I have always hated paying taxes, mostly because I hated the feeling that I somehow was paying more than my fair share because I failed to check the appropriate box. I hated the feeling that everyone else knew something (or someone) that I didn’t know and thus was paying significantly less (kind of like the feeling that I still have when I buy a car). It is not a political stance. In other words it is in no way a reflection of my feelings on how the government spends the money (that is another blog).
What I always hated is that it was so confusing to fill out tax forms. I hated having to understand the differences between so many terms I never use in my everyday life: exemptions, deductions, credits, dependences, accelerated depreciation, unrealized appreciation; the list goes on and on. I hated thinking about the different tax consequences of IRAs, FICAs, 401(K)s, and Annuities. I hated the forms with confusing meaningless titles: For example “Form 8084-d.” Who comes up with the names? Is there a form 8084-e? What about Forms 1 through 8083? And how are those titles the least bit helpful in explaining what is required?
It felt like too much to learn for a once a year event and thus I found an accountant I trusted, signed where she said to sign, and put the subject out of my mind for another year.
Once I started doing divorce work, I quickly realized I could no longer hide from my aversion to taxes. Instead of a once a year event, I was confronted with tax questions several times a week. Tax consequences are a really important part of a divorce agreement and can cost my clients thousands of dollars. While I am not ready to hang up a shingle as a certified tax accountant, I have learned what my clients must watch out for when it comes to the tax consequences of their divorces. What I have learned from various classes, conversations with accountants I had on speed dial and lots of experience, is that (shockingly) calculating tax implications can be fun – kind of like a logic puzzle – and are definitely a powerful tool to use when negotiating a settlement.
So I have put together a list of some of the basics -- things you should know when you are going through a divorce and things you must make sure your attorney includes in your settlement agreement. It is not “Divorce and Taxes for Dummies” (because I am not, and I am assuming you are not “Dumb”, just because there are things we would rather think about other than taxes), but rather I think of it as “Divorce and Tax Information for People Who Have Lots of Interests Other Than Taxes and Don’t Want to Be Bothered to Learn Everything There is To Know about the Tax Consequences of Divorce Unless They Have to (Like Me)”
1. How to File: A lot of clients are confused about how to file if they were married for part of the tax year: married filing separately? married filing jointly? Or single? The first thing to know is that your status at the end of the calendar year (i.e. December 31st the year. If you are single on that day, meaning a settlement agreement and final decree have been filed, you have to file as a single person even if you were married for most of the year. We always pay attention to this when scheduling a final hearing date. If we know our client will benefit from filing as a married person, we will ask for a Court date after January 1st finalizing the divorce in December.
2. As to whether to file married filing separately or married filing jointly, if you are going through a divorce, but still married at the end of the calendar year, this will differ from case to case. What we always write in our separation agreements is that the parties will consult with an accountant to determine what filing status is more beneficial for their family. This is an easy calculation for a tax accountant. Whatever way the taxes are filed, both parties will split the amount owed or the amount received equally.
I have had some clients say that want to file separately regardless of the financial benefit of filing jointly. I get it. Many people want to end all entanglements. Moreover, if you file jointly and your ex doesn’t meet his or her obligations to the IRS, you will be held responsible and many don’t want to assume that risk. What we do in these cases, is still have thecalculations done, and then let our client make an informed decision about how much the “de-
entanglement” and/or risk is worth.
3. Child Support versus Spousal Support (Commonly referred to as Alimony) : Child Support is not considered taxable income. This means that the person receiving child support does not have to declare the money paid as income (and thus pay taxes on it) and the person who pays child support cannot deduct the child support payment from his or her income. To the contrary, Alimony is treated as taxable income. Any money you receive as Alimony will be added to your gross income and will increase your tax responsibility. The person paying Alimony can deduct the money paid as Alimony from his or her gross income and thus lower his or her tax bill. In order to qualify as alimony, the payments must be made as ordered in a written divorce or separation agreement and the parties cannot be living in the same house (Interestingly enough, another example of the government obsession of where people live in determining their rights – see earlier blog regarding marital rape). I am sure you have figured out the issue here. If one spouse is required to pay spousal support and child support, it is very much in that person’s interest to have as much of the payment as possible characterized as Alimony. Conversely, for the person receiving child support and spousal support, it is in their interest to have as much as possible of the payment characterized as child support. Attorneys must pay attention here and protect their client’s interests. I often use this factor as a negotiating tool. Perhaps we will accept a bigger child support allocation, but the spousal support will continue longer than the standard guidelines.
4. One of the surprising tax consequences of divorce is that couples can divide most of their assets, including cash, without having to pay any income of gift tax. This rule applies to assets transferred “incident to a divorce”. Whether they transfer before or after the divorce is irrelevant as long as it can be shown the transfer is related to a divorce. This surprised me since my perception has always been that the government will use any opportunity possible to collect more taxes. Of course, this doesn’t mean that these assets will never be taxed. Generally the person to whom the asset is transferred takes over the existing tax basis. Thus when the asset is sold, the person is responsible for paying taxes on the growth. This is important because the potential tax consequences should be calculated into the value of the transfer of appreciable assets. Let me give you a simple example: Gail and Joe have two assets to transfer: $500,000.00 worth of Stock A with a basis of $100,000.00 and $500,000.00 worth of Stock B which has a basis of $300,000.00. If Gail takes stock A and Joe takes Stock B as part of their divorce agreement, neither will have to pay taxes at the time of the transfer. On paper, it looks like they are receiving equal amounts in the settlement. Each is receiving $500,000.00 worth of stock. But, when Gail sells her stock, she will have to pay taxes on $400,000.00 of the amount. At a 33% tax rate, this will cost her approximately $132,00.00 making what she was awarded in the divorce really worth $368,000.00. When Joe sells his stock, at the same tax rate he will just have to pay $66,000.00 making his Stock B worth considerably more than Stock A. As you can see $500,000.00 worth of stock does not necessarily equal $500,000.00 in stock. This is something you and your attorney must stay on top of when ensuring that assets are split equally.
The fact that I have enjoyed writing this blog is testimony that my attitudes about taxes has drastically changed. And I have so much more to share!, but am running out of space. Stay tuned for part two of my divorce tax tips.