible to the payor.

Dissomaster and other programs like it also have the capability of suggesting shifting the tax burdens of the parties so that money that would have been paid as taxes can actually be paid as support. This tax shifting is called arbitrage and is most impactful when one party is a very high earner and one party has little or no income. The benefit of arbitrage is that the high earner will pay fewer taxes and the low earner will receive more support. This is something to bear in mind in settlement negotiations and, in the right situation, is a win-win solution for both parties.

 WHETHER TO FILE JOINT OR SEPARATE TAX RETURNS:
Generally, spouses will pay fewer taxes if they file jointly.  However, the downside of this is that this presents several issues, such as, who will pay the tax due, who will receive the refund, and who pays the estimated taxes. The big risk in this is if one party, such as a business owner, underreports income and exaggerates deductions. Both parties are jointly and severally liable for the taxes and penalties due on a joint return.  If you don’t trust the other party, then don’t file together.

 If you do file jointly and the IRS determines an arrearage due, there is an innocent spouse provision in the Internal Revenue Code. This requires that the innocent spouse knew nothing about the underpayment and did not benefit from the nonpayment of taxes. This provision is not automatically granted and many spouses are relieved, but many are also denied relief from the tax liability on a jointly filed return. This is true especially when the parties’ business has been the sole support of the parties’ household during the marriage, paid for their cars, lifestyle, etc.

IRC 66, requires that each party report one-half of the community property income on their separately filed returns. This is a problem in divorce, because one spouse may not know the extent of the other party’s income or investments. There is also an innocent spouse provision for this situation, but, again, it is not granted automatically.

If you have children from a prior relationship and are paying child support, that may be one reason to file separate returns with your current spouse.  The parent of those other children in a support hearing will be entitled to your tax return.  If you file separately from your current spouse, then your current spouse’s income tax return will not be available to the parent of those other children in a support proceeding. If you file jointly, however, then the return, showing both your and your current spouse’s income, will be available to the parent of those other children.

 DEPENDENCY EXEMPTIONS
 Which party will have the children’s exemption affects the amount of taxes the parties will pay and triggers tax planning and negotiation in divorce settlements.

 IRC 152(e) sets forth the rules for determining which parent is entitled to take the child’s dependency exemptions.  If the child receives over one-half of the child’s support during the calendar year from the child’s parents who are divorced or separated under a written separation agreement, or who live apart at all times during the last six months of the calendar year, and such child is in the custody of one or both of the child’s parents for more than one half of the year, that child will be treated as a qualifying child or qualifying relative of the noncustodial parent for the calendar year. 

The general rule is the custodial parent will receive the dependency exemption and will be eligible to claim head of household status.  Do keep a journal of where the child stayed during the year because, although the divorce decree may say one parent has physical custody, the child may actually be staying more than half of the year with the other parent who is paying support.  You must keep records to support your claim of head of household based on where your child was actually staying during the year in case your return is questioned by the IRS.  Such inquiry may occur years after the fact.  

The parties may reach an agreement that the noncustodial parent will have the dependency exemption to help shift the tax burden between a high-income earner and a lower-income earner. One caution is that when income reaches a certain high level, the entire benefit of the dependency deduction has been phased out, thereby wasting the exemption. As the maximum amount of a party’s Adjusted Gross Income has reached the limit as this amount changes from time to time.  

FORM 8332: This is the form that is used to transfer a child’s dependency exemption from one parent to the other. This form is available to be downloaded from the IRS website. This form must be attached to the noncustodial parent’s tax return to show that the noncustodial parent is entitled to take the child’s deduction.  Remember to have this executed at the same time as your Judgment or other child support orders are signed. 

EXEMPTION FOR COHABITANT: The cohabitant of a taxpayer can be a qualifying relative pursuant to IRC 152(d) if that cohabitant is not a spouse and has resided with the taxpayer for the entire taxable year in the same principal place of abode and their relationship is not a violation of the law.  The phrase “not a violation of law” doesn’t have application in California because adultery was decriminalized decades ago in California. However, there may be some states that still do have such restrictive statutes in this regard which may prevent a taxpayer from claiming this exemption. 

PROPERTY DIVISION:
In 1984, IRC 1041 was enacted that made all transfers of property between spouses or ” incident to divorce” nontaxable events.     

IRC 1041(b): Such transfers are received by the recipient spouse as gifts with the same adjusted tax basis that the transferor had in the property. This means that there are no capital gains taxes on the transfer.

 IRC 1041(c):  “Incident to divorce” means if such transfer occurs within 1 year after the date on which the marriage ceases, or is related to the cessation of the marriage.

  • A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than 6 years after the date on which the marriage ceases. A divorce or separation instrument includes a modification or amendment to such decree or instrument.
  • If the transfer is more than 6 years after the marriage ceases, there is a rebuttable presumption that the transfer is not an “incident to divorce.” The presumption can be rebutted by a showing of legal or business impediments to transfer or valuation dispute and the transfer was promptly effected after such impediment was removed.


