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The Divorce Encyclopedia
Tax Consequences


Term Definition Tax Consequences - tax liabilities associated with divorce.
Application in Divorce Depending on the size of the marital estate and the terms and conditions of a separation and divorce, the pain of divorce can be made worse by its tax consequences. A prudent divorce attorney, therefore, advises his or her client on any likely tax consequence that may result from the equitable distribution of property. Moreover, in community property states some special considerations unique to these jurisdictions may apply.

In property settlements, transfers between spouses are gifts and are not taxable. However, in order the pay a settlement, sometimes couples must disturb assets in a way that creates tax consequences. For example, taxes may result when a party must withdraw funds from a restricted account, such as a pension fund. Other situations where taxes must be considered is the sale of assets received in a settlement, such as a house, which may create a capital gains liability; when both parties make an in-kind distribution of property, such as set-off and trades; when the parties take future income from a pension to be received later. While the sale of a house can sheltered with rollover of gain in some cases or an exclusion of the gain for individuals 55 and older, other transactions may result in taxable events.

In distributing property, courts consider the tax consequences when it can be demonstrated that the distribution creates a tax event and that the amount can be reasonably determined. In general, if the sale of an asset is not necessitated by the divorce and voluntary, tax consequences are not considered.

In alleging tax consequences, the burden of proof is with the party asserting that the consequences should be considered.

Generally, spousal support -- alimony -- is treated by the Internal Revenue as income shifting. It is deductible to the payor and taxable to the payee.

A number of special situations may arise, however.

As part of their separation agreement, spouses may decide to make the payments nondeductible to the payor and tax free to the recipient. (One way of the other, the government gets its money).

In community property states, alimony pendente lite payments from community property are not deductible to the payor unless the payment is more than one-half of the community property income.

The distribution of any ERISA-qualiifed pension, profit-sharing or bonus plan may have adverse tax consequences because under the I.R.S. Code and ERISA these benefits are not assignable, and can only be transferred via a QDRO.

Child support is not deductible to the person who pays it, nor is it taxable to the person who receives it.

When the payor puts assets in a fund for the payee, payments from the trust are taxable according to I.R.S. rules on trust taxation, but the payor receives no deduction for the amounts paid from the trust.

Divorcing spouses must consider the consequences of what are called recapture rules.

A payor spouse must include as gross income any front-loaded spousal support, which are large payments in the first years of the divorce that diminish to nothing later. Recapture applies to alimony payments when the alimony paid decreases by more than $15,000 annually within a three-year period after a divorce. Alimony, as mentioned, is tax deductible to the payor and taxable to the payee, but if in a three-year period a taxpayer’s alimony decreases by more than $15,000 from the amount of the proceeding year, the IRS regards the alimony payments as property distribution and recaptures the obligor’s income retroactively. In this, the I.R.S. recovers the tax benefit of a deduction or a credit taken by a taxpayer. Recapture means the IRS disallows the deduction or credit. The purpose of recapture is to prevent a divorcing couple from dividing their property and calling the distribution alimony.

Even when couples do not face major tax problems related to assets and distribution, they must make other tax decisions. Couples with minor children must also decide which spouse takes the dependency exemption, the child care credit, and medical deductions for a dependent child.

When on spouse cashes out his or her interest in a family business during a divorce, care must be taken so that the transaction is considered a transfer of property between spouses, or former spouses and therefore incident to divorce and tax-free.

See ERISA, QDRO.

See also Recapture; Alimony; Child Support.

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