Divorce and TaxesFinancial and Tax Aspects of Divorce

Glenn Schwier, CPA, JDMarcia Geltman, CPA

October 1, 2015www.nisivoccia.com

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IntroductionNew Jersey has one of the lowest divorce rates in the country. It may be due to just being nice people or the fact that we have one of the highest median household incomes in the nation. People in New Jersey tend to marry about 2 years later age than most of the country. In the US, men usually marry at 28.9 years old, and women at 26.9. New Jersey residents marry at ages 30.2 and 28.5 respectively. We are in good company with Delaware, Massachusetts, New York and North Dakota!

Today we will cover:• Property Settlement Agreements• Transfers in Trust• Life Insurance• Tax Implications

– Filing status and dependents– Alimony– Retirement plans and QDROs– Estimated tax payments– Divorce costs– Innocent spouse relief and equitable relief

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Short Quiz

1. Harry and Wilma were married for 51 years but decided they need a break (permanent) from each other. Harry is going to give up the house to Wilma. Should he sell it to her or give it to her as part of the settlement?

2. Alternatively, Harry is considering keeping the house in his name alone but allowing Wilma to live in the house. Harry will pay the mortgage, real estate taxes and utilities. Can Harry deduct these costs as alimony?

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Short Quiz (continued)

3. Harry will move into an apartment with his new girlfriend, Floozy. Since he will be paying all the costs of the apartment, he plans to file as head of household. How smart is Harry?

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IRS Code Sections Related to Divorce

Though many IRS code sections impact divorce rules, there are 3 specifically dealing with divorce.

Section 1041 – Equitable Distributions

Section 71 – Alimony

Section 682 – Distributions through trusts and estates

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Property Settlements

Generally no gain or loss on transfer of property as a result of a divorce.

Exceptions: • If spouse is a nonresident alien.• Certain stock redemptions• Certain transfers in trust

To be non-taxable the transfer must occur within one year of marriage ending or related to end of marriage.

Recipient assumes same basis in property.

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Equitable Distribution

• Property Settlement• IRC 1041

– Non taxable event transfer to former spouse outright or in trust

• Property acquired before, during or after end of marriage • Ownership separate or joint• No gain or loss recognized• Does not apply to services

– Applies to arms length transaction with consideration paid for property, cash, exchange of marital right or assumption of liabilities

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Before Marriage

• IRC 1041 does not apply prior to marriage– Example Prenuptial Agreement

• Transfer in exchange for release of marital rights• Not a gift or 1041• Taxable sale• Basis FMV

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Property Transfer

• Holding period– Transferee includes holding period of transferor

• Basis– Property treated similar to a gift– Transferee receives Transferor’s basis

• Carryover Basis – Immediately before transfer

• No impact on tax basis– Transferee required to make payment to Transferor – Liabilities exceed property value

• Gift Rule lesser of FMV or adjusted basis for calculation of loss on sale does not apply

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Property Settlement Special Rules

• Gain Recognized– Transfer to trust

• Installment obligations• Adjusted basis of property is exceeded by liabilities

assumed

– US savings bonds bearing accrued interest• Assignment of income doctrine• Transferor recognizes income in year of transfer

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Property Settlement

• Current spouses no requirement ever get divorced for 1041 to apply

• Former Spouses– Transfer of property incident to divorce

• Not more than 1 year after date marriage ceases or• Transfer related to end of marriage

– Pursuant to divorce instrument and– Not more than 6 years after date of end of marriage

» After 6 years presumption against

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Property Settlement Third Party Transfer

• Transfers to third parties– Divorce instrument– Written request– Ratification

• Writing must state intended to qualify for 1041 treatment

• Received by transferor prior to first income tax return after transfer made

• Beware of deemed sale

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Closely-Held Business

• Transfer shares• Split business• Stock redemption

– Deemed distribution to transferor• Long term capital gain

– Primary and unconditional obligation• Deemed distribution transferee

– Change tax consequences by agreement between spouses

• Liquidation• Direct sale between spouses incident to divorce

– 1041 applies

• Valuation

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IRAs

• IRA– No QDRO (Qualified Domestic Relations Order)– Transfer pursuant to divorce/separation decree or written

instrument incident to divorce• Nontaxable event• Treated as owned by transferee• Written separation agreement does not qualify

– Transfer after divorce final

– Spouse takes distribution and pays it to other spouse• Taxable event• Constructive receipt exception

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Qualified Retirement Plans

• QDRO (Qualified Domestic Relations Order)– It must create or recognize the existence of the right of the alternate payee to

receive all or a portion of a participant's benefits under a qualified retirement plan.

– Alimony– Child support

• Treated as paid to employee/participant

– Property settlement• Tax free rollover

• ERISA exception– Transfer right to alternate payee

• Improper QDRO - taxable to employee• Spouse may be able to rollover to IRA

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QDROs

• It must specify the following:– The name and last known mailing address of the participant and each

alternate payee covered by the order; – The amount or percentage of the participant's benefits to be paid by

the plan to each to each alternative payee (or the manner in which the amount or percentage is to be determined);

– The number of payments or periods to which the order relates; – And each qualified retirement plan to which the order applies.