GAIN ON SALE OF PERSONAL RESIDENCE:
IRC 121(a) Exclusion: This is an important aspect of tax law that may have an impact on every homeowner.  This exclusion says that gross income shall not include gain from the sale or exchange of property if, during the 5 year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.

IRC 121(b) LIMITATIONS: Exclusion is limited to $250,000 on a separate return and $500,000 on a joint return if the parties meet certain very specific qualifications.  This exclusion can only be taken every 2 years. This exclusion doesn’t apply to the portion of gain already depreciated. Parties may elect not to have this section apply.

PROPERTY TAX CONSEQUENCES – PROPOSITION 13: Transfers of real property between spouses or former spouses in connection with a property settlement agreement or judgment of dissolution of legal separation do NOT constitute a “change of ownership” requiring reappraisal for property tax purposes.

QUALIFIED DOMESTIC RELATIONS ORDERS (“QDRO”):

QDRO’s are used to transfer interests in pension, retirement and 401k plans without tax consequences between spouses.  They create an enforceable interest in the plans and amounts received as payouts after retirement are taxable to the recipient and not the employee spouse.

  • In the event a plan contains an early retirement option, the QDRO can provide that non-participant spouse may begin receiving benefits at the early retirement age even if the participant spouse has not retired.
  • A QDRO can provide that payments begin at the later age of 50 or the date participant could begin receiving benefits if the participant terminated employment.
  • A QDRO can also provide that the nonemployee spouse receives a lump sum distribution. That lump sum will not be taxable to the recipient spouse if rolled over into an IRA, but the transfer must go directly from the Plan subject to the QDRO to the IRA (“trustee to trustee”).


 Transferring interest between spouses in an IRA doesn’t require a QDRO. The IRA funds are rolled over directly from one IRA into the other spouse’s IRA. This rollover is not taxable.   However, if money is withdrawn from the IRA, then, of course, that is a taxable event.

 DISABILITY BENEFITS: are nontaxable to the recipient. However, if these benefits are awarded to the other spouse, then they will be taxable.  

STOCK REDEMPTION: Example: A and B own all 1,000 in M Corp as community property. The stock is worth $ 1 million with a basis of $20K. B is active in the business and A is not. As part of the community property division, M Corp will REDEEM W’s stock with corporate funds plus a note that calls for additional future payments.

  • Treasury Regulation 1.1041-2T: (a)(1): the form will be respected; A, rather than B, will be treated as having received a distribution from M Corp.
  • 1.1041-2T(c)(1), (d) ex. (2): Even if applicable tax law is to the contrary (for example if B had an obligation to buy A’s shares and M Corp discharges this obligation by buying them) if the Martial Settlement Agreement provides that the spouses intend the distribution to be taxed to A, it will be so taxed. The agreement must state that it supersedes any other agreement concerning the disposition of the stock.
  • 1.1041-2T (d), ex.(3): This is also true even if B guarantees that M corp will make the deferred payments to A.
  • 1.1041-2T(c)(2), (d) ex.(4): If the Marital Settlement Agreement states that the parties wish the distribution to be taxed to B instead of A, it will be so taxed. In other words, the distribution is treated as received by B who then transfers the funds to A in an IRC 1041 transfer.
  • IRC 302: If the redemption of A shares occurs while they are still married, and if the corporation has a corporate surplus (“earnings and profits”), the distribution will be taxed to Spouse 2 as a dividend rather than as capital gain.
    • Therefore, redemption should occur after the marriage is dissolved.
    • Even if this is not possible, A can get capital gain if she has no interest in the corporation, even as an employee, does not acquire any such interest for 10 years, and files an agreement promising to notify the IRS if she does (an interest as a creditor is permissible)


DEDUCTIBILITY OF ATTORNEY FEES
The general rule is that the attorney’s fees incurred in a divorce are personal and not a business and not tax deductible.

BUSINESS: This is true even if most of the fees were spent by the parties who wanted to keep the business in the property division.  One exception may be where both parties are involved in the business and a part of the attorney’s fees was incurred over actual business disputes having nothing to do with the divorce.

EXPENSE OF TAX PLANNING/TAX ADVICE: If the party is seeking spousal support or taxable distributions from a pension plan,  that party can deduct the fees incurred for this.  However, these are itemized deductions and may not be all deductible because they must exceed 2% of the party’s Adjusted Gross Income.  Further, the Alternative Minimum Tax may negate or minimize the effect of these deductions. 

Ask your attorney to segregate or flag attorneys fees that may be deductible in their bills, such as for tax advice or to acquire taxable income such as spousal support or distributions from pension plans, rather than lumping everything together on one billing statement. 

 CAPITALIZATION: However, there are situations where, even if the attorney fees are not deductible on the current tax returns, they may be allowed to be added to the COST BASIS of the business so that when it is sold, the basis of the business is increased by the amount of the fees.