May 9, 2006

 

 

TAX ISSUES RELATED TO DIVORCE

 

 

Sponsored By:

The Bank of New York

 

 

 

 

 

 

 

 

 

 

Howell Bramson, Esq.

Kathleen Donelli, Esq.

11 Martine Avenue

White Plains, New York 10606

(914) 946-3700

web: www.mccarthyfingar.com

e-mail: info@mccarthyfingar.com

Table of Contents

Page

4          I.          Ownership of Marital Residence

4          II.         Marital Property Divisions - §1041

5          III.        Sale or Exchange of Personal Residence

6          IV.       Deduction for “qualified residence interest.”

6          V.        Dependency Exemption

6                      A.        Qualification of the Child as Dependent

7                      B.        Who Can Claim the Dependency Deduction?

8                      C.        Pre-1985 Separation Agreements

9                      D.        Phase-Out Limitations

10        VI.       Head of Household Designation

10        VII.      Innocent Spouse

10                    A.        Means For Obtaining Relief

10                    B.        Requirements for Innocent Spouse Relief

11                    C.        Separation of Liabilities

11                    D.        Election of Separate Liability

11                    E.        Equitable Relief

12                    F.         Proposed Language for Separation Agreements

12        VIII.     Alimony/Maintenance/Spousal Support

12                    A.        IRC §§215 and 71

12                    B.        Alimony or separate Maintenance payments defined

14                    C.        Recomputation where excess front-loading of alimony                                                     payments

16                    D.        Alimony and separate maintenance payments

20        IX.       Qualified Domestic Relations Orders

20                    A.        QDRO

20                    B.        Types of Plans

21                    C.        Plan Categories

21        X.       Practical Advice

21                    A.        Deducting legal fees on income tax returns

21                    B.        Applying pre-commencement income tax overpayments to post-commencement income tax payments

21                    C.        Need to tax impact capital gains taxes on:

·        Sale of marital residence

·        Transfer of securities

·        Distribution on options that cannot be transferred

·        Transfer of retirement benefits

 

 

I.          Ownership of Marital Residence

 

            A.        Only owner can deduct taxes and interest on mortgage payments.  Can avoid the problem by structuring payments as spousal support.

 

            B.        Payor of spousal support can deduct as alimony interest and property taxes paid directly to mortgagee or taxing authority if payments are required by agreement.

 

II.                  Marital Property Divisions - §1041

 

            A.        No gain or loss recognized upon transfer of property between spouses or former spouses if transfer is incident to a divorce. (Overrule Davis Case.)

 

            B.        Equitable distributions are not taxable.

 

            C.        Applies to sales and exchanges, inter-spousal gifts and in-kind distribution of property.

 

            D.        Applies to losses as well as gains.  “Passive activity losses” is exception to carryover basis.  If H transfers property with suspended losses to W, W will not be able to deduct the suspended losses.  Instead, added to basis.

 

            E.        Holding period tacks.

 

            F.         Requirements

 

                        1.         Applies to transfer of property between spouses and between former spouses if the post-divorce transfer is incident to divorce.

 

                        2.         “Incident to Divorce” - - safe harbor –

 

                                    a.         Transfer occurs not more than one year after divorce or

 

                                    b.         Transfer is related to cessation of marriage if:

 

                                                (i)         Pursuant to divorce or separation instrument, and

 

                                                (ii)        Transfer occurs not more than six years after the

                                                            divorce (payments could be later).

 

                                    If both of the above are not met, presumption that not

                                    covered by 1041.  Presumption can be rebutted.

 

                        3.         What if no transfer is made?

 

                                    See LTR 9143050 (H was plaintiff in patent infringement suit.  Under divorce court’s order, had to pay W 25% of amount received).  Held - - no transfer.  H is taxed on full amount.

 

            G.        Carryover Basis - - must consider tax consequences.

 

            H.        Installment Obligations - - can transfer without acceleration.

 

            I.          Sometimes taxable transfer is desirable.

 

            J.         Installment sale between spouses

 

                        Interest is taxable to recipient.  Interest may or may not be deductible by payor.

 

                        (i)         Deductible if secured by house

                        (ii)        Deductible if business and investment interest

                        (iii)       No imputed interest in 1041 transaction (see Treas. Reg § 1.1274-1(b)(3)(iii))

 

            K.        Business Interests

 

                        Consider use of preferred stock (if C corp., partnership, or LLC)

 

III.        Sale or Exchange of Personal Residence

 

            A.        Gain on sale of principal residence is excluded up to $250,000 (or

                        $500,000).  See Section 121.

