Tax Aspects Of Divorce
In divorces, a number of tax issues arise which need to be addressed throughout the proceeding to ensure that the parties receive what they bargained for after taking into account federal and state taxes. The following are the primary tax issues arising from a divorce:
1. Innocent Spouse
Those taxpayers whose spouses failed to disclose everything may be entitled to tax relief. There are statutory limitations in terms of requesting relief, and it is important that your marital settlement agreement be drafted correctly to protect you.
A. Innocent Spouse Relief: Congress dramatically expanded the innocent spouse provisions of the Internal Revenue Code when it passed §6015 as a part of the Internal Revenue Reform and Restructuring Act of 1998. Under this new legislation, a taxpayer can obtain innocent spouse relief under three different avenues. The first is the traditional approach, §6015 (b), which has been revised to make it easier for a taxpayer to qualify as an innocent spouse. The second, referred to as the Separate Liability Election under §6015(c), is for those spouses either no longer married, legally separated or have lived apart for at least 12 months. This section is much more advantageous for the taxpayer to try to come under, as the burden of proof on the knowledge component is shifted to the IRS as opposed to the taxpayer. Finally, a taxpayer may even obtain innocent spouse relief on equitable grounds, under §6015(f), if the taxpayer is ineligible for any of the other two sections. See our articles for further discussion in this area.
2. IRC § 66
If your spouse doesn’t furnish you with the appropriate tax information, you are entitled to relief under IRC § 66 if you comply with all the requirements.
A. Community Property Tax Relief: Responding to the plight of abandoned spouses who were taxed even though they did not receive their share of the other spouse’s earnings, Congress enacted § 66 of the Internal Revenue Code, which disregards the applicable community property laws if:
- One or both spouses has earned income as defined by § 911(b).
- They live apart during the entire calendar year and do not file a joint return.
- No portion of the earned income is transferred directly or indirectly between them before the close of the calendar year.
This remedial shift of tax liability when one spouse in effect ignores the other spouse’s right to receive his or her share of the community income also applies in certain limited circumstances even if the spouses are not living apart. Section 66(b) authorizes the commissioner to disallow the tax benefit of community property law to any taxpayer, with respect to any income of that taxpayer, if he or she acts as if solely entitled to the income and the other spouse is not notified of the existence of the income prior to the due date for filing a return. Conversely, the other spouse should be relieved of liability.
3. Division Of Property
In general, property divisions pursuant to a divorce are non-taxable, but there are exceptions and it is important to understand all the rules.
A. Transactions Governed by § 1041: Section 1041 applies to any transfer of property by an individual to his or her spouse or to a former spouse incident to divorce, whether the transfer is a gift, a cash sale for an amount equal to the property’s fair market value, a transfer pursuant to a divorce settlement or some other form of transaction. A division of jointly owned or community property between spouses or former spouses is governed by § 1041, whether the division is equal or unequal. However, the provision only applies to transfers of property, not to transfers of services, and transfers to nonresident alien spouses are also excluded. Section 1041 generally applies whether the transfer is directly to the spouse or to a trust for the spouse’s benefit. Other transactions between an individual and an entity controlled by the individual’s spouse are not usually subject to § 1041. Section 1041 applies to a transfer to a former spouse only if the transfer is incident to divorce. A transfer is considered incident to divorce if it occurs within one year after the divorce or is related to the cessation of the marriage. In contrast, a transfer occurring more than one year after the divorce is usually incident to divorce only if it is pursuant to a divorce or separation instrument and occurs not more than six years after the date on which the marriage ceases.
B. Nonrecognition by transferor: Section 1041(a) provides that no gain or loss is recognized by an individual on a transfer of property subject to § 1041. The transfer is treated as a gift, even if it is a cash sale or is made as part of a hotly contested divorce settlement in which neither party intends to bestow any gratuitous benefits on the other. As a consequence, even depreciation recapture, which is sometimes taxed even when gain is not recognized, is not taxed on a transfer of depreciable property under § 1041.
C. Treatment of transferee: Under § 1041(b), property received in a transfer subject to § 1041 is excluded from the transferee’s gross income as a gift, and the transferee takes the transferor’s adjusted basis for the property. A collateral consequence of the basis rule is that the transferee-spouse’s holding period includes the period during which the transferor held the property. Assume W transfers shares of stock (value $100, basis $80) to her spouse, H: W recognizes none of the $20 gain inherent in the stock, H has no income on receipt of the stock, the stock has a basis of $80 in H’s hands and H’s holding period dates back to when W purchased the property. These results are obtained whether the transaction is a sale of the stock for $100, a gift or pursuant to a property settlement in divorce.
