Despite the best of intentions when couples say, “I do,” more than a few will find themselves eventually saying, “I don’t.” Aside from the emotional issues involved in divorce, there are also tax and financial considerations. The resolution of these issues may depend in part on how amicable the parties remain, their financial status, and whether they live in a community property or common-law state.
Timing of Divorce
A taxpayer’s marital status is determined on the last day of the year. If the divorce is final by the last day of the year, then the spouses are treated as unmarried for the entire year, assuming neither has remarried by the end of the year. If the divorce has not been finalized by the end of the year, the spouses are married for tax purposes, and can file a joint return or separate returns. In addition, if the spouses live apart for the last six months of the year and one maintains a household for a dependent child, that spouse may qualify to file as head of household. Divorcing couples therefore may want to carefully consider in which year to get divorced; the couple may save money depending on whether they file jointly or divorce and each file as unmarried.
Legal separation has the same tax effect as divorce. Thus, if a couple is legally separated on the last day of the year, then they are treated as unmarried for the year. Merely living apart and considering themselves to be separated is not a legal separation for tax purposes.
Alimony is an umbrella term covering payments for support by one spouse for the other; states may label such payments as alimony, spousal support, or separate maintenance. Alimony may be temporary (i.e., during the course of the divorce process), rehabilitative (for a limited period to give the recipient-spouse time to complete an education or get a job), or permanent. Permanent alimony is usually awarded only for marriages lasting more than 10 years and where the recipient-spouse likely cannot reenter the workplace in a meaningful way. From a tax perspective, alimony is taxable to the recipient-spouse and deductible by the payor-spouse only if all of the following conditions are met:
- Payments are made pursuant to a divorce decree or separation agreement.
- Payments are made in cash.
- The divorce decree or separation agreement does not designate the payments as nontaxable to the recipient and non-deductible by the payor.
- The spouses live apart.
- There is no liability to make payments after the death of the recipient-spouse.
- The payments are not support.
Voluntary payments, such as amounts paid without any court order prior to a final decree of divorce, are not treated as alimony (e.g., Milbourn v. Commissioner, TC Memo 2015-13, http://1.usa.gov/1pGTvDk). Payments made to a third party for the benefit of the former spouse, such as health insurance premiums to cover the former spouse, may be deductible alimony, assuming all the other conditions are met.
The IRS requires the payor-spouse to report the Social Security number (SSN) of the recipient-spouse to ensure that amounts deducted align with amounts reported as income. Nevertheless, the Treasury Inspector General for Tax Administration (TIGTA) found in 2014 that there was a $2.3 billion gap between the amount of alimony deducted and the amount reported as income (Significant Discrepancies Exist Between Alimony Deductions Claimed by Payers and Income Reported by Recipients, TIGTA Report 2014-40-022, http://1.usa.gov/21rkONO). To close this tax gap, the IRS may increase scrutiny of alimony deductions to ensure that recipient-spouses are reporting the income.
CHECKLIST FOR DIVORCE
- Consider filing separately if a spouse has concerns about becoming liable for taxes on a joint return.
- Consider the long-term tax consequences in property divisions (e.g., which assets have potential gains).
- Prepare an inventory of marital assets and liabilities (e.g., mortgages).
- Consider the rules for a dependency exemption for the couple’s child. Make sure that the divorce decree specifies which spouse is entitled to the exemption. If the non-custodial spouse is entitled to the exemption, ensure the custodial spouse signs a permanent or annual waiver on Form 8332.
- Nail down the desired treatment for alimony (taxable or nontaxable). Both spouses should agree to the treatment. Consider that the payment of a former spouse’s medical costs under the terms of a divorce settlement is deductible alimony. In effect, these costs become deductible as adjustments to gross income rather than itemized medical deductions subject to the applicable adjusted gross income (AGI) floor.
- Decide on tax liability for stock redemptions.
- Couples who co-own a corporation which one spouse wants out of can agree in writing that either a redemption of stock will be taxable to the transferor-spouse or taxable to the redeeming spouse.
- Make arrangements for transfers of retirement benefits. No court order is necessary to make transfers of IRAs tax free as long as they are incident to divorce. Note that tapping IRA funds to satisfy alimony is a taxable event. Use qualified domestic relations orders (QDROs) to avoid tax on the plan participant when the retirement account is paid (in whole or in part) to an alternate payee (e.g., former spouse).
