Getting a divorce is a painful experience for your client, but you can help ease the pain by ensuring that the settlement will protect your client’s tax interests. The following ten tips, when used correctly, can save your client, and sometimes both sides, money in a divorce action.
Tip 1: Negotiate the Tax Exemption
If the divorce decree is silent regarding the dependency exemption, it remains with the custodial parent (IRC 152(e)). The custodial parent is defined as the parent who has physical placement of the child for the greater portion of the calendar year (Treas. Reg. 1.152-4(b)).
The exemption is often one of those frustrating issues that has more emotional than financial significance. Much as the custodial parent does not want to give up the exemption, for example, it is not worth the attorney fees to litigate. One suggestion for reaching a settlement: Many states will allow the award of the exemption to be conditional on payments being current by the end of the year. The custodial parent may agree that getting the support on a regular, timely basis during the year is well worth the price of giving up the exemption. Try this language in the decree specifically making the award conditional on support obligations:
Tax Exemptions and Deductions. The wife shall be entitled to claim the youngest child, John, Jr., as an exemption, dependent, and deduction for all tax purposes, state and federal. The husband shall be entitled to claim the oldest child, Linda, as his exemption, dependent, and deduction for all tax purposes, state and federal, provided all support payments provided herein are current and timely. Each party shall duly execute Form 8332 of the Internal Revenue Service to reflect the foregoing.
Please note that support obligations can be read broadly enough to include medical expenses and other child-related obligations.
Tip 2: Don’t Waste the Tax Exemption
The tax exemption is wasted under one of two circumstances: If it goes to a parent with not enough income or the one with too much income.
Quite simply, if there is no income, there can be no deduction. For 1996, if the income of a single person is less than $6,400 per year or if the income of a person filing as head of household is less than $8,250 per year, the extra exemption is wasted.
Similarly, don’t waste the exemption on the rich. For taxpayers whose adjusted gross incomes for 1996 exceed $114,700 for a single taxpayer, or $143,350 for head of household, personal exemptions phase out by 2 percent for every $2,500 of income over those amounts. The phase out is complete at $237,200 for a single taxpayer and $265,800 for head of household (IRC 151(d)(3)). It is a waste to give these taxpayers the extra exemption.
Tip 3: Two Can Be Head of Household (Sometimes) Under IRS rules, head of household status follows placement of children and cannot be negotiated or allocated by a court (IRC 2(b) and Treas. Reg. 1.2-2(b)). However, when there are two or more children and equal placement, parties can arrange for both parents to claim head of household status.
Sample divorce language: Tax Filing Status. For the purposes of tax filing status, the parties agree that Catherine lives the majority of the time with the husband and Laura the majority of the time with the wife. The parties agree not to assert any contrary position with any taxing authority.
The parties may wish to arrange one special day at the end of the year for each child to spend with his or her “tax parent.” In fact, this could become a game; parents could spend some of their tax savings on a special activity with their “tax child.” How’s that for an “everyone wins” scenario? The parents save money on taxes and the kids have a good time.
Tip 4: Some Attorney Fees Can Be Tax Deductible
People hate to pay their divorce lawyers, perhaps more than they hate to pay other types of lawyers. Criminal defendants usually have publicly paid lawyers. Personal injury litigants pay their lawyers with “found” money from their recovery. Business clients treat attorney fees as a cost of doing business. Divorce clients, who are at a financially disadvantageous time in their lives, pay lawyers with personal funds that could be used for other things more enjoyable than a divorce.
Some of the sting can be taken out of attorney fees by maximizing the deductibility to the client. Plus, due to the 2 percent floor, it may encourage the client to pay the fees on a timely basis to save money on taxes.
While the costs of getting the divorce are personal and are not deductible (IRC 262; U.S. v. Gilmore, 372 U.S. 39 (1963)), some of the costs of the divorce are deductible if the client itemizes deductions and the total miscellaneous deductions exceed 2 percent of the payor’s adjusted gross income. Deductible costs may include:
- Fees for tax planning.
- Fees for obtaining taxable income.
- Fees for securing interest in qualified retirement plans.
Tax planning will be necessary to maximize the advantage of deductibility. Other tax deductible costs, such as paying for tax return preparation, should be paid in the same calendar year as the attorney fees.
If the attorney fees are paid over more than one year, which is frequently the case when the retainer is paid at the beginning of the action and the balance of fees at the end, the deductible portions of the fees may have to be prorated over the years paid.
Tip 5: Some Attorney Fees Can Be Capitalized
While attorney fees in relation to conservation of interest in property are not deductible, clients may be able to add these costs to the capital basis of the property. Although there may be no immediate tax gain, such capitalization can increase depreciation (if the property is depreciable) or decrease the gain (or increase the loss) when the property is sold.