 

            B.        Requirements for Exclusion

 

                        1.         Owned and used as principal residence for periods aggregating two years or more in the five-year period ending on date of sale.

 

                        2.         Once every two years.

 

                        3.         If married couples file a joint return in year of sale, either spouse’s ownership and use qualifies.

 

                        4.         Special rules for separated and divorced taxpayers (71(d)(3))

 

                                    a.         If selling T/P previously obtained the home from spouse or former spouse in 1041 transaction, the T/P’s  holding period includes that of spouse or former spouse.

 

                                    b.         If spouse or former is granted use of home under a divorce instrument, that occupant’s use of property as his or her residence during that period is imputed to other spouse.

 

                        5.         Amount of Exclusion - $500,000 if (a) joint return in year of sale; (b) either spouse meets ownership requirements; (c) both meet use requirement; and (d) neither has used exemption in last 2 years.

 

IV.       Deduction for “qualified residence interest.”

 

            A.        What is the meaning of “one other residence of the taxpayer?”

 

                        1.         Probably requires the residence to be owned, in whole or in part, by T/P.  If ownership transferred to ex-spouse, T/P can’t deduct interest (unless qualifies as alimony). 

 

                        2.         Only needs to own portion.  Thus, portion T/P pays which does not qualify as alimony can be deducted as qualified residence interest.

 

            B.        Use as residence - - Does it qualify as “second residence” if non-occupant spouse?   As long as someone uses it as “residence,” probably qualifies, but not clear.

 

            C.        If taxpayer owns portion of property and ex-spouse occupant owns part, payments of his own share of housing expenses cannot qualify as alimony (not payments “on behalf of” payee).

                                   

               

V.        Dependency Exemption

            A.        Qualification of the Child as Dependent

For a child to qualify as a dependent for the dependency deduction, both parents together must provide more than one-half of the child's support during the year and the child is either:

1.         Less than 19 years old;

2.         Less than 24 years old and a full-time student;

3.         The child is 19 years old or older and is not a student but has income during the year of less than the exemption amount.

Dependent must have a Social Security number, unless born in December. Omission of dependent's Social Security Number will result in processing delay and possible $50 penalty. [IRC § 152]

 

IRC § 152 delineates a list of persons who may be considered "dependents".  The taxpayer seeking to claim such individual as a "dependent" must have provided over half of that person's support for the calendar year. Besides children, parents, siblings, stepchildren, stepparents and in-laws are among the delineated individuals.

 

B.   Who Can Claim the Dependency Deduction?

1.         Generally, the parent who has custody of a child may claim the dependency deduction, unless otherwise released to the non-custodial parent, or the court otherwise determines. Custody is determined by the divorce decree or separation agreement. If the agreement is silent, custody is determined by which parent has physical custody during the greater portion of the calendar year.

            2.         There are certain situations in which a non-custodial parent may claim the dependency exemption:

a.         A separation agreement is in effect that designates the non-custodial parent as the person entitled to claim the exemption. [Multiple parties provide support, but none provides over one-half (1/2) of the dependent's support.  Taxpayer contributed over 10% of support and other supporters are not claiming dependent.]

b.         The custodial parent relinquishes his right to claim the exemption to the non-custodial parent. This is done by completing IRS Form 8332.

c.         Court awards exemption [Sheehan v. Sheehan, 152 A.D.2d 942, 543 N.Y.S.2d 827 (A.D. ___ Dep’t 1989)].  Multiple rulings around the country have upheld trial court wards splitting dependents (multiple children) between the parents.  Eickelberger v. Eickelberger, 93 Ohio App.3d 221 (Ohio App. 12 Dist. 1994); Pineiro v. Pineiro, 683 So.2d 148 (Fla.3d DCA 1996)] Get the court to order the releasing party to sign Form 8332; include release as part of separation agreement and divorce judgment along with language that the releasing party will not claim the dependent. 

Notice, that the custodial parent has the control over the assignment of this exemption.

3.         a.         Pursuant to the authority accorded by IRC Section 152 (3) (2), successful completion and attachment of IRS Form 8332 enables the non-custodial parent to claim the dependency exemption.  Satisfying the signature requirement is critical for this to occur.

            b.         Along with the signature of the custodial parent confirming his or her consent, Form 8332 requires the taxpayer to furnish:

(i)         The names of the children for whom exemption claims were released;

(ii)        The years for which the claims were released;

(iii)       The Social Security number of the custodial parent;

(iv)       The date of the custodial parent's signature; and

(v)        The name and the Social Security number of the parent claiming the exemption.

