Federal Income Tax – Taxes and Divorce
Posted on August 27th, 2016
Divorcing people find themselves very interested in several sections of the Internal Revenue Code. Where one spouse has substantial retirement benefits, the parties should examine the rules for a Qualified Domestic Relations Order, or QDRO, which can divide the retirement benefits between the parties. If one party will be making payments to the other, the parties are allowed to determine which of them will be taxable on the payments through the Alimony rules of Section 71 of the Code.
In property settlements between divorcing parties, no gain or loss is recognized. The parties should realize, however, that the “basis” (cost) of whatever property they receive will carry over from when the couple acquired it. This can make a large difference when a party later sells the property. They should make an effort to divide both the property and the basis fairly. There is a $500,000 exclusion of gain on selling a marital residence. The excludable gain is only half as much for a single person. Couples with a large gain on their residence must be careful to sell at the proper time, and under the right conditions to maximize the exclusion.
The custodial parent normally gets the dependency exemption for dependent children. Only if the custodial parent signs off on claiming the exemption is the non-custodial parent allowed to claim the child or children.
Legal fees incurred in getting a divorce are not deductible. Legal fees incurred in getting tax advice, or in obtaining or collecting taxable alimony, are deductible.
QUALIFIED DOMESTIC RELATIONS ORDERS
The legal instrument for dividing retirement plans between the divorcing parties is the Qualified Domestic Relations Order (QDRO).
Retirement Plans come in two flavors: (1) Defined Contribution Plans, where the current value can be determined at any time, but the retirement benefits are not determinable, and (2) Defined Benefit Plans, where the retirement benefit is pre-defined, but the value at an earlier date can only be determined by an actuary.
Most retirement plans are subject to the Employee Retirement Income Security Act (ERISA). Plans that are subject to ERISA must provide for Qualified Domestic Relations Orders (QDROs) to divide retirement benefits between the plan participant and his or her spouse or other dependents.
Before QDROs, retirement plans were taken into account in divorce settlements, but the non-participant spouse was often given additional property to “offset” the retirement plan value retained by the participant spouse. The offset method is still often used for simplicity where the value of the retirement assets is small. The offset method won’t work in all cases because parties often don’t have enough assets outside of the plan to offset the value of the plan.
QDROs allow plans to be divided by the “Deferred Division Method” or the “Shared Benefit Method”. “Deferred Division” implies that both spouses will use the plan assets for retirement, but they are not required to. Many QDRO divisions are immediately rolled over into an IRA, or simply cashed out. The early withdrawal penalty does not apply when cashing out a QDRO. There are rumors that people have divorced in order to receive QDRO funds which are usually not available under retirement plans, and to avoid the early withdrawal penalty.
The “Shared Benefit Method” assures that both spouses will use the retirement fund for their retirement. Shared benefit assigns a portion of each benefit payment to each spouse. The shared benefit method avoids the necessity of valuing the plan at the time of divorce. The shared benefit method is often used where withdrawals from the plan have already begun before the divorce.
Plan administrators are often available to assist with forms or wording of QDROs. A QDRO can’t increase a plan’s obligations; it can only divide existing obligations between the plan participant and his or her spouse or dependents. Plans can have a variety of benefits besides a normal retirement annuity—survivor benefits, augmented early retirement benefits. These benefits should be addressed in the QDRO. Both parties and their attorneys should read at least the Summary Plan Description to know what benefits are available to be divided.
QDROs can divide retirement plans in favor of children or other dependents as well as spouses.
QUALIFIED ALIMONY/SECTION 71 PAYMENTS: DEDUCTIBLE BY PAYOR, TAXABLE TO PAYEE
Qualified Alimony is defined in Section 71 of the Internal Revenue Code. The definition in Section 71 does not correspond to other definitions of alimony in the legal or real world. In Section 71, there is no requirement that Alimony be for support, or that it be paid in periodic payments. Section 71 Alimony that is taxable to the payee is deductible by the payor.
Section 71 requires that deductible alimony be paid in cash. Property or the use of property doesn’t count as alimony. Payments can be to a third party “on behalf of” the payee. Deductible alimony must be paid under a Court Order or Written Separation Agreement. The Court Orders mentioned in Section 71 are: a decree of divorce; a decree of separate maintenance; a written instrument incident to a decree. The parties may write their own Written Separation Agreement calling for payments that will qualify as alimony under Section 71.
To qualify as deductible alimony the payments must not be designated as non-deductible/non-taxable in the governing instrument. The parties cannot be members of the same household at the time the payments are made.
