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Hi, everyone, and thank you so much for tuning into the Divorce Field Guide. My name is Ani Mason, and I am a divorce lawyer and mediator, and I’m also the creator of this podcast.
Today, we’re in Episode 16 and we are going to be talking about taxes.
Before we begin, let me highlight something that I think you already know which is that I am not a CPA, and I’m not a tax attorney. I’m going to be talking in this episode not as an expert on taxes, but more from the perspective of a divorce attorney and mediator about the different kinds of issues and topics (tax-related) that come up in a divorce and how we speak to those different issues in a divorce process.
With each topic that I cover in this episode, I will try to give you a sense for, first of all, what it is that I’m talking about and, then, secondarily, how do we address this in a divorce.
One of the topics that we typically address in a divorce settlement agreement is what kind of filing status you and your spouse will claim on future tax returns, while you are still legally married.
Just to back up a little bit, “filing status” is, basically, how you declare or describe yourself to the IRS and to your state tax authority. The options that you have are: married filing jointly, married filing separately: head of household and then single.
Each of these tax filing statuses has different tax rates, and brackets, and different tax benefits that correspond to it, so there is definitely an impact on your ultimate amount of taxes owed to the government by your chosen filing status.
Which is why people, sometimes, prefer to clarify between them and to negotiate between them what their filing status will be. If it’s important to one of you that you file jointly, or if it’s important to one of you that you clarify that, actually, you will be filing head of household, and your spouse will be filing married filing separate, you may want to speak to and clarify that in your agreement.
I just want to flag there for you that your marital status on December 31st of the calendar year counts as your marital status for the entire year. If you were divorced on 12/31 of 2018, you are considered unmarried for the entire 2018 calendar year. Same, by the way, for if you get married during the calendar year.
FUTURE TAX REFUNDS
Another topic, tax-related, that we will commonly speak to in a divorce negotiation and the contract drafting process is: If you were to receive, in the future, a refund for past tax years, for tax years during the marriage, what would you do with it?
The basic ways that people will share potential future refunds are: (i) splitting them equally, 50/50, (ii) having one person take the entire thing, and the other person not being entitled to any of it, (iii) dividing the refund pro-rata in proportion to income (that could either be in proportion to income for the tax year in question, the tax year that you’re getting the refund for, or it could be in proportion to your incomes at the time that you receive the refund, so, whenever it is in the future that you actually receive the refund; and (iv) sometimes, I don’t know if to call this “by responsibility” or also “by income”, but people may say if the refund is clearly tied to one person’s reported income, or deductions, or exemptions, or whatever, they will be entitled to it. And if we can’t clarify whose income or deductions the refund is tied to, then we will split it 50/50, or will we’ll share it pro-rata based on our income for that tax year.
So, those are some of the common options with regard to future refunds.
FUTURE TAX LIABILITIES (ON PAST TAX RETURNS)
Then, the flip side of that, the worse side of that, is future tax liabilities.
If you, three years hence, you are audited, and it is determined that you underpaid taxes, you will owe taxes, in the future, for a past tax year.
Where the tax year that liability concerns was during the marriage, we will speak to who’s responsible for that future liability, and how are you sharing responsibility.
The options for dividing responsibility run along the same lines as they do for sharing entitlement to a refund.
Those are: (i) you can split evenly, (ii) one person can take all, (iii) you can do the pro-rata thing, in proportion to your incomes either for the present year, when you owe that liability, in 2018 (whatever you’re earning then), or for the tax year to which it corresponds, or (iv) you can do it based on more of that, sort of, “income responsibility” model, like, if this tax liability arose clearly out of your income or your claimed deductions that were later disallowed, you are going to pay it.
EXISTING TAX DEBTS
Two other things: If, when you are going through a divorce process, you already know that you have an outstanding tax debt, you would speak to that more in the section of your agreement that deals with your outstanding debts rather than, necessarily, in the tax section.
Sometimes, you might repeat what you said in the debt section in the tax section, but if you know that you do owe $20,000 to the IRS, that’s already been determined, that you have an outstanding debt and you’re on a payment plan, that is more just specifically spoken to in the debt section because it is, likely, a marital debt if it was incurred during the marriage.
LEGAL RESPONSIBILITY FOR TAXES: TO YOUR SPOUSE VS. TO THE GOVERNMENT
The other thing I want to point out is there is a big difference between assigning responsibility for – and I’m speaking here more to taxes owed or tax liabilities – big difference between assigning responsibility for those between you in your contract, and how the IRS sees your responsibility for the particular tax debt.
If you file jointly, as in married filing jointly, during your marriage, it doesn’t really matter whose income or disallowed deduction the particular tax debt is tied to. You are both what’s called “jointly and severally liable” meaning, you’re both a 100% responsible, with some very slim exceptions, for whatever the tax debt is, if you both signed, validly signed, the return.