- Advise on deducting legal fees related to tax advice in the divorce.
- Determine the impact of divorce on Social Security benefits.
- Revise wills and beneficiary designations.
Children of the Marriage
Having a child complicates the divorce process. Unfortunately, the child may become a negotiating hot spot, with parents vying for custody, support payments, and concessions. For tax purposes, the two key issues are child support and the dependency exemption.
Payments to support a child are not taxable to the recipient-spouse or deductible by the payor-spouse [IRC section 71(c)]. These include payments labeled as child support, as well as payments construed as child support because they are related to a contingency involving the child—for example, if the amount is reduced or eliminated when the child attains majority. If there is a delinquency in both alimony and child support, payments are applied first toward child support before being applied toward alimony (e.g., Becker v. Commissioner, TC Summary Opinion 2015-2, http://1.usa.gov/1Ri5M7d). If a parent fails for some time to pay required child support, the IRS can apply a federal tax refund to the delinquency [IRC section 6402(e)]. For this purpose, “past due support” means a delinquency for which the IRS has been notified by a state in accordance with section 464(c) of the Social Security Act.
Payments to support a child are not taxable to the recipient-spouse or deductible by the payor-spouse.
The dependency exemption for a child can be claimed automatically by the custodial parent, i.e., the parent with physical custody for the greater part of the year (26 CFR section 1.152-4). Claiming the dependency exemption may also entitle the custodial parent to claim head of household status, the child tax credit, and the earned income tax credit [IRC sections 2(b), 24, and 32, respectively]. The custodial parent can also waive the dependency exemption to allow the noncustodial parent to claim it. To do so, the custodial parent must sign Form 8332, Release/Revocation of Release to Claim Exemption for Child, and attach it to the tax return of the noncustodial parent. The waiver can be annual or permanent. A divorce decree can require the custodial parent to sign the waiver, but the decree itself is not a waiver for tax purposes.
Which parent should receive the exemption depends on their respective financial statuses. Usually the parent with the greater income claims the exemption, but if such parent is a high-income taxpayer subject to the phaseout for exemptions, then it makes more sense for the other parent to claim the exemption. Financial negotiations during the divorce process should take this tax break into account.
No gain or loss is recognized on the transfer of property related to divorce (IRC section 1041); instead, the recipientspouse steps into the shoes of the transferor-spouse for basis purposes [IRC section 1041(b)]. When the recipient-spouse sells the property, he or she recognizes gain or loss on the transaction at that time. Therefore, property settlements should factor into tax results. For example, stock worth $10,000 with a basis of $2,000 presents the recipient-spouse with a potential gain of only $8,000.
The couple’s home often becomes a prime issue in divorce. Both spouses may continue to own the property, even though only one is given possession of the residence. Sometimes, the spouse living in the home is directed or desires to sell the home once the couple’s child has grown and is no longer living there. For purposes of the home sale exclusion, two special rules apply:
- A spouse who receives title to the home is treated as having owned the house during previous period of ownership as well, be it joint or by the other spouse. This can help such spouse meet the two-out-of-five–year ownership test for the exclusion [IRC section 121(d)(3)(A)].
- A former spouse who continues to own the home occupied by the other spouse is treated as having used the home during the period that the other spouse uses it; again, this enables the former spouse to claim the exclusion [IRC section 121(d)(3)(B)].
Legal Fees for Divorce
Generally, legal fees to obtain a divorce are not deductible. For example, a business owner whose ownership is at stake in a divorce settlement usually cannot deduct legal fees, even though they relate to the business (e.g., Melat v. Commissioner, TC Memo 1993-247, http://bit.ly/1Ri7fKV). The courts view the origin of the claim as a division in marital property, for which no deduction of legal fees is allowed. A spouse who obtains alimony, however, may deduct the portion of legal fees related to the production or collection of such income [IRC section 212(1)]. The attorney handing the divorce for this spouse should itemize the services so that the spouse can deduct the applicable portion of the fees.
