Divorce Tax Implications and Financial Planning
To prevent expensive and unnecessary added tax costs to a marital settlement, maximize the net asset and income property awarded, and avoid possible post-divorce financial pitfalls, it is crucial to consider the tax aspects of divorce and plan for its long term economic consequences
Financial Planning in Divorce – Avoiding Financial Disaster
Careful review of the long-term financial consequences of a divorce settlement is essential.
Although obtaining a certified divorce financial analyst is often advisable for high asset complex divorces, at Weintraub Law Office, we can help prepare and analyze much of the basic financial planning work such as valuing assets and liabilities, developing realistic budgets, estimating spousal maintenance needs, comparing after-tax proposed settlements, and developing alternate settlement proposals.
Settlements that appear fair on the surface do not always take into account the long term economic consequences associated with post-divorce spouses relying on their individual finances to maintain separate households, particularly where when there is a substantial disparity in current and prospective earnings and children involved.
Example: The Smaller Earner Takes the Big House Scenario
A foreseeable problem occurs when a relatively low income earning spouse with few prospects at significantly increasing future income takes over a large home and associated high mortgage so the children can continue to reside in it. The “breadwinner” has moved out and is living in an inexpensive rental.
While the spouse may have retained equity in the home in exchange for savings awarded the other spouse, the asset is tied up in the house and may not be accessible unless she sold it at potentially great cost (i.e., after incurring costs of improvement to prepare for sale, real estate commissioner fees, and excise taxes). Even if a retirement plan were obtained, it is typically not accessible without severe tax penalties for early withdrawal. The result is that the spouse may end up needing to sell the home with little or no savings left. The “breadwinner” spouse, however, has managed to grow his savings appreciably as his earnings have foreseeably improved. With careful financial planning and an alternate divorce settlement, such long-term consequences may be avoidable.
Alimony (Spousal Maintenance) is Gross Income
Alimony or spousal maintenance payments received by an individual are includible as gross income on his or her tax return. The payor spouse is allowed a deduction from gross income for payments of alimony. Depending on each party’s individual tax brackets, this can be an important issue to address in property settlement negotiations.
Making Sure Alimony Payments Are Tax Deductible
There are certain IRS requirements to be met before alimony payments qualify as deductions:
- Payments in cash or check. The payments must be made in cash or by check and received by or on behalf of the former spouse. Cash payments for such things as rent, mortgage, and tuition liabilities may qualify, though an accountant should be sought to confirm if such “indirect” cash payments on behalf of the spouse are contemplated.
- Payments in accordance with a divorce or separation agreement. The payments must be made in accordance with a divorce or separation instrument such as a written separation agreement, separation contract, court order (including a temporary order), or decree.
- Payments should not be described as child support or as part of a property settlement. Child Support payments, unlike alimony, are not tax deductible. Similarly, payments made as part of a property settlement are not tax deductible.
- Payments must end at recipient spouse’s death.
- The former spouses must be living apart and not file a joint tax return.
- Payments cannot be front loaded. Alimony that is excessively high in the first two post-separation years is considered part of the property settlement and subject to “recapture”. “Recapture” means excess alimony payments in the first and second years must be included in the payor’s gross income in year three.
Property Transfers Are Generally Not Taxable Events in Divorce
Transfers of property between spouses based on a divorce, legal separation, or separation agreement are generally not taxable events, so no gain or loss is reported. For example a husband’s transfer of his property interest in the marital residence to his wife as part of a divorce settlement is not reportable as capital gain or loss to the recipient spouse.
Tax Consequences Are Generally Not a Factor in Valuation
Unless the tax consequences are imminent, or result from a trial judge’s decision regarding property division, and the tax is not speculative, tax consequences are not considered in valuing marital assets for property division purposes.
For example, a spouse awarded a retirement account who may decide post-divorce to withdraw monies early cannot factor in any future 10% penalty tax and income tax consequences to reduce the current value of the account for property division purposes. However, if the parties agree in their divorce settlement that early withdrawal is necessary to provide sufficient liquidity to meet the spouse’s financial needs, the tax consequences can be used as a factor.
Who Gets the Dependent Child Exemption in Divorce
The federal tax code, by default, allows the parent with custody of a child for the majority of the calendar year to use the dependency exemption deduction for that child. The dependency exemption acts like a tax deduction. However, the tax code allows the custodial parent to waive that right so the non-custodial parent can use it, and allocation of the dependency exemption is often divided between the spouses, or even allocated to the higher earning spouse, in a divorce. The parent claiming the dependency exemption also claims the child tax credit for the child.
Washington courts awards the dependency exemption based on a number of factors including which parent provides the majority of the child’s support and the degree of economic benefit each party would obtain from the exemption. An accountant may be necessary to calculate potential benefits.
