Financial and tax traps of divorce.
Practitioners who assist lawyers with the financial and tax aspects of divorce proceedings should develop a checklist to alert the lawyer and client to certain pitfalls that can cause uncertainty either before the final decree of divorce or long after the spouses have gone their separate ways. The following problems focus on the unusual or sometimes hidden issues that usually are not anticipated.1. Tax basis rules for transfers of property between spouses incident to divorce.
Example: Fred and Wilma agree that she will transfer her half interest in their beach condo to Fred. Fred agrees to transfer his half interest in their publicly traded stock to Wilma. The value of each portion of the assets transferred is $250,000. However, Fred's basis in the stock is $220,000. Wilma's basis in the beach condo is $75,000.
Under Section 1041, no gain or loss is recognized on the transfers to either spouse. However, the basis of the transferee spouse is the same as the transferor spouse. Therefore, Fred's basis in the portion of the condo is $75,000 and Wilma's basis in the stock received from Fred is $220,000. What appeared to be an even trade has created a potentially adverse income tax problem for Fred if he sells the condo.
Solution: Practitioners should carefully evaluate the tax-basis of each marital asset before a written separation agreement is finalized.
2. Credit problems for a former spouse caused by the ex-spouse long after the final decree of divorce is recorded.
Example: Dick and Jane own a home as joint tenants. Their written separation agreement requires Jane to transfer her interest in the house to Dick. The order also requires Dick to continue the house payments, pay property taxes, and pay the homeowners insurance. Three years after the divorce has become final, Dick loses his job and can no longer make the house payments.
Meanwhile, Jane and her new husband, Lancelot, have applied for a bank loan to purchase a new home. Jane is surprised to learn that Dick's non-payment of the old mortgage debt created a credit problem because the old house loan is in both spouses names. Her separate credit history reflects the non-payments because she is jointly and severally liable on the old note and mortgage.
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Solution: The separation agreement should require Dick to refinance the loan as a condition precedent to the transfer of the house title.
3. Ex-spouse collects life insurance proceeds and IRA rollover account of deceased spouse.
Example: Oscar and Joyce have been divorced for eight years. Oscar's will, executed after the divorce, devised all of his assets to his daughter, Mary. Oscar died suddenly of a heart attack. Mary is the personal representative of Oscar's estate. During the probate process, Mary discovers that Oscar failed to remove Joyce as the designated beneficiary of his IRA account, personal life insurance policy and group term policy carried by his employer. Mary also discovers that the payors of the benefits are required to pay the proceeds to the named beneficiary, in this case, Joyce.
Solution: In addition to changing his will, the client must also review all insurance policies and other assets that pass at death by means of a beneficiary designation.
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4. Ex-spouse remembers to remove his spouse as beneficiary of his group life, IRA and private life insurance policy substituting his children in equal shares as beneficiaries.
Example: Farquar and Freda divorce and Freda is the custodial parent of the three minor children. Freda is not skilled in finances but her new, overbearing husband #2 is a financial expert (even though he lost a bundle in the dot.com bust). Farquar is killed in a car accident. Because Farquar failed to establish a trust with a responsible person as a trustee, all of the proceeds from the life insurance and IRA are paid to the ex-wife as custodian/conservator for the benefit of the minors. Assuming that the proceeds are not lost or squandered; the children will receive their shares at age 18. [Side note: Bill, who was in the car with Farquar and in the exact same personal situation as Farquar, created a trust in his will for his children and appointed a competent trustee. All benefits were paid to the trustee who will hold the assets in trust for the benefit of the children until they attain age 25.]
Solution: Estate plans should carefully consider when a child should receive an inheritance and who should manage the assets for the child during the period of minority or for a period beyond minority.
5. The IRS is required to notify a taxpayer of the issuance of a Statutory Notice of Deficiency or the filing of a Federal Tax Lien at the taxpayer's last known address. (Internal Revenue Code Section 6212(b))
Example: Minnie, a South Carolina resident and homemaker, divorced her self-employed husband in 2002 on the grounds of adultery. The joint income tax return they completed in 2001 was actually filed on April 15, 2002. Minnie moved back home to Minnesota to live with Mom and Dad. The IRS began an audit of the 2001 return in February of 2003. The ex-husband received the notices of examination at the address listed on the 2001 return. The ex-husband ignored all IRS notices, including the Statutory Notice of Deficiency that was mailed to the taxpayers by the IRS via Certified Mail at their last known address (the address listed on the 2001 Tax Return). The IRS assessed a deficiency of $85,000 on July 31, 2003. After four Collection Letters that were ignored by the ex-husband, the IRS filed a Notice of a Federal Tax Lien against Minnie and the ex-husband in the county court house where the ex-husband resides. Minnie was a full-time student and not employed in 2002 or 2003. In 2004, Minnie graduated from Tech School with an A.A. degree as a dental hygienist. Once employed, she visited the local car dealership to buy a new car. She was shocked to find that her credit report reflected a Federal Tax Lien and a debt to the IRS of $85,000.
Solution: Had she known to do so, Minnie would have filed with the IRS Form 8822, change of address. Had the form been filed, she would have received copies of all notices and had the opportunity to defend the case and possibly avoid liability.