If a number of assets are involved in the litigation, the fees must be specifically allocated among them, or the IRS can apply a prorated allocation of the costs (Bernard D. Spector, 71 TC 1017, rev’d on other grounds, 641 F.2d 376 (5th Cir. 1981)).
Of course, there must be a basis for deductibility in the legal services performed in the case. Careful billing records should be kept that delineate services on behalf of a particular asset.
Tip 6: Just Calling a Payment “Maintenance” Doesn’t Necessarily Make It Tax Deductible
IRC 71, which defines alimony and maintenance payments, applies to any interspousal payments intended to be deductible whether they are labeled spousal support, section 71 cash periodic payments in lieu of maintenance, or family support. If your client intends the payments to be deductible, the requirements of this section must be met. They are:
- Payment must be in cash (IRC 71(b)(1)). Services or a transfer of property other than cash cannot be considered alimony.
- Payment must be made pursuant to a divorce or separation instrument; that is, a decree of divorce or separate maintenance or a written instrument incident to such decree, a written separation agreement, or a decree requiring payments for spousal support/maintenance (IRC 71(b)(2)).
- Payment must be to or on behalf of spouse (IRC 71(b)(1)(A)). Payments to third parties (medical or dental payments, health insurance, rent, mortgage payments, or tuition) may qualify. They cannot be voluntary and must meet all other requirements of IRC 71. For example, payment of a mortgage obligation qualifies only to the extent of the recipient’s ownership interest in the property. If in the divorce, title to the real estate was transferred to the recipient spouse, the entire payment may be deductible. However, if the payor has any ownership interest in the property, only part of the payment may be considered alimony, as the payor would be satisfying his or her own obligation on the mortgage and not paying the entire amount on behalf of the recipient.
- The divorce or separation instrument cannot designate the payments as nontaxable and nondeductible (IRC 71 (b)(1)(B)). Parties can elect whether payments shall be treated as taxable or nontaxable or the court can so decree. The IRC indicates that in the absence of language to the contrary, it can be assumed that the intent was that the payments are deductible to the payor. Whenever there are interspousal payments, it is much better practice to specifically designate the intended tax result of the payments.
- Payor and payee spouses cannot be members of the same household at the time the payment is made (IRC 71(b)(1)(C)).
- The payments must terminate upon the payee’s death (IRC 71(b)(1)(D)). There can be no liability to make any payment for any period after the death of the payee (no mention of payor); and there can be no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse. Don’t rely upon state law providing for termination of payments upon death. Specifically provide in the final settlement agreement that the payments terminate upon the payee’s death. (See Treas. Reg. 1.71-1T Q/A-11 and Q/A-12.)
- Don’t disguise child support or property division payments as maintenance (IRC 71(c) and (f)).
Tip 7: Avoid the “Child Support” Trap of 71
IRC 71(c) requires that no portion of the payment can be fixed as child support. The word “fix” means that a reader would be able to precisely determine what portion of the payment is alimony and what portion is child support. Reference to a specific dollar amount need not be made in the instrument for a payment to be fixed as child support. (See Sperling v. Commissioner, 726 F.2d 948 (2nd Cir. 1984) and Abramo v. Commissioner, 78 TC 154 (1982).)
The IRS recognizes that the laws of most states allow for payments that are a combination of maintenance and child support. In Wisconsin these payments are called family support. With the passage of child support percentage standards, over the years practitioners have heard frequent rumblings from the IRS as to whether these percentages would be imputed in the family support payments, making such portion of the payment nondeductible, as that portion is for child support. If the instrument does not specifically provide a mechanism for determining what portion of each payment is actually for child support, the entire payment will be treated as alimony (Neu-Kraemer v. Commissioner, 52 T.C.M. (CCH) 363 (1986)).
No portion of the payment can be identified as “child support.” However, even if the instrument does not identify a portion as child support, if the instrument specifies that the payment is to be reduced upon an event related to a child (such as the child attaining a specific age, marrying, dying, leaving school, or similar contingency) or at a time that could clearly be associated with such contingency, the IRS will treat that payment as child support; it will not qualify as alimony and will not be deductible to the payor. This provision frustrates many family support agreements that provide for automatic step downs as each child reaches the age of majority.
Even if the payments would otherwise qualify as alimony and the instrument does not explicitly provide for a reduction in the payment contingent upon an event related to a child, there are two situations in which the reduction of payments will be presumed to be clearly associated with events relating to a child:
- 1. The payments are reduced not more than six months before or after a child is to attain the age of 18, 21, or the local age of majority.
- The payments are reduced on two or more occasions that occur not more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24 inclusive. (Treas. Reg. 1.71-1T Q/A-18. See example in the temporary reg.)Note that a payment may be treated as fixed and payable for the support of a child of the payor even if other separate payments are detailed in the instrument for the support of the child (Treas. Reg. 1.71-1T Q/A-16).
