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KATHRYN IRENE PHILLIPS

TAX ISSUES IN FAMILY LAW

 Every family law case involves some aspect of tax law. The purpose of this article is to help parties involved in family law cases to be aware of some of the tax issues of their cases. The information in this article is of a general nature and is not intended to apply to any specific case.  The nuances of tax law are too complex to present a definitive presentation here and you are, therefore, advised to seek the advice of your tax professional on all tax aspects of your case.

 Four of the general areas of family law impacted by taxes will be discussed in this article: 

  • Spousal and Child Support

  • Dependency Exemptions

  • Property Divisions

  • Deductibility  of Attorney Fee 


 SPOUSAL AND CHILD SUPPORT

CHILD SUPPORT: The most common impact of taxes in family law is first seen in the calculation of child support and temporary spousal support.  In California, it is mandatory to first determine child support pursuant to the Guidelines set forth in the Family Code before the court’s can vary from that amount.  The tax filing status, number of exemptions, and certain deductions allowed from the parties’ gross income are applied to determine net spendable income available for support. A formula set forth in the Family Code is then used to determine the amount of support. That formula is so complex that it must be performed by a computer program. A common program used by the courts for this is Dissomaster.  The DCSS also has its own program for calculation of Guidelines child support. These same computer programs also calculate an amount which the court may award as temporary spousal support. Child support is not tax deductible to the payor.

Dissomaster and other programs like it also have the capability of suggesting shifting the tax burdens of the parties so that money that would have been paid as taxes can actually be paid as support. This tax shifting is called arbitrage and is most impactful when one party is a very high earner and one party has little or no income. The benefit of arbitrage is that the high earner will pay less taxes and the low earner will receive more support. This is something to bear in mind in settlement negotiations and, in the right situation, is a win-win solution for both parties.

SPOUSAL SUPPORT: The general rule is that spousal support, called alimony, in the Internal Revenue Code (“IRC”) is deductible by the payor and taxable to the recipient. However, there are very specific criteria set forth in IRC 71 that must be met to trigger this.  The general rule is that gross income includes amounts received as alimony or separate maintenance payments, provided:

  • The payment must be in cash (not land, car, or other such things)
  • The payment was to a spouse (must be or have been married)
  • Pursuant to a divorce or separation instrument, which means

  • A decree of divorce or a written instrument incident to such a decree
  • A written separation agreement
  • A decree requiring a spouse to make payments for support of the other spouse, such as for temporary support after separation but before trial.
  • The written instrument must state that the payments terminate on the death of the spouse.


If you and your spouse separate and support payments are thereafter made to a spouse, but there is no written agreement for this, the payments are not deductible to the payor nor taxable to the recipient. Also, this can’t be cured by making an agreement retroactive to cover payments already made. Further, if the parties file a joint tax return for the period the payments are made, then both parties are liable for the taxes on the combined income. 


Note that due to the new U.S. tax code amendments,  spousal support will no longer be deductible to the payor if the agreement is entered into after January 1, 2019. 

ATTEMPTS TO TRY TO MAKE NONDEDUCTIBLE CHILD SUPPORT OR PROPERTY DIVISIONS INTO DEDUCTIBLE SPOUSAL SUPPORT ORDERS:    The IRS is very much aware that parties may try to shift nondeductible child support to deductible spousal support, or a nondeductible property division to deductible spousal support and take deductions that they are not really qualified to take on their tax returns. There are a some important pitfalls to avoid:

  1.  IRC 71(c): If the alleged spousal support payments are payments “RELATED TO CONTINGENCIES INVOLVING THE CHILD”, then the payment will be determined to be nondeductible child support and not spousal support.  
    1. “Contingencies involving the child:” such as attaining a specified age, marrying, dying, leaving school, or a similar contingency.
    2. Presumed to be “contingencies involving the child” if
      1. If the alleged spousal support is reduced  not more than 6 months after or before a child of the payor becomes the age of 18, 21, or local age of majority.
      2. The alleged spousal support is reduced on 2 or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24. The certain age must be the same for each child, but need not be a whole number of years.
      3. This is a rebuttable presumption


IRC 71(b)(1)(D):   One of the requirements for payments to be spousal support deductible by the payor  is that the payments must terminate on the death of the recipient spouse.  If, for example, a divorce decree provided for payments of $1000 per month to spouse, but after that spouse’s death, those payment would continue to be paid to another person until a specified amount would be paid, that will most likely be determined to be a nondeductible division of property and deductibility will be denied to the payor. The payee spouse, however, will benefit by this because taxes paid on that $1000 per months will likely be refunded.  