The IRS doesn’t particularly care if you and your spouse then say in your divorce agreement, “Okay, my spouse is going to be 100% responsible for this,” or “they’re going to be 75% responsible, and I’m only 25% responsible, if we have a future tax debt,” if it was a tax return that you filed married filing jointly.
If you filed married filing separately, you are, in the eyes of the IRS, individually responsible for taxes owed on your individual, separate returns.
But in the eyes of the divorce court or divorce law, if the debt was incurred during the marriage, it may well be seen as a marital debt to be divided between you.
So I just want to draw that distinction. And, I want you to be aware that you can’t completely clear yourself of any tax liability just simply by saying that your spouse is 100% responsible for it in your divorce agreement. Even though that is positive, it’s something positive, it just doesn’t definitively protect you from any future action against you by a taxing authority.
With regard to future audits, by the way, it’s very common to say that the spouses, in the event of an audit, will cooperate with each other, freely share paperwork, and generally collaborate. That’s, kind of, a no-brainer because both people really have an interest in an audit going favorably for them.
You may, though, speak to how the costs would be handled. You may say, we would share 50/50 the cost of any audit, or this spouse will cover, either due to their higher income or due to their, maybe, riskier tax practices.
You don’t have to speak to it, but especially if you anticipate that you will be audited, you may want to speak to it in your agreement.
FUTURE TAX LIABILITIES (ON FUTURE TAX RETURNS)
Next topic that is commonly covered in a divorce agreement (related to taxes) is taxes owed on future returns. Let me give you some examples.
FUTURE CAPITAL GAINS TAXES OWED
For instance, if you share real estate, let’s say you have a home together, and you make a plan to co-own your home for a couple of years and then sell it down the road. When you sell your home, if you sell it for substantially more than you bought it for, you have realized what is called a “capital gain,” and you are taxed on capital gains.
Well, we want to speak to how you are going to share responsibility for any capital gains taxes owed on the property.
An important thing to know about a home, a primary residence, is that both spouses, if you meet the eligibility test, can be eligible to exclude, or not pay taxes on, $250,000 of capital gain each. So, together, the spouses could exclude or not have to pay taxes on $500,000 of capital gains, which is a big deal.
There are ways that we can address that and maintain the exclusion within a divorce contract, and that’s something you really need to speak to your mediator or your attorney and CPA about it. It should be a joint effort, honestly.
TAXES ON DEFERRED COMPENSATION
Another type of future tax that is common to speak to in a divorce process is if part of your or your spouse’s employment involves equity-based compensation – for instance, stock options or restricted stock units, or stock appreciation rights – you will not have, necessarily, been taxed on that income at the time you “received” it.
I just want to distinguish between the time that your employer says to you or to your spouse, “We are awarding you, whatever, 6,000 restricted stock units, and they will vest in three separate sections, or tranches, over the next three years, 2,000 RSUs at a time.” At the time that you are granted that award but you don’t have a vested interest in the restricted units, you won’t have necessarily paid your income taxes on them.
But, in the future, when they do vest, as in when you are entitled to exercise, liquidate them, do whatever you want with them, you will be taxed on them.
So, something spouses need to negotiate and keep in mind with regard to splitting deferred compensation or equity-based compensation is, let’s think about, will taxes be due on this compensation or this asset in the future? If they are, how are we accounting for that in our agreement?
EFFECTIVE TAX RATE VS. MARGINAL TAX RATE
Actually, on that subject, I do want to make a distinction that may be helpful to keep in mind between your overall tax rate, your total percentage of all income that went to taxes, versus your marginal rate, as in, you’re paying a higher rate of taxes for the last dollars of your income than you are for the first dollars of your income, if that makes sense.
So, the taxes that you pay when you realize an additional $100,000 in equity-based compensation in a given year, you’re often taxed at a higher rate than you were on your first $300,000 of compensation in the calendar year.
That’s just a flag for you that that issue exists, and that really is something for you to clarify and understand better with your own tax professional.
CHILD-RELATED TAX BENEFITS
Another subject that we speak to, in addition to future taxes owed on future returns, are future tax benefits on future tax returns. Most common among those are child-related tax benefits.
There are numerous child-related tax benefits. We typically speak to what’s called the “dependency exemption.” That is because, if there are – I don’t know how many, but say – five or six child-related tax benefits that you can claim on a tax return, there are only two that you can trade between spouses in a divorce.
The most commonly traded one is the dependency exemption.
If you don’t say anything about it, it is the entitlement of the custodial parent, but you can agree to trade entitlement to it, and there’s a form called “Form 8332” that the custodial parent will use to record giving the permission to the other parent to claim, say, a particular child for a number of years. It can be one year at a time, it can be for a series of years ongoing, basically, any way you want to, sort of, divvy it up.