• Tax liability only shifts if (former) spouse– Child support – taxable to employee

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QDROs

To be a QDRO, an order must not:

• Require the plan to pay increased benefits;

• Require the plan to pay benefits to a "new" alternate payee when a previously named alternate payee is already entitled to those benefits; or

• Require the plan to provide a type or form of benefit or any option that is not otherwise provided for by the plan.

However Internal Revenue Code Section 414(p)(4) does provide an exception that permits a QDRO to require the payment of "early retirement benefits" to a alternate payee even when the plan participant is not entitled to such benefits.

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ERISA vs State Law

• Section 3B:3-14 - Revocation of probate and non-probate transfers by divorce or annulment; revival by remarriage to former spouse.

• ERISA trumps state law– Former spouse named beneficiary of qualified plan– Divorce decree former spouse waives retirement plan– If no QDRO or beneficiary change

• Divorce decree ignored

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Transfers in Trust

• IRC 682– Transferee treated as beneficiary– Not alimony– 671-679 grantor trust rules do not apply– Child support

• Transferor has obligation to support• Taxed to transferor

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Transfers to Trust

• IRC 1041 applies - Similar to gift• No gift tax• Carryover basis• Advantages

– Avoids recapture– Does not have to end at death –

beneficiary/estate– Reversion to transferor or children

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Tax Implications

• Alimony v child support• Filing status• Dependents• Life insurance• Passive activity property• Retirement plans - QDROS• Divorce costs• Innocent spouse relief

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Alimony

Deductible by Harry and included in income by Wilma.

Above the line deduction and income. Therefore, impacts Adjusted Gross Income

Alimony is considered earned income for tax purposes. Not subject to Medicare and Social Security but is eligible for IRA contributions and EIC.

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Alimony (post 1984)

Defined in IRC Section 71Payment is made under divorce, separation agreement, or pendent lite. – Must be written instrument. Does not have to be a fixed amount, but

must meet certain specifications.– It must be paid in cash (not property or notes). Can be paid on behalf

of person. - i.e. rent – Instrument does not indicate otherwise– Parties are not members of same household – applies only if divorced.– Payer's obligation ends at payee’s death (best to state in agreement).– Must file separate tax returns.

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If payments are not alimony, what are they?Either property settlement or child support

– Child support payments relate directly to the child. Indication is if payments stop if child:

– Dies– Becomes employed– Leaves school– Leaves household– Marries or– Attains specified age or income level

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Unallocated Payments

• If alimony isn’t specifically stated in the agreement the amounts paid are presumed to be alimony. But there are conflicting court cases. May look at state law to see whether payments cease at death.

• If an amount meets the requirements of alimony but the document states it is not alimony ** the tax impact must be expressly stated in document and attach copy to tax return each year.

• If amounts paid are less than that stipulated, the payments go first towards child support.

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Life Insurance

• Property settlement – not subject to the transfer for value rules.

• Premium payments deductible as alimony?depends on who owns the policy.

– Harry owns policy, premium payments not deductible.

– If Wilma suspects Harry will not survive too long living with Floozy, she may purchase a life insurance policy on Harry’s life and has Harry pay premiums. (premium payments would be treated as alimony)

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Marital Residence

• Spouses can’t sell residence to each other. This would be part of an equitable distribution. (could sell to third party)

• IRC 121 applies if not incident to divorce– $250,000/$500,000 exclusion

• 2 of last 5 years principal residence– Holding period includes transferor spouse’s ownership period

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Residential Cost

Harry pays all expenses of house in which Wilma lives.

*If Harry owns house - Howie deducts real estate taxes and mortgage interest. He can treat utilities as alimony.

*If Wilma owns house - Treated as alimony.

*If Wilma and Harry own house jointly - ½ interest expense is alimony and the other ½ is deductible expense. All the real estate taxes are deductible expense and not alimony.

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Alimony Recapture

• Purpose– Front loading alimony

– Disguised nondeductible property settlement payment from receiving alimony treatment

– This might happen if you change the divorce instrument, fail to make timely payments, reduction in ability to make payments or reduction in need to receive payments.

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Alimony RecaptureApplies if payment decreases by >$15,000

Example:– Year 1 $50,000– Year 2 $24,000– Year 3 $8,000Payment in year 2 exceeds year 3 by more than $15,000. ($1,000 recapture in year 3)Payment year 1 exceeds the average of year 2 and year 3 by more than $15,000 ($50,000-$15,000 - $15,500 = $19,500)

Adjustment made in year 3 = $20,500.

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Alimony Recapture

• Exceptions:– Safe Harbor decreases by less < $15,000– Death – Remarriage– Temporary and pendente lite support– Payments based on variable compensation such as

business, rental, or self-employment income.