Tip 8: Avoid the Recapture Rules of 71
The recapture rules in IRC 71 are meant to discourage front-end loading and thus discourage disguising property divisions as deductible alimony payments. Unless you’re consciously doing some tax planning utilizing this vehicle, you should avoid the recapture rules.
Note that over the past dozen or so years, various minimum term and recapture rules have applied. The 1986 act contained a provision allowing spouses to modify pre-1987 instruments to take advantage of the new legislation (T.R.A. 1843(c)(2)(B)(1986)).
The 1986 act that applies to instruments executed after December 31, 1986, provides for a three-year look back; recapture occurs only in the third year; and the reduction cushion is $15,000. In year three, recapture occurs if: (1) alimony paid in year two exceeds payments in year three by more than $15,000; or (2) alimony paid in year one exceeds the average annual alimony paid in years two and three by more than $15,000. In both cases, the excess is recaptured.
There are exceptions to this rule: When the payment ceases upon the death of either spouse or remarriage of the payee spouse, or when the payments fluctuate and are not within the control of the payor spouse (i.e., payor pays a fixed portion of income from a business or property, or employment compensation).
Tip 9: Transfers of Property Between Spouses Tax Free
The Deficit Reduction Act of 1984 enacted IRC 1041 and sought to alleviate many problems and inconsistencies relating to the transfer and taxability of appreciated property under the Davis case (Davis v. U.S., 370 U.S. 65 (1962)).
Property transfers between spouses are governed by IRC 1041. The general rule is that no gain or loss is recognized on a transfer of property from an individual to a spouse or former spouse; but in the case of a former spouse, no gain or loss is recognized only if the transfer is incident to a divorce. A transfer of property is incident to a divorce if the transfer (1) occurs within one year after the date on which the marriage is dissolved, or (2) is related to the cessation of the marriage. The temporary regulations provide that transfers related to the cessation of marriage must be pursuant to the divorce or separation instrument (including modifications) and must occur within six years of the date the marriage ends.
The transfer is treated as a gift and the transferee spouse acquires the transferor spouse’s basis. Likewise, the holding period of the transferor will carry over and “tack” and become the holding period of the transferee. IRC 1041 nonrecognition treatment applies to losses as well as gains.
Note that transfers of property prior to marriage are not covered by IRC 1041. Premarriage transfers of property pursuant to the terms of a prenuptial agreement will result in the recognition of gain or loss.
The sale or transfer of the marital home, however, requires special considerations. Timing of the sale can save the parties significant taxes and benefits. You should be familiar with the IRC sections relating to deferment of recognition if the proceeds are reinvested in a new residence within two years and the one-time exclusion of $125,000 of gain under IRC 121. For more information, consult the many excellent articles written on this subject and enlist the advice of a good accountant familiar with tax law in this area.
Tip 10: U.S. Savings Bond Interest Accrued Must Be Recognized on Transfer of Bonds
Generally, transfers of publicly traded securities pursuant to a divorce instrument result in no recognition of tax at the time of transfer. U.S. Savings Bonds are an exception. The transferor must report as income all interest on the bond that has been earned up to the date of transfer that has not been previously reported. The transferee spouse will be taxed on interest earned after the transfer, which can usually be deferred until the bond is cashed in or matures.
Sidebar: For More Information
There are many excellent publications available from the IRS “FREE” of charge that contain a wealth of information, including:
- Publication 503: Child and Dependent Care Expenses
- Publication 504: Divorced or Separated Individuals
- Publication 523: Selling Your Home
- Publication 554: Tax Information for Older Americans
- Publication 555: Federal Tax Information on Community Property
Sidebar: Alimony Recapture Worksheet
Step 1: Calculate Recapture for Year 2
1. Alimony paid in year 2 $______
2. Alimony paid in year 3 $______ plus $15,000 ______
3. Subtract line 2 from line 1 (not less than zero)______
Step 2: Calculate Recapture Base for Year 1
4. Alimony paid in year 2 ______
5. Amount from line 3 above (year 2 recapture) ______
6. Subtract line 5 from line 4 (not less than zero)______
7. Alimony paid in year 3 ______
8. Add lines 6 and 7 ______
9. Divide line 8 by 2 ______
10. Floor for recapture 15,000
11. Add line 9 to line 10 ______
Step 3: Calculate Recapture for Year 1
12. Alimony paid in year 1 ______
13. Amount from line 11 above ______
14. Subtract line 13 from line 12 (not less than zero) ______
Step 4: Calculate Total Recapture
15. Amount from line 3 ______
16. Amount from line 14 ______
17. Add line 15 to line 16 ______
Line 17 is the total recapture amount