IRC 71(b)(1)(C): Requirement to live separate and apart:  From date of separation to date of entry of your divorce decree, can live separately in same home and still take spousal support deductions. However, from the date the divorce decree is entered, the parties must be living separate and apart to take the spousal support deductions. This may be a real problem for people in Southern California where housing is so expensive and it may take a long time to refinance, do a loan modification, short sell a house, or sell the house.


RECAPTURE: IRC 71(c):    Spouses may agree that payor will pay a huge amount of alleged spousal support in year 1 after the divorce, with substantially less in years after that.  This is also called “front-loading.” The IRS views this as an attempt to pass off a payment to equalize division of property, which is not tax deductible, as deductible spousal support.  There is a specific formula used by the IRS to calculate the recapture amount and the tax consequences of this can be  very substantial.
                     EXAMPLE OF RECAPTURE: Spouse 1 agreed to pay Spouse 2  $96,000 spousal support during the 1st year after the divorce decree was entered, and then $18,000 per year for the next two years. This is classic and the recapture formula will yield an amount recaptured as $63,000. That means that the payor spouse can’t take $63,000 of the spousal support as a deduction and the recipient spouse will not have to pay taxes on that $63,000.  The recapture of this front-loaded, nontaxable property division as deductible spousal support will result in substantial taxes and penalties to the payor. The payee, however, should receive a substantial tax refund.


The IRS also examines the second and third years after a divorce for any recapture amounts, and there is a special formula they use to determine recapture in the second and third years, as well.  


One exception to the Front-loading recapture is where there are fluctuating payments, such as payments of a percentage of income from royalties as spousal support. In year 1 may be a great amount and then in years 2 and 3 nothing because no more royalties. IRC71(f)(5) covers this situation.          

 WHETHER TO FILE JOINT OR SEPARATE TAX RETURNS:
Generally spouses will pay less taxes if they file jointly.  However, the downside of this is that this presents several issues, such as, who will pay the tax due, who will receive the refund, who pays the estimated taxes. The big risk in this is if one party, such as a business owner, underreports income and exaggerates deductions. Both parties are jointly and severally liable for the taxes and penalties due on a joint return.  If you don’t trust the other party, then don’t file together.

            If you do file jointly and the IRS determines an arrearage due, there is an innocent spouse provision in the Internal Revenue Code. This requires that the innocent spouse know nothing about this and not have benefited from the nonpayment of taxes. This provision is not automatically granted and many spouses are relieved, but many are also denied relief from the tax liability on a jointly filed return. This is true especially when the business has been the sole support of the parties’ household during marriage, paid for their cars, lifestyle, etc.


IRC 66, requires that each party report one half of the community property income on their separately filed returns. This is a problem in divorce, because one spouse may not know the extent of the other party’s income or investments. There is also an innocent spouse provision for this situation, but, again, it is not granted automatically.

If you have children by a prior relationship and are paying child support, that may be one reason to file separate returns with your current spouse.  The parent of those other children in a support hearing will be entitled to your tax return.  If you file separately from your current spouse, then your current spouse’s income tax return will not be available to the parent of those other children in a support proceeding. If you file jointly, however, then the return, showing both your and your current spouse’s income, will be available to the parent of those other children.

 If parties file separate returns, the spouse paying spousal support must provide the payee spouse’s name and social security number on the payor’s tax return. Some tax professionals also advise a payor spouse to issue a 1099 to the payee spouse to assure the payee spouse includes all of spousal support actually paid by the payor to the payee spouse in that calendar year.

 DEPENDENCY EXEMPTIONS
The per child exemption is currently $4000 for 2015. Which party will have the children’s exemption affects the amount of taxes the parties will pay and triggers tax planning and negotiation in divorce settlements.