Qualified Retirement Plans and Other Employee Benefits
Benefits from qualified retirement plans, IRAs, and other employee benefit programs are important considerations during divorce. Divorcing spouses may want to change beneficiary designations to plans, as well as to life insurance policies, so that former spouses do not inherit benefits, as well as take the other actions below.
The divorce settlement may award benefits accrued by the working spouse (the participant) to the other spouse (the alternate payee). As long as this is done by a qualified domestic relations order (QDRO), the participant is not taxed on benefits transferred to the alternate payee [IRC section 414(p)], and the early distribution penalty does not apply [IRC section 72(t)(2)(C)]. The QDRO cannot compel the distribution of benefits to the alternate payee; it merely awards them to this spouse. Benefits are payable on the earliest retirement date, even if the participant has not separated from service [IRC section 414(p)(4)(B)]. Service is defined as—
- the date on which the participant is entitled to a distribution under the plan, or
- the later of 1) the date the participant attains age 50 or 2) the earliest date on which the participant could begin receiving benefits under the plan if the participant separated from service.
The alternate payee is not taxed if, when benefits are payable, they are rolled over or directly transferred to a qualified retirement plan or IRA of this spouse. The IRS and the Department of Labor (DOL) provide sample language for a QDRO at http://www.dol.gov/ebsa/Publications/qdros_appD.html.
Funds in an IRA transferred to a former spouse incident to divorce are not taxable to the owner [IRC section 408(d)(6)]. The transfer is also exempt from the 10% early distribution penalty [IRC section 72(t)]. If an IRA owner uses funds from the account to pay alimony, child support, or anything else related to the divorce, however, the funds are taxable and not exempt from the early distribution penalty [e.g., Bunney, 114 TC 259 (2000), http://1.usa.gov/22fWNeP]. The IRA owner must transfer the interest in the IRA, and not the funds themselves, in order to escape tax on the transfer. There may be an offsetting alimony deduction where applicable.
If a spouse is covered under the other spouse’s employer’s health plan and the employer is subject to the Consolidated Omnibus Budget Reconciliation Act (COBRA), the spouse may opt to continue on the plan for up to 36 months (29 USC 1161). The DOL answers FAQs on COBRA at http://www.dol.gov/ebsa/faqs/faq-consumer-cobra.html.
Usually an employee commits to contributions in medical flexible spending accounts (FSAs) for the year; however, upon divorce, the employee can change the contribution for the balance of the year [26 CFR section 1.1254(c)(2)(i)].
Other Tax Issues
Premium tax credit.
A couple who opts to receive on an advance basis the premium tax credit (IRC section 36B) for health insurance purchased through a government marketplace should notify the marketplace about the change in marital status. This changes the taxpayer’s advance payment amount.
If the IRS audits a joint return filed prior to the divorce and finds that taxes are owed, the divorce decree or settlement agreement can stipulate which spouse is liable for any deficiency or whether the amount should be split between them.
Social Security Benefits
Divorce does not necessarily extinguish spousal rights to collect Social Security benefits. If the marriage lasted at least 10 years, a divorced spouse can collect benefits based on an ex-spouse’s earnings if unmarried and at least 62 years old. The ex-spouse does not have to be collecting benefits but must be eligible to do so (i.e., at least 62 years old as well). The benefit is 50% of the other spouse’s full retirement benefit if benefits commence at full retirement age. A divorced spouse collecting benefits under these conditions does not affect benefits for the ex-spouse, the ex-spouse’s children, or the ex-spouse’s current spouse. Note that the 10-year marriage duration may affect the timing of a divorce.
The death of a former spouse does not bar a surviving divorced spouse from collecting benefits. Again, if the marriage lasted at least 10 years, the survivor can collect starting at age 60 (or 50 if he/she has a severe disability). This is permitted even if the surviving divorced spouse has remarried, as long as the remarriage occurred after reaching age 60 (or after age 50 if disabled). A former spouse can also collect benefits if the divorced wage earner has died if the couple has a child under age 16 (or older but disabled). In this case, the age or length-of-marriage rule does not apply, as long as the survivor is caring for the child.
Divorce is never easy, and taxes complicate a difficult situation. Attention to tax and financial issues, however, helps the parties involved create certainty and avoid problems later on. CPAs should use the accompanying checklist to make sure they cover the essentials.