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What filing status to use when divorcing?–Determined at year end

• Single – Not eligible for any other filing

• Married Filing Joint – married as of 12/31

• Married Filing Separate – married but elect to file separate returns. (Usually pay more filing MFS)

Tax rates are slightly higher, AMT exemption is cut in half as well as a number of other exemption amounts, lose credits for dependent care expenses, loose EIC along with other credits. When might it be tax advantageous to file MFS? One spouse has high income and low medical expense. The other spouse has low income and high medical expense or other deductions whose deductibility is based on AGI. Or to avoid tax liability of spouse.

• Head of Household – see next slide

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Head of Household

Head of Household – better tax benefits than other filing statuses.

To qualify –• unmarried or considered unmarried on 12/31, • paid more than ½ cost of maintaining your home, • and a qualifying person lived with you for more than ½ the year.

Unmarried for this purpose only if your spouse did not live in your home during the last 6 months of the year.

Qualifying person is a child, grandchild or parent for whom you can claim as a dependent.(child will qualify if you can’t claim only due to a noncustodial parent agreement). Also limited exceptions for other relatives.

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Dependent Tests – Qualifying Child

– Son, daughter, foster child, brother, sister– Under age 19 at end of year

• Or under age 24 at end of year, student and younger than you or permanently disabled

– Custodial - lived with you more than half year– Child provided less than half own support– Not filing joint return unless only to claim refund– Or custodial parent signs Form 8332

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Dependent Test – Qualifying Relative

• Qualifying Relative– Not qualifying child– Must be related to you

Or must live with you for full year • *and doesn’t violate local law.

– Gross income test • Less than personal exemption amount ($4,000 in 2015)

– You provide more than half support

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Form 8332

• Custodial Parent– Dependent exemption– Equal nights – higher agi

• Noncustodial parent– Form 8332– Custodial parent releases exemption– 1 year or all future years– Attach tax return

• Custodial Parent can revoke– Use 8332 Part III– Reasonable notice to Noncustodial– Attach tax return

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Medical Expenses of Child

Either spouse can claim medical expenses which they paid on behalf of the child, whether or not they can

claim the child as a dependent.

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Passive Activity Property

S-Corporations – suspended losses transferred to Wilma

Partnerships - Passive ActivitiesNo deduction to Howie at time of transferWilma’s basis is increased by amount of suspended passive losses but suspended losses will not be allowed as a deduction in any year.

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Estimated Tax Payments

• Joint estimated tax paymentsDivision

• Parties agree – can be allocated however wished

• No agreement– Allocated based on percentage of tax each owes– Must include statement showing calculation and

former spouses social security number

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Divorce Costs

• Divorce Costs– Generally not deductible

• Deductible Costs• Costs incurred in helping to determine your correct

tax liability. - (accountant fees, actuaries, appraisals). The bills should be itemized. These are deductible as itemized deductions subject to 2% AGI floor.

• Helps to itemize the bill.

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Innocent Spouse

• Married Filing Joint

• Joint and individual liability– Both spouses responsible for taxes, penalties and interest on

joint return– Even if Divorce decree designates former spouse liable for

previously filed joint returns

• Relief– Innocent spouse– Separation of liability– Equitable

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Innocent Spouse Relief

• Requirements– Timely filed form 8857

• 2 years from IRS began collection activity against you

– Filed joint return

– Understated tax on return due to erroneous items of your (former) spouse

– No knowledge or reason to know• Actual or reasonable person

– Lifestyle

– Facts and circumstances• Unfair• No significant benefit

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Innocent Spouse Relief

• Understated tax

– More tax owed than on return

• Erroneous items

– Unreported income

– Incorrect deduction, credit or basis

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Separation of Liability Relief

• Only liable for understated tax only allocable to yourself

• Must have filed joint return

• No longer married or legally separated• Not members of same household last 12 months

• File Form 8857 in 2 years from start of collection activity against you

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Equitable Relief

• Understated tax or unpaid tax– Only option if filed accurate return

• Requirements– Timely filed Form 8857

• Exception– Balance due 10 years– Refund/credit – 3 years filed/2 years tax paid

• Unfair to hold you liable– Not eligible for innocent spouse or separation– Filed joint return

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Equitable Relief

• Factors– Marital status– Economic hardship– Abuse/mental and physical health– Divorce agreement obligation– Current compliance with tax laws– Knowledge –

• Understated tax• Unpaid tax

– Would or could not pay tax

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Relief Allowed

– Must be timely filed claim for relief

– No fraudulent transfers/scheme to avoid taxes

– No Knowledge

– Income tax liability related to (former) spouses income

• IRS Publication 971 – flowcharts

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Conclusion

Thank you for participating in our seminar.

Please do not hesitate to contact us should you haveany questions or need assistance.

Glenn Schwier, CPA, JDMarcia Geltman, CPA

Nisivoccia LLP

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