 IRC 152(e) sets forth the rules for determining which parent is entitled to take the child’s dependency exemptions.  If the child receives over one half of the child’s support during the calendar year from the child’s parents who are divorced, or separated under a written separation agreement, or who live apart at all times during the last six months of the calendar year, and such child is in the custody of one or both of the child’s parents for more than one half of the year, that child will be treated as a qualifying child or qualifying relative of the noncustodial parent for the calendar year. 

The general rule is the custodial parent will receive the dependency exemption and will be eligible to claim head of household status.  Do keep records of where the child stayed during the year because, although the divorce decree may say one parent has physical custody, the child may actually be staying more than half of the year with the other parent who is paying support.  You must keep records of this in case your return is questioned by the IRS, and such inquiry may occur years after the fact.  

The parties may reach an agreement that the noncustodial parent will have the dependency exemption to help shift the tax burden between a high income earner and a lower income earner. One caution is that when income reaches a certain high level, the entire benefit of the dependency deduction has been phased out, thereby wasting the exemption. For 2015, the phase out occurs with an Adjusted Gross Income (AGI) of $309,900 on a joint return and $258,250 on a single return. 

FORM 8332: This is the form that is used to transfer a child’s dependency exemption from one parent to the other. This form is available for downloading from the IRS website. This form must be attached to the noncustodial parent’s tax return to show that the noncustodial parent is entitled to take the child’s deduction. 

EXEMPTION FOR COHABITANT: The cohabitant of a taxpayer can be a qualifying relative pursuant to IRC 152(d) if that cohabitant is not a spouse and has resided with the taxpayer for the entire taxable year in the same principal place of abode and their relationship is not a violation of law.  That phrase “not a violation of law” doesn’t have application in California because adultery was decriminalized decades ago in California. However, there may be some states that still do have fornication and adultery statutes, which may prevent a taxpayer from claiming this exemption. 

PROPERTY DIVISION:
MAJOR CHANGE IN THE LAW:  In 1984, IRC 1041 was enacted that made all transfers of property between spouses or " incident to divorce" nontaxable events.     


IRC 1041(b): Such transfers are received by the recipient spouse as gifts with the same adjusted tax basis that the transferor had in the property. This means that there is no capital gains taxes on the transfer.

 IRC 1041(c):  “Incident to divorce” means if such transfer occurs within 1 year after the date on which the marriage ceases, or is related to the cessation of the marriage.

  • A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than 6 years after the date on which the marriage ceases. A divorce or separation instrument includes a modification or amendment to such decree or instrument.
  • If the transfer is more than 6 years after the marriage ceases, there is a rebuttable presumption that the transfer is not “incident to divorce.” Presumption can be rebutted by showing of legal or business impediments to transfer or valuation dispute and transfer was promptly effected after such impediment was removed. 


COHABITANTS AND REGISTERED DOMESTIC PARTNERS (“RDP”) are not treated as married for federal tax purposes.  RDP’s are treated as married for California, but not for federal tax purposes.

  • Green v. Commissioner case: the settlement for restitution claim by cohabitant was taxable to her.
  • Reynolds v. Commissioner case: Cohabitants had implied joint ownership in property divided when they broke up and, therefore, the division of this property is not taxable.
  • EXAMPLE: A & B  own a family home valued at $1 million with a basis of $100,000 (i.e., a gain of $900,000), and stock valued at $1million but a basis of $1.1 million (i.e., a loss of $100,000).  If they agree that A will take the house and B will take the stock, that may look on the surface like an equal division of their property. However, A may be taxed on a gain of $900,000 on the house, and B will have a loss of $100,000. This division has very drastic tax implications for the parties upon sale or transfer of those assets.  


GAIN ON SALE OF PERSONAL RESIDENCE:
IRC 121(a) Exclusion: This is an important aspect of tax law that may have an impact on every homeowner.  This exclusion says that gross income shall not include gain from the sale or exchange of property if, during the 5 year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.

IRC 121(b) LIMITATIONS: Exclusion is limited to $250,000 on a separate return and $500,000 on a joint return, if the parties meet certain very specific qualifications.  This exclusion can only be taken every 2 years. This exclusion doesn’t apply to portion of gain already depreciated. Parties may elect not to have this section apply.

PROPERTY TAX CONSEQUENCES – PROPOSITION 13: Transfers of real property between spouses  or former spouses in connection with a property settlement agreement or judgment of dissolution of legal separation do NOT constitute a “change of ownership” reuiring reappraisal for property tax purposes.