Filing Status before the Divorce is Obtained
A spouse’s marital status for tax filing status purposes is generally determined at the end of the year.
If still married on December 31, the couple can file a joint income tax return or each spouse can file a separate (married) income tax return.
A spouse may also file as head of household if the couple separated prior to July 1 and continues to live apart at year’s end, the divorce (or decree of legal separation) has not been entered by the end of the year, and for the last six months of the year the parent has paid more than half the cost of maintaining the household that was the main home of the dependent.
For tax filing status post-divorce, See Tax Issues After a Washington State Divorce.
Reporting Taxable Income before the Divorce is Obtained
With some exceptions, a couple filing separate returns for the year must report community income and deductions equally. Thus, if a couple separates during the year, and file separate returns, they must report one-half of the community income and deductions for the period prior to the separation date. This means separated spouses often must exchange W-2 and year to date pay stub information which each other to properly file their tax returns for the year of separation.
The Innocent Spouse Rule and Divorce
A joint tax return imposes “joint and several” liability on spouses, so mistakes or intentional omissions by one spouse can leave the other fully liable for the underpaid tax. The IRS can collect against the “innocent spouse” unless that spouse can meet the requirements of the Innocent Spouse Rule. To pursue an “innocent spouse” claim, hiring a tax lawyer is advised.
Divorce lawyers often include hold harmless and indemnity clauses in settlement agreements and decrees to protect the “innocent spouse” against potential future harm. Such provisions allow the “innocent spouse” to obtain a judgment for reimbursement. The only way to prevent collection, however, is by meeting the requirements of the rule.
Deductibility of Legal Fees in Divorce Cases
You cannot deduct legal fees and court costs for getting a divorce. However, you may be able to deduct legal fees for tax advice in connection with a divorce and legal fees to obtain taxable income (i.e., alimony or spousal maintenance).
Tax Consequences of Equity Compensation Plans
Tax consequences of equity compensation plans, and addressing the mechanics by which spouses are to exercise stock compensation awards post-divorce, are complicated matters that require an experienced divorce lawyer. The following information provides a summary comparison of such plans and their tax consequences.
- Employee Stock Options
Stock options give employees the right to buy the company’s shares at a price fixed at date of grant for a specified number of years. Employees must meet certain vesting requirements, such as continuation of service and/or meeting of performance goals, before the right can be exercised. There are two types of stock options with different tax consequences:
- Nonqualified Stock Options (NSO). Nonqualified stock options allow an employee to purchase the employer’s shares at an amount determined by the grant price. Once vesting requirements have been met, the employee may “exercise” the stock option by purchasing the stock at the grant price. The difference between the grant price and the fair market value of the shares on the date the option is exercised (i.e., exercise or strike price) is the “spread”. The “spread” is taxed as ordinary income or loss at the employee’s tax bracket and included in the individual’s W-2 even if the shares are not yet sold. However, if the employee does not sell the stock upon exercise of the option but does so at a later time, any difference between the fair market value on the date of exercise and the sale price is reported as a capital gain or loss.
- Incentive Stock Options (ISO). Incentive stock options qualify for special tax treatment. Subject to certain holding period and other requirements, an ISO allows an employee to defer taxation from the date of exercise to the date of sale of the underlying shares. When sold, the difference between the grant price and the proceeds from sale of shares is taxed as capital gain or loss.
- Employee Stock Purchase Plans (ESSP)
These plans allow employees of a corporation to purchase the corporation’s stock, usually at a discount (typically 10%-15%), at the end of an offering period. Employees contribute to the plan through payroll deductions which increase during the offering period. On date of purchase, the company uses the accumulated funds to buy company shares on behalf of the employee. Employees are not taxed until they sell the stock. Upon the employee’s sale of shares, the difference between the share value at the beginning of the offering period and the discounted price (or the actual profit on sale if less) is taxed as ordinary income, and any other gain or loss is taxed as capital gain or loss.
- Restricted Stock Units (RSU’s)
Restricted stock plans generally give employees the right to obtain and purchase shares at cost, discount, or no cost, depending on the plan, only after vesting requirements are met. The shares of stock are restricted from being delivered until vesting and forfeiture requirements are satisfied. The difference between the grant price of the stock and the fair market value of the stock as of the date of vesting is taxed as ordinary income. However, if the employee does not sell the stock at vesting and sells it at a later time, any difference between the fair market value on the date of vesting and the sale price is reported as a capital gain or loss.
Bo Weintraub, a graduate of the University of Washington School Of Law’s Masters in Tax Program, is uniquely qualified to handle the complicated tax aspects of divorce.