Divorce & the IRS Whipsaw
Volume 6 Issue 4 -- July/August 2002
As if divorce were not bad enough by itself, there’s the potential problem of taxes.
In the ancient past, the ex-spouse who paid the alimony, usually the ex-Husband (“H”), was not allowed to deduct the alimony from his taxable income. Tax law eventually changed and alimony became deductible to H and taxable to the assumed recipient, the ex-Wife (“W”).
While alimony is now tax deductible to H, child support and property settlement payments still are not, but they are tax-free to W. Thus, the stage is set for the struggle over labeling B is the payment alimony, child support, or a property settlement?
The determination usually revolves around the wording in the Divorce Decree or Property Settlement Agreement (“PSA”). The PSA usually addresses alimony, child support (if any), and the property settlement between the spouses.
If the PSA is unclear about the definition of alimony, H & W may report the payments inconsistently. The Internal Revenue Service (“IRS”) may notice, for example, that H is claiming a deduction for alimony and W is not reporting the same amount as income from alimony. Essentially, the income is tax free to both spouses, a result not condoned by your friendly tax authorities.
Rather than decide which ex-spouse is correct, the IRS usually takes the position that both are wrong. For example, the alimony claimed by H will be disallowed as a deduction to H; meanwhile, W will be taxed on the same payments she did not report. The IRS takes inconsistent positions and lets the ex-spouses “duke it out” knowing that both cannot win. Since the IRS lets H & W argue, knowing full well that ultimately one must win, the IRS is, in essence, standing on the sidelines, waiting for one spouse to concede or eventually lose in court, if the controversy goes that far.
Since 1984, the tax law has six criteria to determine what is “alimony” under a PSA, which is typically incorporated in or confirmed by the Divorce Decree:
Understandably, when spouses are fighting during a divorce and their attorneys may not be communicating effectively, it is easy to toss up one=s hands in disgust and not worry about future tax issues. Also, some divorce attorneys do not provide tax advice.
One point often overlooked from a tax perspective is that of filing tax returns for the final year of marriage. In some cases, the spouses do not designate that a joint return will be filed. If there is a dispute on this point that cannot be amicably resolved, the only remedy may be to go back to the Court that issued the Divorce Decree and request enforcement against the non-consenting spouse.
Another situation which creates headaches and tax issues is joint ownership of real estate after a separation or divorce. Occasionally, divorcing spouses continue to own real estate jointly after the divorce. In such cases, there are both tax and legal issues which can be very difficult to surmount, such as:
When and how will H & W agree to sell the property?;
Who pays, and is entitled to deduct, maintenance and mortgage payments?;
Since a joint return cannot be filed, how will gain from the sale of the property be reported by the spouses?
Continuing business interests in an operating company (corporation, LLC, or partnership) can create substantial problems too numerous to mention.
This newsletter cannot cover all of the tax issues of divorce. It can only point out the need to consider taxes in divorce planning.
Copyright 2002
Published by the law firm of Newland & Associates, PLC
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