To qualify as deductible payments, there must be no liability to make payments for any period after the payee’s death, and no liability to make any substitute payments. The lack of liability for continuing payments may (and should) be stated in the governing instrument (Decree or Separation Agreement), or it can be a feature of local law. In Michigan, “Alimony” does not survive the payee’s death. Note that “Qualified Alimony” does not necessarily correspond to alimony as defined in Michigan divorce law. There does not need to be any support element or Periodic Payments in “Qualified Alimony.”
If the alimony payee is concerned to receive a certain amount from the dissolution of the marriage even if he or she should die, this would be an ideal place to use life insurance. The alimony payee can insure his or her death, but the alimony payor should not provide that insurance directly.
If you wish to describe “Qualified Alimony” be sure to state that the payments end in the event of the death of the payee, regardless of how unlikely that death is before the payment of the alimony—even if the payment is being made on the same day the agreement is signed.
Qualified Alimony payments cannot be treated as child support in the document, either directly, or by adjusting the “Alimony” payments as the children reach certain ages.
Excessive “front loading” of alimony payments in the first three years will cause a portion of payments to be recaptured in the third year. Front loading is the most complex requirement Qualified Alimony must meet, but it only tests the first three years, so the math is manageable. Front loading is only concerned with decreasing payments. If the payments stay level or increase, there is no front loading issue.
Excessive “front loading” is calculated as follows:
- Begin with the third year’s payment(s).
- Second year payments will not be excessively front loaded if they do not exceed third year payments plus $15,000.
- First year payments will not be excessively front loaded if they do not exceed the average of the second and third years’ payments plus $15,000.
It might be easier to apply two rules of thumb which avoid going through the calculations: You can have one $15,000 “step down” in the first three years, or you can have two $10,000 “steps down” in the first three years without excessive front loading. Note that years one, two and three are calendar years. If the first payment is near the end of year one, year two’s payment may be paid shortly thereafter.
Qualified Alimony need not be paid for support. It can be used to pay attorney fees, to equalize property settlements, to buy out a business interest, to divide a small or non-qualified pension plan, to make the “interest” portion of a property settlement deductible to the payor, or for any other reason the parties may have, so long as the requirements are met.
PROPERTY SETTLEMENT: NO GAIN OR LOSS IS RECOGNIZED ON TRANSFERS BETWEEN THE SPOUSES OR INCIDENT TO A DIVORCE
A transfer is “incident to a divorce” if it occurs within one year of the divorce, or if it is related to the cessation of the marriage. A right of first refusal granted in a property settlement was found to be “related to the cessation of the marriage” years after the divorce.
The transferee spouse takes the property as if received by gift from the transferor spouse—cost basis and date basis carry over. Divorcing parties (or their attorneys) should compare not only the current values of the property being divided, but also the basis of the property, so that one spouse is not burdened with excessive low-basis assets which will generate taxable gains in the event of sale. Cost basis can be adjusted in some cases by borrowing against the property before its transfer.
How should the parties take potential tax liability into account? Subtracting a calculated tax from the current value sort of assumes an immediate sale. Ignoring the potential tax sort of assumes the property is never sold. It seems appropriate to compromise somewhere in the middle. Michigan courts have seldom reduced property values for potential tax liability, generally finding that assuming a taxable sale of the property was speculative.
If property is to be disposed of in a divorce, it is important to transfer the property between the spouses (tax-free) before the sale to locate the tax liability where it is appropriate. The tax liability is determined by the ownership of the property when it is sold. If property is sold by husband and wife as joint owners in Michigan, it is reported one-half on each spouse’s tax return. If property becomes co-tenancy property under the divorce decree, it will be an equal co-tenancy unless the court specifies otherwise. The parties are free to divide property or the proceeds of sale of the property in another proportion; make their ownership interests proportionate to their sale proceeds, or someone will pay too much tax. If the property is to be sold and Husband is to receive 1/4 of the proceeds, make him a co-owner of 1/4, or he will be paying tax on 1/2 of the sale proceeds, including part that goes to his EX.
While the parties can divide their property between themselves to control their tax consequences, they can’t “assign” taxable income earned by one to the other. An attorney who assigns half of an expected fee to his spouse will be taxable on the whole fee. Most adjustments of taxable income between the spouses can be solved using Section 71 payments.
A common problem of divorcing couples is buying out a business interest of a soon-to-be ex-spouse in a tax efficient manner. One way it is done is to “hire” the ex-spouse to pay her with deductible corporate dollars. A second way is to pretend to hire the ex-spouse, paying her for no services with deductible corporate dollars. If this sham is discovered by IRS, the result is no deduction to the corporation, and the taxation of a dividend to the owner. A solution is to pay the dollars to the continuing owner, who transfers them to the ex-spouse using Section 71 Qualified Alimony.