Under Form 8332, the assignment of the dependency exemption can be released for the current tax year, or the assignor can release the claim to the dependency exemption for all future years or for a specified number of years.  A signed form 8332 or its equivalent must be attached for each year the non-custodial parent is taking the exemption.

[NB. - If the assignor is the recipient of child support, a provision could be included in the separation agreement that the assignment of the dependency deduction(s) would only be effectuated if the payor/assignee is not in default with his/her child support payments. Thus, Form 8332 should be signed and delivered on an annual basis if such motive is sought.]

            4.         In order for assignment of the dependency exemption to be available, the assignor, spouse or former spouse [assuming both are the parents of the child] must (a) be divorced or legally separated; (b) have lived separate and apart at all times during the last six months of the calendar year; and (c) have a child that is in the custody of one or both of the parties (as parents) for more than half of the calendar year.

            5.         Paternity Actions. IRC § 152(e) refers to children of divorced or legally separated parents. The Code refers to child of "divorced" parents when addressing the support test. Cases around the country have followed the application of the dependency deduction to non-married persons. In Radim v. Commissioner, TC Memo 1987-348, the holding imposes the burden of proving payment of over one-half of the dependent's support and disallows reliance upon a waiver from the other parent which is applicable only for separated or divorce parents.

6.         The release by the custodial parent may be revoked. However, such revocation is only considered by IRS if the non-custodial parent refrains from claiming the child as a dependent. Thus, this is reason for annual signing of Form 8332 rather than open-ended assignment.

C.        Pre-1985 Separation Agreements

For those who have been divorced under an agreement executed prior to 1985 in which it provides that the non-custodial parent is entitled to the dependency exemption, the non-custodial parent must provide at least $600 of child support to the child. In looking at whether or not this test is met, the child support owed for an earlier year, if paid, is considered support for the year paid, up to the amount of the required child support for that year.

D.        Phase-Out Limitations

The IRC sets forth limitations as to the availability of the dependency deduction for higher income taxpayers. Do not argue over a dependency deduction where there may be no benefit to your client.

1.         The deduction for personal exemptions is phased-out ratably for taxpayers once their income gets to a certain level. For the year 2006, these thresholds are as follows:

The exemption is phased-out once the threshold AGI is reached. These phase-out thresholds are adjusted annually.

            2.         These thresholds are to be adjusted annually for inflation.  For tax years beginning in 2006 and 2007, the personal exemption phase-out amount is itself reduced by the applicable percentage. Specifically, in 2006 and 2007, the personal exemption reduction amount equals two-thirds of the otherwise applicable reduction amount.  See Section 151(d)(3)(E) of the Code.

 3.        Negotiation of dependency deduction

a.         Because of the phase-out tied to levels of income, in negotiating who will get the exemption(s), one should keep in mind the parties levels. This approach should maximize the tax benefit of the dependency exemptions.  If the parties can agree and settle on allocating exemption back and forth every other year, why not expand the language in the agreement to include the following:

b.         Possible language: If it is determined that the spouse who is allocated the dependency exemptions cannot obtain any tax benefit from them for a particular year, due to their level of income or any other reason, that spouse will agree to sign Federal Form 8332 allowing the other spouse to take the various dependency exemptions. Any tax savings generated to the other spouse who has now taken the dependency exemptions shall share the tax benefits received equally with the other spouse.

VI.       Head of Household Designation

Under IRC §2(b)(1), “head of household” can only be claimed by the parent with whom the child primarily resides.  Therefore, a parent having “joint legal custody” could not claim “head of household” status if the children reside with the other parent.  However, if the parents have “shared physical custody,” there does not seem to be a prohibition against designating one child’s residential address with one parent and the second child’s residential address with the other parent.

 

VII.      Innocent Spouse

A.        When one files a joint income tax return, both taxpayers are jointly and individually liable for the entire tax. However, if one spouse qualifies as an "innocent spouse", he/she will be relieved of the tax, penalty and interest. A spouse can get innocent spouse relief through the following means:

1.         Innocent Spouse relief

2.         Separation of Liability

3.         Equitable relief

B.        Requirements for Innocent Spouse Relief

Qualified as an innocent spouse -- to meet this test, one will need to meet the following requirements:

1.         A joint return had been filed for the taxable year.

 

2.         The joint return contains understatement of tax attributable to a grossly erroneous item of the other spouse.

 

3.                  The other spouse did not know and had no reason to know there was such an understatement of tax at the time the return was signed.