If you have multiple kids, one person taking one of each of the two kids, or one person takes two and the other person takes one, if you have three kids. It can really go however you want to share this benefit, which is nice. There’s a lot of flexibility there.
Or you don’t have to say anything at all, and in that case, the custodial parent is the one entitled.
I do want to flag that at a certain level of income, an exemption like this or a tax benefit like this can be phased out. So, it actually, depending on what your income level is, it may or may not create a tax benefit for you. That is definitely something to clarify with a CPA.
REAL ESTATE-RELATED TAX BENEFITS
In addition to child-related tax benefits, there are tax benefits related to your home, if you own your home. Two common ones to speak to are the mortgage interest deduction and real estate taxes.
What we are speaking to there is who is entitled to claim these things as a deduction on their tax return in future tax returns.
That may simply be, well, the wife is staying in the home, and she is entitled to claim the mortgage interest deduction and the real estate taxes associated with the home.
Or maybe the husband is staying in the home, but you’re doing some sort of sharing of expenses for three years, and then selling the home, you may, in that case, negotiate a sharing of the tax deductions or tax benefits related to the home.
It’s really up to you, and it’s very flexible.
Let me turn now to addressing some of the trickier tax-related issues or common pitfalls that I see among tax-related issues in a divorce.
CONFUSING PRE- AND POST-TAX INCOME
The first one, I know for some of you this may be getting very basic, but first confusion that I see is confusing pre-tax income and post-tax income.
Basically, the distinction is, for instance, if you earn a salary of a $100,000, that is pre-tax income. You do not have a $100,000 of spending money in your pocket after you pay taxes. I don’t know, maybe you have $75,000 or $72,000 – I don’t know what your effective tax rate is – but you have some amount less than that of post-tax income.
This is really important when you are trying to look at your income and your expenses to figure out, what do I have coming in on a monthly basis or at an annual basis, and what are my outflows, and how am I ensuring that those things match up, to the best of my ability?
Specifically, keep in mind that child support is post-tax income or a post-tax payment. You do not declare it as income. And I know we’ve covered this in our prior episode on support, but child support, you don’t declare as income, you don’t pay taxes on it. It is just like, if you have salary, what you get in your take-home paycheck. It’s post-tax income.
Similarly, if you are paying child support, you are paying for that with your post-tax income.
If your salary is a $100,000 and you’re paying child support of $10,000, it’s not that you have $90,000 to work with. In fact, let’s say your salary is $100,000 and after taxes you have $75,000 of post-tax income to spend. You are paying your child support obligation out of that amount, out of that $75,000.
So, if you’re paying $10,000 a year child support obligation, you actually have $65,000 a year to work with and to cover your own expenses.
PRE-TAX ASSETS VS. POST-TAX ASSETS
Similar to that confusion is confusing pre-tax and post-tax assets.
What I mean by that is if you have a checking account in your local bank, and you have $50,000 in there, that is post-tax money. You do not owe taxes on that.
Whereas, if you have $50,000 in, for instance, a retirement asset like a 401k, that is pre-tax money, and it is not worth the same as $50,000 in a checking account. You will have to, when you withdraw that money, assuming you withdraw it after the proper age, you will have to pay income taxes on it. (If you withdraw it prior to the proper age, you will have to pay income taxes and a penalty on it.)
At a minimum, for instance, for the retirement asset, you are going to pay taxes on that asset in the future, so you want to be careful to not be comparing apples and oranges in saying, “Okay, you keep $50,000 in retirement accounts, and I’ll keep $50,000 in this shared checking account.”
That may work, but just do that with the awareness that the $50,000 in retirement, actually, is not the same as the checking account because you will owe a future tax liability on that.
TAX RETURN INCONSISTENCIES
Another problem that comes up for people, and this is not so much in the negotiation phase as it is in the years following the divorce, where they are just separately filing their taxes and going about their lives, is the problem of inconsistency on future returns.
I see that come up in two key ways.
Claiming the Same Child
One is where both parents are claiming the same child as their qualifying child. They’re, for instance, claiming a dependency exemption for that child.
That can really open you up to an audit. So, you want to be crystal clear about what your plan is for claiming your child or children as a qualifying dependent on your future tax returns.
Different Amounts of Alimony Claimed
Then, similarly, where you have alimony or spousal maintenance being paid, you want to be crystal clear that you’re both claiming the exact same amount.
Surprisingly, this happens not infrequently, and people get audited as a result, which really stinks and is expensive for you, where you claim $12,000 in income, and your spouse claims a $15,000 deduction for alimony.
You don’t want to do that. That opens you up to more scrutiny of your taxes than, ideally, you would like.
TAXABLE ALIMONY VS. TAX-FREE CHILD SUPPORT
Another topic where people can get into some trouble around alimony is, well, twofold.