Another way to handle the buyout of the ex-spouse would be by the redemption of stock. Assume W owns 100% of Company X. W transfer 50% of Company X to H. H’s shares are redeemed by Company X over time. Company X’s obligation to H is guaranteed by W. This is all a perfectly acceptable way to have the business buy out the ex-spouse (with after tax funds), provided W has no “primary and unconditional obligation” to make the payments due H. If she does have a primary obligation, then the corporation is paying her obligation, which will be treated as a dividend taxable to her.
The parties might also arrange for the use of Qualified Retirement Plan funds to buy out the ex-spouse. A QDRO pays the ex-spouse (or soon-to-be ex-spouse) the buy-out value. This provides security to the spouse receiving the funds, it preserves the business owner’s cash flow, and the retirement fund might be replenished for the business owner over time.
MARITAL RESIDENCE GAIN EXCLUSION
Internal Revenue Code Section 121 provides for the exclusion of $250,000 of the gain on the sale of a residence for a single person, and an exclusion of $500,000 of gain for a married couple. Requirements are (1) that the home be owned and used as the parties’ primary residence for two years out of the last five years before sale, (2) that the parties have not used the exclusion in the last two years, and (3) that the couple file a joint return. Both parties must satisfy the two year use requirement, but only one needs to satisfy the two year ownership requirement. The two year ownership and use requirements are pro-rated if an early sale is caused by unforeseen circumstances—loss of job, health problems, or divorce.
Unmarried co-habitants—A & B, unmarried, have owned their home jointly and have lived in it for over two years. They are about to sell it for a gain of $256,000. By virtue of their joint ownership, the gain is attributed 1/2 to each of them. Each has an exemption of $250,000 available, so each of their gains are excluded. If only one had owned the home, there would be only one $250,000 exclusion.
Newly married—A & B marry and buy a new home. They each sell their previous homes, A’s for a gain of $300,000, and B’s for a gain of $200,000. Each had owned and occupied their respective homes for more than two years. A is allowed an exclusion of $250,000, and B is allowed an exclusion of $200,000.
If a single homeowner marries the spouse must reside in the home (and not sell another home) for two years before the couple qualifies for a $500,000 exclusion.
The date basis for purchase of the home transfers from one spouse to the other if the property is transferred in a divorce. Use by a spouse or former spouse which is specifically provided in the divorce decree or written separation agreement is attributed to the non-occupant spouse. Arrangements for the custodial parent to use a co-owned home while children are minors, then house to be sold, will qualify for the $250,000 exclusion for each co-owner, even though the non-custodial parent has not lived in the home for years.
In joint ownership each party can deduct the interest and taxes that he or she paid.
In co-ownership each party can deduct the interest and taxes he or she paid only up to that party’s proportional interest in the property.
Tenancy by the entireties (marital joint ownership) converts into equal co-tenancy upon divorce, unless the divorce decree specifies otherwise.
The marital home can be a qualifying first or second home for the non-custodial parent (for the purposes of deducting mortgage interest) if his or her children live there.
With some planning, the parties can use the Alimony definition of Section 71 to assign the home deductions to whomever benefits from them.
CHILDREN’S DEPENDENCY EXEMPTIONS
The general rule is that the custodial parent gets a child’s dependency exemption UNLESS he or she agrees not to take the exemption on Form 8332. This general rule applies whenever the parents together provide more than half of the support for the child, and have custody of the child for more than one-half of the year.
Any substitute for Form 8332 must have all of the information contained on Form 8332. A letter of intent or a letter of agreement between attorneys or parties won’t serve as a substitute for Form 8332. The Form can be signed once to cover one year or many years into the future. Probably the best practice is for the custodial parent sign Form 8332 each year after all support payments are made. Assignment of the dependency exemption to the non-custodial parent in the divorce decree is not effective BUT Michigan courts can require the custodial parent to sign Form 8332 if that is equitable or conforms to a divorce judgment.
Either parent may deduct medical expenses paid for their dependent child.
Legal fees that either spouse pays in a divorce are considered personal and non-deductible. Fees that either party pays for tax advice are deductible under Section 212(3) of the Internal Revenue Code which provides that all fees paid to plan or calculate taxes are deductible.
Legal fees related to the production or collection of taxable alimony are deductible. Fees for fighting against the award of alimony are not deductible.
If the parties are married on December 31, they are treated as married for tax purposes. They may file a tax return as “Joint”, or as “Married Filing Separately”. Joint return filing rates are the lowest of any filing method. Married Filing Separately rates are the highest.
There is an exception for a parent who has been separated from the other parent for the last six months of the year, and provides a home for one or more dependent children. The separated parent can file as “Head of Household”, with rates lower than Married Filing Separately, and even lower than Single filing. The other parent, unless he or she also provides a home for another child or children, must file as Married Filing Separately.
When the divorce is final, the custodial parent providing a home for the dependent children can file as Head of Household. The non-custodial parent can file as Single.