D. Transfers of Encumbered Property: Section 1041 usually applies to transfers of encumbered property between spouses or former spouses, even if the indebtedness exceeds the property’s adjusted basis, and even if the indebtedness is incurred in anticipation of the transfer. Assume W owns property worth $100 that has a basis of $60 but is subject to a mortgage of $80. If the property is transferred by gift to H, who takes subject to the mortgage, W recognizes no gain on the transfer, even though a gift of encumbered property is normally characterized as part gift and part sale for the amount of the mortgage that exceeds basis. Similarly, H takes W’s basis of $60 for the property, not a cost basis of $80 as a nonspousal donee would. None of these results would change if the $80 mortgage represented a borrowing obtained by W immediately before the transfer to H.
E. Transfers to nonresident alien spouses: Section 1041 does not apply to a transfer to a spouse or former spouse who is a nonresident alien. The principal effects of this exception are:
- Gain or loss is recognized on a sale to a nonresident alien spouse, and the spouse takes a cost basis.
- A nonresident alien spouse’s basis for property received by gift is determined by § 1015, not § 1041.
- A transfer of separate property to a nonresident alien spouse or former spouse incident to divorce is taxable under United States v. Davis and the other pre-1984 authorities.
F. Record-keeping requirements: A spouse or former spouse making a transfer of property subject to § 1041 must, at the time of the transfer, supply the transferee with records sufficient to determine the adjusted basis and holding period of the property as of the date of the transfer.
G. Business entities: It is very important to consult your tax advisor, as § 1041 may not apply to the division of these assets and as a result immediate tax consequences can occur.
H. QDRO: In general, a QDRO is a judgment, decree or settlement agreement in a divorce action that assigns rights to distributions from a qualified plan to a spouse, former spouse, child or other recognized dependent that is entitled to receive benefits payable under a plan. To qualify, a QDRO must specify the following:
- The name and address of each alternative payee.
- The amount or percentage of each alternative payee’s interest (or the manner in which it is to be determined).
- The number of payments or the period to which the order applies.
- The plan or plans to which the order applies.
A QDRO may not alter the amount or form of benefits payable under the plan. Pursuant to Section 1457 of the Small Business Job Protection Act of 1996, the IRS has promulgated sample language for use in QDROs.
I. Sale of Residence § 121: The divorce attorneys and their clients have many issues to consider here in order to mitigate the tax impact of selling the residence now or in the future. If they decide to sell now and the title to the property is in both names or either name, then they would claim a $500,000 exclusion on a joint return (assuming they are still married when they sell the residence). If they are divorced and ownership to the property has been awarded 50 percent each and the title transferred to a co-tenancy, then they are each eligible to claim $250,000 on separately filed returns. If they sell now, the “out spouse” will be eligible for the exclusion as long as the ex-spouse resided in the residence during two of the five years before sale, even if he or she now resides in a new residence that was purchased. Both parties must then wait two years from the sale date of the marital residence before they are eligible to claim another exclusion on the sale of their replacement residences. Under the rules, a taxpayer can exclude up to $250,000 on the sale of a principal residence every two years.
Alimony is generally taxable and child support generally is non-taxable. There are exceptions and your attorneys must understand the tax laws in this area completely to ensure the correct tax result.
A. General Alimony Requirements: Sections 71(a) and 215, respectively, include alimony or separate maintenance payments in the payee’s gross income and allow the payor a deduction for such payments. In addition to meeting the requirement that the payments be made under a divorce and separation instruments, the payments must meet the statutory definition of alimony or separate maintenance payments in § 71(b)(1). This definition, which was enacted in 1984 to eliminate many of the complexities and uncertainties of its predecessor, introduces its own complexities, the primary one of which is created by § 71(f), concerning the front-end loading of payments. Section 71(b)(1) provides that the term alimony or separate maintenance payments includes only cash payments that meet all of the following four requirements:
- Each payment must be received by or on behalf of a spouse or former spouse under a decree of divorce or separate maintenance, a written separation agreement or a decree requiring support or maintenance payments.
- The instrument must not designate the payment as one to which the tax regime for alimony is inapplicable.
- In most cases, the spouses must not be members of the same household when the payment is made.
- There must be no obligation to continue the payments after the payee’s death.
Judicial interpretation has added an additional requirement to these explicit statutory conditions; amounts in excess of those that are legally required to be paid under the divorce instrument, the payment of which is motivated by the payor’s sense of moral obligation, are not alimony.
