We had about the softest winter I have ever experienced in New England this year, but it is till nice to look around and see the signs of Spring. If you follow tax blogs, one of those signs is the return of The Wandering Tax Pro. He spends tax season, less the final day, working 168 hours a week, preparing returns by hand, scorning the expensive and unreliable software most of the rest of us use. I was really pleased at how welcoming he was when I joined the ranks of tax bloggers, despite my being a CPA. Bob picked up on my recent post about divorce and indicated that he was interested in expanding on the topic, so I invited him back to do another guest post.
Ain't It The Truth
by Robert D Flach
Peter J Reilly tells it like it is, and, as my British friends would say, calls a spade a shovel in his post “Divorce Lawyers – Frequently Not the Best Tax Advisors”.
As I have said in the past, while you would certainly want Arnie Becker as your divorce attorney, you should have the divorce agreement reviewed and approved by Stuart Markowitz before signing it. [The Pro's pop culture reference had me stumped, until I did some research. Here's a clue.]
Let me begin by addressing the three items discussed by Peter in his post.
Get That Form 8332
If the divorce agreement states that the non-custodial parent is entitled to the dependency exemption for one or more of the dependent children, either annually or every other year, I would not rely on the agreement itself as a substitute for the Form 8332 if the custodial parent refuses to sign it, regardless of how well written it may be.
There should be some kind of “incentive” or “punishment” built into the agreement. While I am not a lawyer, nor am I conversant in divorce law, I would think that it could be written into the agreement that the non-custodial spouse has the right to withhold alimony and/or child support payments until the Form 8332 is signed. Or if the custodial parent refuses to sign the Form 8332 the “injured” parent has the right to deduct the lost tax benefit from future alimony or child support payments.
If You Say It Is Not Alimony It Is Not Alimony – If You Say It Is Alimony Maybe It Is
I had a problem with claiming an alimony deduction for a client based on erroneous wording in a divorce agreement. It dragged on for a long time, and was finally resolved in my client’s favor only after bringing in the Taxpayer Advocate Office.
The problem arose from the wording in the “Dual Judgment of Divorce with Property Settlement Agreement”. It first stated that –
“The parties expressly waive past, present and future alimony against one another.”
But this was followed by –
“The Husband shall pay to the Wife the sum of $650.00 per month which should be applied to pay the monthly rent for {the ex-wife’s apartment}. The balance should be used to defray the cost of insurance or other expenses related to this property.”
My argument was that this $650.00 per month payment qualified under all these conditions –
• The payments were made periodically by the taxpayer in the form of a check.
• The payments were required by the divorce decree.
• The taxpayer and his ex-spouse did not live in the same residence at any time during the year.
• The payments were not for the support of a dependent child.
• The taxpayer and his ex-spouse did not file a joint return for the year.
I further pointed out that the payments were not –
• Child support.
• Noncash property settlements.
• Noncash property settlements.
• The spouse’s part of community property income.
• Payments made to the ex-spouse for the use of the ex-spouse’s property.
• Payments for the upkeep of property owned by the taxpayer.
The problem probably would not have arisen if the agreement had been worded –
“The parties expressly waive past, present and future support payments against one another.”
And the agreement did not specifically state that payments would cease upon the death of the ex-wife, although it did say –
“The Husband’s obligation to pay this support shall terminate upon either the expiration of ten (10) years from the date of the Judgment of Divorce or upon Wife’s remarriage of upon the Wife being the fee simple owner of this property or other property as a primary residence.”
Another “or” – “or upon the death of Wife” – should have been included.
It Is Not Easy To Get Innocent Spouse Treatment
I do not agree with Peter when he says – “I really think in a divorce situation the default assumption should be separate returns”
I look at each and every return of a currently married couple, whether or not in the middle of a divorce, and determine whether to file joint or separate based on the specific facts and circumstances of the situation. My goal is to file in such a way that the couple pays the least amount of net combined federal, state and local taxes.
I do agree that there are times when a divorcing couple should consider filing separately regardless of the tax consequences – e.g. there is a large balance due that is the result of the income, deductions and withholding of one spouse, one spouse is self-employed, one spouse simply does not trust the other.
Other Issues
In his post Peter only skims the surface on tax-related divorce issues. Tax consequences, both current and future, must be considered and factored into many aspects of the divorce agreement and property settlement.
Let us say a couple has $200,000 in assets to split - $100,000 in CDs (basically cash) and $100,000 in stocks and mutual fund shares. The wife wants to take the cash and give the husband the investments.
It seems equal at first glance – but is it? You must look at the “after-tax” value of the individual assets.
The “after-tax” value of $100,000 in cash is $100,000. But if the husband were to sell the investments for $100,000 on the day of receipt he would very likely have to pay federal and state tax on the gain from the sale.
As there is no basis adjustment for the distribution of assets in a divorce, the original cost of the stocks and mutual fund shares at purchase follow these investments to the husband. If the original cost was $70,000 there would be a $30,000 capital gain. If we assume that the gain would be long term, and the husband is in at least the 25% federal tax bracket the $100,000 would end up as only $95,500 after deducting the federal tax liability. And even less when any state and local income tax is factored in. This is not an equal distribution of the assets.
If there were a $30,000 net capital loss instead then the husband would eventually save anywhere from $4,500 to $7,500 in federal taxes as a result of the sale – so he would be in pocket” perhaps $105,000. Again not an equal distribution of assets.
One must also consider tax consequences when it comes to paying the expenses of, and claiming the dependency exemption for, any children. The availability of education tax benefits, currently phased out based on level of income, and other factors should be reviewed when drawing up the divorce agreement.
A divorce agreement states that the non-custodial parent must pay 100% of the college expenses of his child. That parent’s income is such that he/she would not be able to take advantage of any of the various tax benefits for tuition and fees. Even if the income was not a factor, the non-custodial parent could not claim the benefits if he/she is not claiming the child as a dependent. However, the custodial spouse, who claims the child as a dependent, can claim the full $2,500 American Opportunity Credit.
If the tuition and fees for the child total $50,000, and the non-custodial parent pays the full $50,000 directly to the college, the custodial parent ends up $2,500 “in pocket”.
In such a case the divorce agreement could state that the non-custodial parent must pay 100% of the college costs of the child less any related tax benefits received by the custodial parent. Or that subsequent alimony and/or child support payments are reduced by any related tax benefits received by the custodial parent.
The bottom line – have your divorce agreement run by your tax professional before signing it.
TTFN
The basis issue is one that I am really sensitive about. An old tax shelter joke was that the only two sure ways to bail out of a burned out tax shelter are to die or give it to your spouse and get a divorce. The most dramatic example is probably a house versus a retirement account. I have not noticed the basis issue generating as much Tax Court litigation as dependency and alimony, though.
Why the Pro ends tax season a day early is a rather touching story. Bob's office is in Jersey City. He had a client who always came in on the last day. The tradition was so strong that when he came in a couple of days early one year, Bob sent him out and told him to come in on the last day. Bob's client Officer Maurice Barry of the Port Authority Police was last seen in the North Tower of the World Trade Center on September 11, 2001 - going up the stairs. Since then the Pro ends tax season a day early in his honor.
You can follow me on twitter @peterreillycpa.
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