6. Tax filing status is determined on the last day of the tax year.
Example: Oscar and Ellen live in a state that permits divorce on the grounds of a one-year separation. Ellen earned $11,000 in 2003 as a part-time employee and $13,000 in Social Security benefits. Oscar earned $24,000 as a service worker. They elected to live separate and apart on February 8, 2003. Ellen's lawyer field the written separation agreement with the family court. The divorce decree was issued on March 3, 2004. On April 15, 2004, Ellen and Oscar each filed their own tax returns as single taxpayers. Internal Revenue Code Section 7703(a)(1) provides the determination of whether an individual is married shall be made at the close of the taxable year. Section 7703(a)(2) provides that a person is not married if he/she has a decree of divorce. Therefore, Oscar and Ellen are married on December 31, 2003. As a result of a routine examination of Ellen's return, Ellen's filing status was changed to married filing separately. In addition, Ellen could not exclude from her gross income her $13,000 Social Security benefits. The tax auditor explained to Ellen that even though her total wages and Social Security payments were under $25,000, there is no exclusion from taxation of Social Security benefits when the taxpayer files as married filing separately.
Solution: Fortunately, if Oscar will agree, Internal Revenue Code Section 6013(b)(1) permits Ellen and Oscar to file a joint return after filing a separate return, provided the Statute of Limitations has not expired.
7. Sec. 6013(d)(3) of the Internal Revenue code provides that the tax liability with respect to a joint return shall be joint and several.
Example: In 2002, Bill was arrested by the Secret Service and charged with conspiracy to commit mail fraud and money laundering violations. Bill and others embezzled more than $7,000,000 from investors. The Treasury Department seized all of Bill's records for the 2002 tax year. One year later, Bill was convicted by a Federal jury and sentenced to a term in prison. The IRS sent separate letters to Bill and his wife, Jean, requesting that they file a return. Jean, with the help of their tax preparer, attempted to reconstruct the income for 2002. Jean obtained Bill's W-2 forms and reconstructed her small business income. The wife and the tax preparer were able to construct a return that reflected $75,000 in gross income. The joint return was signed by Bill and Jean and filed with the IRS Service Center.
The IRS has proposed an addition of $7,000,000 in gross income to Bill's and Jean's joint return. If Jean cannot prove she is an Innocent Spouse, under Section 6015 of the code she will be jointly liable for the tax.
Solution: In any case where there may be doubt as to one spouse's income, the other spouse should never agree to filing a joint return.
8. Section 163(h)(2)(D) permits a taxpayer to deduct interest paid during the taxable year on a mortgage upon real estate of which he is the legal owner.
Example: Jack and Jill have been involved in a bitter divorce battle that has spanned two years. In December 2002, the family court awarded temporary possession of the residence to Jill. Jill paid all the house payments for 2003 out of her separate checking account. On his 2003 tax return that Jack filed as married filing separately, he also claimed credit for one half of the mortgage interest (the 1098 Interest form issued by the mortgage company listed Jack's Social Security number). Jill claimed the entire interest deduction on her tax return. The IRS has notified Jack that his return will be adjusted to reduce his claimed interest deduction to zero. Internal Revenue Code Section 163 requires that interest must be paid by the taxpayer during a tax year on a mortgage for which he/she is liable.
Solution: The written Separation Agreement should address the allocation of itemized deductions and dependency exemptions.
9. Certain married individuals living apart are deemed not married for tax purposes.
Example: Jane's husband Chris abandoned his spouse and infant child in December 2003. Jane provided more than half the support for the child for the 2004 tax year. In January 2005, Jane was granted a divorce from Chris on the grounds of desertion. Jane, even though married on the last day of 2004, will be deemed not married for purposes of filing her 2004 return. Chris was not a member of the household during the last six months of 2004 and Jane maintained her home for six months as an abode of her child whom she can claim as a dependent under Section 151 of the Code. Therefore, she can file as Head of Household, thus availing herself of a greater standard deduction and more favorable tax rates.
10. Section 121 permits a taxpayer to exclude up to $250,000 of gain from the sale of his principal residence ($500,000 if married and filing as joint return), provided the taxpayer has owned and occupied the residence for 2 out of the past 5 years ending with the sale of the residence.
Example: In 1998, Joe and Gay purchased a home for $100,000. In 1999, Joe and Gay divorced. Gay was given custody of the children. The divorce decree provided that Gay would maintain possession of the house until the youngest child attained age 18, at which time the house would be sold and each spouse would receive one half of the net proceeds. Gay occupied the house as her primary residence until 2004. Then, the house was sold for $600,000. At closing, each ex-spouse received $300,000. Each ex-spouse had an adjusted basis in his/her one-half of the house of $50,000. Can Joe exclude his gain? Internal Revenue Code Section 121c(3)(B) provides a safe harbor for Joe. This Subsection of the Code provides that in cases where property was used by an ex-spouse pursuant to a divorce decree, the use is also attributed to the nonresident ex-spouse. Therefore, Joe qualifies as an owner and user of the property for 2 out of 5 years preceding the sale.
Solution: The key to Joe's exclusion of gross income is that the written Separation Agreement or Decree of Divorce must provide that Gay could occupy the house.
Robert H. Breakfield, JD, LLM
Charles E. Alvis, MBA, MPA, CPA, CFP
Robert Breakfield is a Professor of Business Law at Winthrop University, Rock Hill, SC. Charles Alvis is an Associate Professor of Accounting at Winthrop University.
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| Title Annotation: | divorce taxation, divorce rules, separation agreements |
|---|---|
| Author: | Breakfield, Robert H.; Alvis, Charles E. |
| Publication: | The National Public Accountant |
| Geographic Code: | 1USA |
| Date: | Dec 1, 2003 |
| Words: | 2184 |
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