 

4.         It would be inequitable to hold the innocent spouse liable for the deficiency attributable to the understatement, taking into account all facts and circumstances. (In this situation, the IRS will consider whether the spouse requesting innocent spouse relief received any substantial benefits from the other spouse's tax deficiency.)

C.        Separation of Liabilities

The spouse, who had previously filed a joint return, may elect to have the liability limited to the portion of the deficiency that is attributable to him/her. The burden is on the taxpayer electing the relief to prove that the allocation is proper (one way is to look at what would have been allocated to the individual if the spouse had filed a separate return for the year in question). The limitation of liability is to the extent that items giving rise to the deficiency are allocable to that spouse. To qualify for this exemption, the spouse electing the relief must be either:

1.                  No longer be married to the other spouse;

2.                  Legally separated from the other spouse; or

3.                  Living apart for at least twelve (12) months from the other spouse with whom he/she originally filed a joint tax return

            Please note that this exception would not be available to the spouse if the IRS can show that assets were transferred between the joint filers as part of a fraudulent scheme, or that the electing spouse had actual knowledge-of the understatement.

 

D.        Election of Separate Liability

1.         The spouse may elect separate liability up to two (2) years after the date the IRS begins collection activities. The spouse may also petition the Tax Court within ninety (90) days after the IRS mails a notice denying innocent spouse relief.

2.         The IRS will not automatically grant relief to the spouse even if all conditions are clearly met.  The spouse requesting the relief must elect this treatment by filing IRS Form 8857, "Request for Innocent Spouse Relief". If the spouse qualifies for relief under the innocent spouse rule, he/she is relieved of liability of tax, interest, and penalties.

            E.        Equitable Relief

                        Even if "innocent spouse" or separate liability elections are not available, the spouse will not be liable if, taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or deficiency.

            F.         Proposed Language for Separation Agreements

                        Language in separation agreements may assist the "innocent spouse" if a future tax liability issue arises.

                        Innocent Spouse Statement.   Wife/Husband has no knowledge as to the contents of any of the parties' federal and state income tax returns prepared by Husband/Wife or on his/her behalf, except as to any income that Wife/Husband has received.   Wife/Husband has not been involved in Husband's/Wife's business and is not aware of the information provided by Husband/Wife to his/her accountant in connection with income and expenses or other deductions related to his/her business(es) or amounts included in their joint federal and state income tax returns. Husband/Wife has read, and it has been explained to him/her by his/her attorney and accountant, the definition of "innocent souse" and related rules as provided by Section 6015 and other related sections of the Internal Revenue Code. Husband/Wife hereby acknowledges that Wife/Husband is an innocent spouse, as defined by the Internal Revenue Code, with respect to the joint federal and state income tax returns filed or to be filed.

 

VIII.     Alimony/Maintenance/Spousal Support

            A.        IRC § 71  — Alimony and separate maintenance payments.

                        General rule.

                        Gross income includes amounts received as alimony or separate maintenance payments.

           

            B.        Alimony or separate maintenance payments defined.

                        For purposes of this section —

                        (1)       In general. The term "alimony or separate maintenance

payments" means any payment in cash if —

A.                 such payment is received by (or on behalf of) a spouse under a divorce or separation instrument,

B.                 the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under this section and is not allowable as a deduction under Section 215,

C.                in the case of an individual legally separated from his spouse under a decree of divorce or under a separation agreement, the payee spouse and the payor spouse are not members of the same household at the time such payment is made, and

D.                there is no obligation to make any such payment for any period after the death of the payee spouse and there is no obligation to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

                        (2)       Divorce or separation instrument.   The term "divorce or separation instrument" means —

A.                 a decree of divorce or separate maintenance or a written  instrument incident to such a decree,

B.                 a written separation agreement, or

C.                a decree (not described in subparagraph (A)) requiring a spouse to make payments for the support or maintenance of the other spouse.

                        (3)       Payments to support children.

                                    A.        In general.  Payments do not constitute alimony or separate maintenance payments to the extent the terms of the divorce or separation instrument fix (in terms of an amount of money or a part of the payment) such payments as a sum which is payable for the support of children of the payor spouse.

                                    B.        Treatment of certain reductions related to contingencies involving child.   If any amount specified in the instrument will be reduced –

            1. on the happening of a contingency specified in the instrument relating to a child (such as attaining a specified age, marrying, dying, leaving school, or a similar contingency), or