As I’ve said, alimony is tax-deductible by the payor, and it’s taxable to the recipient. In theory, if the recipient is at a lower tax bracket than the payor, there can be tax savings to be realized.
So, rather than having the payor take a dollar of pre-tax income and pay taxes on it at 40% and only get $0.60 on the dollar post-tax income, having the recipient of the alimony pay taxes on it at a 20% bracket and end up with $0.80 from that same dollar.
So, there can be, if you’re in very different tax brackets, there can be some, you know, legitimate tax savings that is produced by alimony payments.
In line with that, the IRS is a little bit wary that you might be motivated to call, for instance, child support payments alimony payments and realize the tax savings, or to call a property division, a division of an asset, some account, alimony to realize tax savings.
Let me flag for you how problems can come up in those two areas related to child support and property division.
If the alimony payments that you and your spouse agree to are changing or ending on child-related events, like a birthday, or a graduation from high school, or a college, the IRS may not believe that they are alimony payments, and they may say, “Actually, this is child support disguised as alimony to realize a tax savings, and we’re not going to let you deduct it.”
Then, you’re in, kind of, a mess because the payor spouse has been, they’ve probably agreed to an amount of alimony relying on getting the tax deduction, and that can leave them in a really bad place.
TAXABLE ALIMONY VS. TAX-FREE PROPERTY DIVISION
With regard to alimony being scrutinized as a disguised property division, you want to take note. The division of property in a divorce is tax-free. And, the IRS is wary that you may, instead of transferring a $100,000 from your checking account, you may wish to get a write off as alimony, and you’ll just call it alimony, and pay that alimony for one year, and then stop. That, to the IRS, would obviously be not alimony but dividing property and trying to get a tax benefit for it.
If, in the first three years of your alimony payments, there are reductions in the amount, please look at that closely with your CPA because there’s a particular formula that determines whether the reductions are too steep for the IRS’ taste.
If they are, the IRS may well say, “This is not alimony. This is actually you dividing an asset and just trying to get a tax write-off for it. We don’t believe you, and we’re not going to let you deduct it as alimony.”
The other component to, potentially, having your alimony disallowed by the IRS could be if didn’t terminate on the recipient spouse’s death, which I can’t even think of an agreement that I have seen where it did not terminate on the recipient spouse’s death. Just to flag for you, that is a requirement for alimony to be deductible by the IRS, is that it would end on the recipient spouse’s death.
Then, be careful not to – I don’t know a better term for this than “double dip” – but, sort of, not to duplicate deductions.
For instance, if you are the payor of spousal maintenance, and you’ve agreed with your spouse that you are going to pay the mortgage directly to the bank, and that’s going to be spousal maintenance, you do not want to deduct the full amount of your alimony payment and the full amount of the mortgage interest paid.
This gets into, or would require us to get into, more detail than we have the bandwidth to do in this episode, so I just want to flag for you if a mortgage interest deduction and alimony deduction are on the table in your divorce, you need tax advice as part of your divorce.
DEDUCTING LEGAL FEES
Speaking of tax advice as part of your divorce, a lot of people have the question whether they can deduct the cost, the legal fees for their divorce, whether that’s a deductible expense for taxes.
Generally speaking, it is not. However, fees related to tax preparation are a deductible expense, and you want to consult with your CPA or tax attorney before you commence a divorce to get clarity on whether you may be able to deduct your legal divorce fees that are devoted to discussing tax-related topics like tax-deductible alimony, like all the different topics that we have talked about in this episode – whether those would be deductible, and, if so, what you would need to put in place for them to be deductible.
SHOUT OUT TO THE IRS WEBSITE!
Finally, I just want to direct your attention to the IRS website.
That’s probably not the most, it doesn’t seem like the most thrilling website, but, actually, I have to give the IRS a big shout out because they do an amazing job of explaining and breaking down the multitude, infinity, of different complex concepts that come up in a divorce.
Specifically, they have two publications that may be very helpful for you.
Those are: “Publication 504.” You can just, literally, google “IRS Publication 504.” That is the publication for divorced and separated individuals. It speaks to a host of topics, many of the topics that I’ve spoken to in this episode, and just a host of topics that are relevant for you when you’re going through a legal separation or a divorce process and that, sort of, interface with taxes.
Then, “Publication 523” on selling your home is also very helpful because it has a section that talks about the capital gains exclusion, and the tests for eligibility for the capital gains exclusion, and the different exceptions that are put in place for the individuals who have gone through or are going through a divorce and selling a home.
That is it for our Episode 16 on taxes and divorce. I really hope you found it helpful. Next up, we are going to be talking, in Episode 17, about insurance, both health insurance and life insurance, and also about estate planning.
Until then, thank you so much for joining me and I will look forward to speaking with you soon.