QUALIFIED DOMESTIC RELATIONS ORDERS (“QDRO”):

QDRO's are used to transfer interests in pension, retirement and 401k plans without tax consequences between spouses.  They create an enforceable interest in the plans and amounts received as payouts after retirement are taxable to the recipient and not the employee spouse.

  • In the event a plan contains an early retirement option, the QDRO can provide that non-participant spouse may begin receiving benefits at the early retirement age even if the participant spouse has not retired.
  • A QDRO can provide that payments begin on the later age of 50 or the date participant could begin receiving benefits if the participant terminated employment.  
  • A QDRO can also provide that the nonemployee spouse receive a lump sum distribution. That lump sum will not be taxable to the recipient spouse if rolled over into an IRA, but the transfer must go directly from the Plan subject to the QDRO to the IRA (“trustee to trustee”).


 Transferring interest between spouses in an IRA doesn’t require a QDRO. The IRA funds are rolled over directly from one IRA into the other spouse’s IRA. This rollover is not taxable.   However, if money is withdrawn from the IRA, then, of course, that is a taxable event.

 DISABILITY BENEFITS: are nontaxable to recipient. However, if these benefits are awarded to the other spouse, then they will be taxable.  

STOCK REDEMPTION: Example: A and B own all 1,000 in M Corp as community property. The stock is worth $1million with a basis of $20K. B is active in the business and A is not. As aprt of the community property division, M Corp will REDEEM W’s stock with corporate funds plus a note that calls for additional future payments.

  • Treasury Regulation 1.1041-2T: (a)(1): the form will be respected; A, rather than B, will be treated as having received a distribution from M Corp.
  • 1.1041-2T(c)(1), (d) ex. (2): Even if applicable tax law is to the contrary (for example if B had an obligation to buy A’s shares and M Corp discharges this obligation by buying them) if the Martial Settlement Agreement provides tha the spouses intend the distribution to be taxed to A, it will be so taxed.  The agreement msut stat that it supersedes any other agreement concerning the disposition of the stock.
  • 1.1041-2T (d), ex.(3): This is also true even if B guarantees that M corp will make the deferred payments to A.
  • 1.1041-2T(c)(2), (d) ex.(4): If the Marital Settlement Agreement states that the parties wish the distribution to be taxed to B instead of A, it will be so taxed.  In other words, the distribution is treated as received by B who then transfers the funds to A in a IRC 1041 transfer.
  • IRC 302:  If the redemption of A shares occurs while they are still married, and if corporation has a corporate surplus (“earnings and profits”), the distribution will be taxed to Spouse 2 as a dividend rather than as capital gain.
    • Therefore, the redemption should occur after marriage is dissolved.
    • Even if this is not possible, A  can get capital gain if she has no interest in corporation, even as an employee, and does not acquire any such interest for 10 years, and files an agreement promising to notify the IRS fi she doe (an interest as a creditor is permissible)


DEDUCTIABILITY OF ATTORNEY FEES
The general rule is that the attorneys fees incurred in a divorce are personal and not business and not tax deductible.

BUSINESS: This is true even if most of the fees were spent by the parties who wanted to keep  the business in the property division.  One exception may be where both parties are involved in the business and a part of the attorneys fees were incurred over actual business disputes having nothing to do with the divorce.

EXPENSE OF TAX PLANNING/TAX ADVICE: If the party is seeking spousal support or taxable distributions from a pension plan,  that party can deduct the fees incurred for this.  However, these are itemized deductions and may not be all deductible because they must exceed 2% of the party’s Adjusted Gross Income.  Further, the Alternative Minimum Tax may negate or minimize the effect of these deductions. 

Ask your attorney to segregate or flag attorneys fees that may be deductible in their bills, such as for tax advice or to acquire taxable income such as spousal support or distributions from pension plans, rather than lumping everything together on one billing statement. 

 CAPITALIZATION: However, there are situations where, even if the attorney fees are not deductible on the current tax returns, they may be allowed to be added to the COST BASIS of the business so that when it is sold, the basis of the business is increased by the amount of the fees.

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Phillips@PhillipsFamilyLawyer.com