If death and taxes are inevitable then divorce and taxes are inseparable. One cannot fully appreciate the financial ramifications of a divorce without understanding how taxes impact the bottom-line. Ten common misconceptions about taxes and divorce are:
- Assets having an equal fair market value are always worth the same. Except for cash, appreciated (worth more than what was paid to buy it) assets received in a divorce come with a built-in income tax liability that must be paid when the asset is sold. Each asset will have unique tax characteristics that may make the tax owed on one asset greater than the tax owed on another. Therefore, the net asset value (fair market value less the tax) received may also be different.
- Permanent alimony awarded in a divorce decree is always taxable. It is unless: (a) the divorce court final order or settlement agreement that is incorporated into the order states that it is to be non-taxable and non-deductible; (b) it is not paid in cash; (c) it is to continue beyond the payee spouse’s death; (c) it’s cessation is related in time to a minor child reaching majority; (d) it is front loaded and must later be recaptured.
- Temporary alimony paid while the case is pending is never taxable if the spouses are living together in the same home. It is taxable, whether or not they live together, unless the court order or written agreement states that it is to be non-taxable, the parties are living in the same household after they are legally divorced, or, it is not paid under a court order or written agreement.
- The parent with the higher income gets the dependency exemption for children. This is only true if parents’ share custody and the time with the child equally split or the child has reached age 19. Otherwise, the custodian parent gets the exemption but can relinquish it to the non-custodial parent by signing Form 8332.
- If spouses file separate returns both must use the disadvantaged married filing separately filing status. Either one or both spouses living apart may qualify as Head of Household.
- If one spouse agrees to pay all tax liabilities the other spouse need not worry about IRS. The agreement between spouses to allocate a tax liability is not binding on IRS. IRS will pursue both spouses and all assets for unpaid taxes unless one or both qualify as an ‘innocent spouse” or are eligible for equitable relief. The spouse who pays more than his or her agreed share can seek reimbursement from the other spouse. Indemnification clauses should provide for a process to be followed with regard to post-divorce tax matters.
- Filing separate a separate return is an absolute shield to problems with IRS regarding the other spouse’s income tax debt. Marital assets owned jointly may be encumbered by an IRS tax lien giving IRS the right to seize and sell the property even if transferred to the innocent spouse as part of the divorce court final order.
- A spouse need not worry about prior joint returns if the other spouse had all of the income reported in the return. The non-earner spouse may be liable if IRS audits the prior joint returns and finds more income or disallows deductions about which the non-earner spouse had knowledge. The so-called “innocent spouse” escape hatches may offer some relief, however, but are difficult to establish.
- Fees paid to lawyers and CPAs in a divorce are always deductible. Generally, only fees for tax advice or to obtain taxable alimony are deductible. Fees to acquire assets, however, arguably may be added to the tax basis for determining future gain or loss.
- A stock option out of the money has no value. The intrinsic value is the difference between the strike price and current market price. If the strike price is higher than the market, the option is out of the money; but, it still will probably have an opportunity value that can be valued by an expert using complicated financial models.
See newsletter article, regarding what state court judge may and may not order regarding taxes, posted July 15, 2010 to www.steinbergtaxlaw.com.
© 2007, 2012 by Robert S. Steinberg, Esquire
All rights reserved