It’s Best for the Spouses to Make the Tax Decisions in Their Divorce
Key Points
  • There are many decisions to be made when it comes to divorce and all issues should be addressed including any matter that could have a tax implication for both parties.
  • Issues such as child deduction and dependency exemptions or if there is a retirement account that needs to be decided, may have tax consequences and adversely affect the spouses, individually or jointly.
  • One area that may be overlooked in a divorce and not address properly for tax purposes is capital gains; swapping assets can save on expenses, but it is important to understand any tax issues in equitable distribution agreements.

Many tax decisions a couple can best determine for themselves if they can act in good faith to one another, including the payment of any balance due on a joint income tax return and the distribution of any refund. In property settlements, transfers between spouses are gifts and are not taxable. However, in order to 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.

Tax credits, another consideration for divorcing couples, are either nonrefundable, which can only reduce taxes to zero, or refundable, which can result in a refund. Tax credits include, but are not limited to, 1) the earned income tax credit, which is refundable and for a working low-income eligible filer with or without a qualifying child; 2) the child and dependent care credit, which is available to persons who must incur expenses in order to work; 3) the child tax credit, which is available to a tax payer who claims a dependency exemption for a child under 17 at the end of the year; 4) child adoption credit, a nonrefundable credit of up to $10,160 for qualified adoption expenses.

Divorcing couples can sometimes reduce their joint, and later separate, tax bills by using these credits.

The determination of which of them can claim the dependency exemption is made based on a consideration of which parent has custody, who supports the child, and the degree of cooperation between the parents.

The IRS is not concerned about which parent claims the exemption, but both parents cannot claim the exemption.

In general, the custodial parent is the one who can take the dependency exemption. For the purposes of the IRS, the "custodial parent" is the parent with whom the child or children live for more than six months of the year, no matter what the divorce decree may say.

Child support has no tax status, and it need not be reported as income. It is not taxable, nor is it deductible. Child support does not need to be reported as income. Money exchanged by divorced parents in support of their children is identical to money exchanged by married parents in support of their children.

The distribution of any ERISA-qualified pension, profit sharing or bonus plan may have adverse tax consequences because under the IRS 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.

A couple can avoid tax penalties in the division of a pension. The division of a pension plan in favor of a spouse or former spouse is not a taxable event; distributions, however, normally are and may be subject to a 10 percent penalty if premature. However, when the distribution is done under a Qualified Domestic Relations Order (QDRO), which pays all or part of the benefits to a non-winning spouse, the adverse tax consequences may be avoided.

To steer clear of tax consequences, a couple can swap assets to come up with equitable distribution. Swapping assets saves both spouses the expense of coming up with money for property division and distribution. For example, a couple jointly owns a home and a business and both of these assets are roughly equal. The assets often offset each other. The husband offers his wife his interest in the marital home, in return for her giving him her half of the marital business. Care must be taken when one spouse trades an interest in a family business so that the transaction is considered a transfer of property between spouses, or former spouses, and therefore incident to divorce and tax-free.

A divorce court takes into account the tax consequences of property division. For example, if one spouse ends up paying a large capital gains tax, the court may give him or her more marital property to make up for that loss of money in capital gains tax.

On the other hand, it is possible that a party may receive a tax benefit when property is divided. In that case, the court may award him or her less property, since he or she has realized a benefit. Moreover, in community property states some special considerations unique to these jurisdictions may apply.

The burden of proof is with the party asserting that the tax consequences should be considered. 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.

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INNOCENT SPOUSE RULE -- Section 434(c)(1) of the Internal Revenue Code protects an innocent spouse from tax fraud prosecution under certain conditions. This rule mainly protects women who innocently sign returns while married to men who controlled the finances. An innocent spouse can be protected from liability if 1) a joint return was filed, 2) the return contains a "grossly erroneous" error, 3) he or she establishes "lack of knowledge," and 4) it is "inequitable" to impose the tax on him or her. This rule does not protect the spouse from any legitimate tax obligations for which he or she is responsible under joint and several liability.

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