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Avoid the costly tax missteps of divorce

When a marriage is on the rocks, most Americans know they need a good divorce lawyer. Far fewer know they also need good tax counsel.

Many people assume a divorce is a tax-free event. Under Federal tax law [Code Section 1041], they are technically right - the splitting up of assets is tax free. But all too often, the trap has been baited for future tax liabilities.

The most common tax traps are created by the divorce decree, specifically the division of assets between spouses and provisions concerning custody of children. Another common tax trap stems from past joint tax returns that are challenged by the IRS. One spouse feels that the other caused the tax problems, and that he/she is an "innocent spouse" entitled to relief under the Tax Code.

In this age of specialization, do not expect a divorce lawyer, even the best one available, to know all the nuances of tax law, or how the provisions of the decree can trigger future tax liabilities. If you or members of your family are in the throes of a divorce, have the documents reviewed by a competent tax lawyer or accountant before you go to court.

Division of assets

The spouse who receives an asset also receives the old marital tax basis in that asset. Say a couple have both a $100,000 certificate of deposit (CD) and a $100,000 stake in a mutual fund, which they purchased in the early 1990s. The fund's tax cost basis, including reinvested dividends, is $10,000. The couple splits up and agrees that one gets the fund shares and one gets the CD.

Tax consequences if each needs the cash to start life anew: The person with the mutual fund must sell the shares and pay capital gains taxes on $90,000. Even at today's low 15% rate on long-term capital gains, that is $13,500, and in a high-tax state like New York or California, the total taxes approach $20,000. Compare: The spouse with the CD simply cashes it in with no tax liability.

The situation can get even more complicated if the asset is subject to liabilities exceeding the basis in the asset, as may happen when appreciated property has been refinanced.

The transferor of property under Code Section 1041 is required, at the time of the transfer, to supply the transferee with records sufficient to determine the adjusted basis and holding period of the property.

Important: No sanctions are specified if the transferor fails to comply with these rules. As a result, consideration should be given to incorporating these rules into the divorce decree.

Child support vs. alimony

Alimony is deductible by the spouse who pays it and taxable to the spouse who receives it. Child support is not deductible, but the spouse with physical custody is entitled to tax breaks - a personal exemption for the child, and possibly head of household status, which means lower taxes than paid by a single filer with the same income.

A big tax trap in many divorce decrees today is a provision calling for joint custody of children. This is intended to give both parents and their children the benefit of a family relationship, but from a tax standpoint, it sets the stage for a battle over who claims the child.

Which parent derives the greater benefits from being able to claim a child on a tax return will depend on individual facts and circumstances. The issue ought to be considered and addressed in the divorce decree, lest the benefit automatically go to the custodial parent (the parent the child lives with for the greater portion of the year).

Furthermore, the decree or separation instrument must clearly state a fixed amount for child support, or the entire payment to the ex-spouse may be deemed alimony.

When a parent falls behind in alimony and child support, catch-up payments are applied first to child support.

To be deductible, alimony must be paid in cash or cash equivalents, not services. When a taxpayer transfers property to a trust or buys an annuity to pay alimony, the trust income or annuity proceeds are included in the former spouse's income, but are not deductible by the taxpayer. Payments of trust principal are not taxable to the receiving spouse, but trust income is taxable to the beneficiary spouse.

Innocent spouse

Most married couples file joint tax returns. Doing so nearly always results in lower overall taxes than filing separately. It also means that both spouses are liable for the taxes owed and for any liabilities that result from errors, omissions, or fraud that the IRS might find on their returns.

All too often after a divorce, that joint liability comes back to haunt a spouse "usually a wife but sometimes a husband" who feels she/he was as much a victim of a former mate's duplicity as was the IRS. If that is indeed the case, that person may be entitled to "innocent spouse" relief from having to pay back taxes, interest, and penalties.

Such relief has traditionally been exceedingly difficult to get. The IRS tends to view many people who seek such relief as negligent rather than innocent. To take two extreme examples, a spouse who signs a return without reading it, saying only, "Do we get a refund?" is negligent. One whose spouse engaged in lucrative criminal activities that she took extreme measures to conceal from both him and the IRS is an innocent spouse.

Prior to 1997, tax law [Code Section 6013] provided only limited relief to innocent spouses. Basically, a spouse had to show lack of knowledge, economic benefit, or reason to know, and the issue had to exceed certain thresholds for adjusted gross income.

In 1997, the criteria were expanded and liberalized under Code Section 6015 and Code Section 66. Form 8857, Request for Innocent Spouse Relief, was introduced to allow a spouse who did not know or have reason to know of an error to claim relief from tax, interest and penalties. The changes [Code Section 6015(c)] also provided for allocating, based on earnings, tax deficiencies to individuals who were divorced, legally separated, or had lived apart for 12 months.

Current law also provides for "equitable relief." The IRS may grant relief where, "taking into account all the facts and circumstances, it is inequitable to hold an individual liable for all or part of any unpaid tax or deficiency arising from a joint return." There is a list of such factors in Revenue Procedure 2000-15.

Examples: Hardship, abuse, spouse's legal obligations.

Issues after divorce

There can be tax consequences if:

• A couple owned a business or an investment, like real estate, that is considered a passive activity.
• A home must be sold.
• One former spouse sells property to the other.
• A former spouse is entitled to a share of one?s pension.

The potential snares are numerous. Before starting life anew as a single taxpayer, seek tax advice to avoid costly surprises.