B. Designation as Alimony: Under § 71(b)(1)(B), payments otherwise qualifying as alimony are not included in the payee’s income and are not deductible by the payor if the divorce or separation instrument specifically designates them as outside the purview of §§ 71 and 215. This provision effectively allows divorcing spouses to choose whether cash payments will be treated as alimony, replacing the rigid rule of pre-1985 law under which only periodic payments for the support of the recipient, and not payments made under a property settlement, could qualify as alimony. A designation must be specific.
C. Restrictions on Front-End Loading: The principal complexity of the current alimony rules is found in § 71(f), which limits front-end loading of alimony deductions. Under § 71(f), payments that otherwise meet all the rules for treatment as deductible and includible alimony may be recaptured in income of the payor if the annual payments substantially decline over a brief period. If the payor must recapture previously deducted payments as income, the payee receives a corresponding deduction.
D. Lester/Family Support: Although family support can be totally deductible as alimony, marital agreements must be reviewed to determine if there is a reduction in what would otherwise appear to be alimony. If so, a portion, if not all, of the payment may actually be deemed child support.
E. Child Support: Current § 71(c) continues the rule that any amount fixed by the instrument as support for children of the payor is not considered to be alimony or separate maintenance. For a payment to be fixed as child support, it is not necessary that the decree specify an amount. Child support also includes variable payments designated as child support, such as payments pursuant to a requirement that one spouse reimburse or pay over to the other an amount equal to the medical expenses, whatever they may be, incurred with respect to a child. Contrary to prior law, the statute now provides expressly that an amount is considered to be fixed for child support if the period over which it is payable is determined with reference to an event relating to a child. If payments to a former spouse are to be reduced when a child reaches age 18, marries or dies, each payment prior to the reduction is deemed to include support for this child equal to the amount of the reduction on the occurrence of one of these events. This rule also applies if payments are to be reduced on a specified date and that date is clearly associated with an event relating to a child.
F. Dependency Exemption and Child Tax Credit: Generally the custodial parent is entitled to the exemptions and child credits, unless he or she agrees otherwise in writing.
5. Attorney Fees
In general, attorney fees are not deductible in a divorce proceeding. However, if the family law attorney keeps good records, his or her client may be entitled to the following treatment:
A. Capitalization of Attorney Fees Under § 263 of the IRC: This may be possible if it can be shown the fees were incurred to acquire assets in the divorce. Section 263 disallows a deduction for the cost of acquiring property show useful life extends beyond the taxable year of acquisition. However, such costs may be capitalized as part of the basis of the property and recovered by depreciation deductions in the case of depreciable property, or at the time of disposition in the case of nondepreciable property. See U.S. v Gilmore 372 US 39, 9 L Ed 2d 570, 83 S.Ct. 623 (1963).
B. Attorneys Fees Paid for Production or Collection of Taxable Income: Section 212(1) provides for a deduction for expenses incurred for the production or collection of taxable income. Expenses claimed under this provision may be claimed only if the taxpayer itemizes deductions (subject to the 2 percent rule and AMT) unless the expenses relate to rental or royalty income. Because spousal support qualifying as alimony is includible in the recipient’s gross income, legal fees incurred in obtaining alimony should be and are in fact deductible as a § 212(1) expense.
C. Tax-Related Legal Expenses: Section 212(3) permits a deduction for expenses paid or incurred in connection with the determination, collection or refund of any tax. Expenses under this provision may be claimed only if the taxpayer itemizes deductions (subject to the 2 percent rule and AMT).
D Planning with Respect to Attorney Fees: Planning opportunities with respect to attorney fees are somewhat circumscribed because of the frequent practice of requiring one spouse to pay the other’s attorney fees. In such cases, whether the payment is made by agreement or by court order, neither spouse will be able to deduct the fees. The deduction is available only to the spouse who incurs the fees and actually makes the payment. The husband, if he is required to pay the wife’s attorney fees, is not making the payment to produce income for himself. The wife, if she is the indirect beneficiary of the payment, is actually the taxpayer who incurs the expense. The unfortunate result is that the deduction is lost to both. This immediately suggests, of course, that the parties may be well-advised to substitute a larger deductible alimony payment in lieu of requiring the payor to pay the recipient’s attorney fees. However, be careful of the front-end load requirements and the recapture provisions of § 71(f).
If you are being audited by the Internal Revenue Service, Franchise Tax Board or any other state or local tax authority, contact the tax attorneys of David Lee Rice, A Professional Law Corporation, immediately at (310) 517-8600 for a consultation.