Tax Tune-Ups Filter Tax Errors In Divorce Agreements

By Eva Rosenberg, MBA, EA

Despite a divorce agreement that specifically said that neither party shall pay or receive alimony, Divorced in New York was hit with a tax bill from the Internal Revenue Service for $5,000 on phantom alimony.

Even though IRS was given the divorce agreement, the Service insisted on assessing the taxes. Why? Simply because this woman’s ex-husband could present canceled checks to prove he made payments to her in the amount reported as alimony. IRS didn’t really care that it wasn’t alimony.

What were the payments? The payments were her half of his monthly pension, which was granted to her in the divorce. Unfortunately, the state was sending the money to Divorced’s ex-husband, after the withholding had been deducted and he was paying her half the net. Then he was deducting his full payment as alimony, and pocketing her share of the refund.

This problem could have been easily avoided if the attorney had set up a QDRO, says Patricia Powell, CFP, CEO of The Powell Financial Group, Inc. Martinsville, NJ. Her clients get them all the time.

What’s a QDRO? It’s a qualified domestic relations order. Properly prepared, it would instruct the pension plan to issue a check directly to the ex-wife for her share of the income.

With a QDRO, an ex-spouse could decide whether or not to get a lump sum rolled over to her IRA, cash it out and pay taxes, or continue to get monthly payments. She can designate how much she chooses to have withheld from her check. And, getting credit for her full share of the withholding, if Divorced had reported the pension income properly on her own tax return, she would have owed no tax.

This is a typical error when couples indulge in do-it-yourself divorces, according to Lynne Z. Gold-Bikin, chair of the Family Law Practice Group at Wolf, Block, Schorr and Solis-Cohen LLP in Norristown, PA. Even seemingly simple divorces are more complex than they appear. They involve knowledge of both divorce law and tax law. Gold-Bikin says that if you’re not an expert in tax law, make sure you get that divorce agreement and the settlement reviewed by a tax expert.

Getting Blindsided

If your divorce doesn’t get a tax tune-up, what kinds of errors are apt to occur?

Deceptive Equality

Total assets appear to be evenly split based on fair market value. And everything looks all nice and equitable. But one person just got stuck with all the taxable assets, while the other walked off tax-free, warns Powell. One of the biggest traps for women, especially mothers is that they will generally give up their right to practically everything in order to keep the house and not have to move their children away from their friends and classmates.

For instance:

  • Pensions, 401(k)s and IRAs are taxed at ordinary income rates. With the high distribution added to your other income, this can throw you into the top tax bracket – 35%.
  • Stocks and investments get capital gain treatment – limited to 15%.
  • The house looks like a good deal with that $500,000 personal residence exclusion. But once your ex-spouse signs it over to you – you’ve instantly lost half that cushion. If the appreciation on your residence is substantially more than the $250,000 personal exclusion, Powell advises that you sell the house while you’re still married and can use the full $500,000 joint exclusion. Then either split the money any way that works - and buy your own home in the same neighborhood, which will now have a higher tax basis (basis is the cost, for tax purposes). *
  • Cash is valued at face-value for tax purposes – there is no tax on cash!

How can you avoid this problem? Powell suggests that you sell off the assets with the high tax values and split the cash. Or if that’s impractical, balance the split so the tax costs are taken into account. Powell advises that your certified financial planner, money manager or tax professional can review the tax bases of the assets to help you reach a truly equitable split.

*Note: In most states, property tax on homes keeps up with the increasing market value of the home. In California, due to Proposition 13, property taxes are based on the original purchase price. So, before you do this in California, run the numbers and see if the increased annual property tax payments might cost you more than the potential capital gains taxes.

The Vanishing Alimony Trick

Alimony recapture can be a common problem, cautions Gold-Bikin. IRS Publication 504 explains what the recapture is:

2When to apply the recapture rule. You are subject to the recapture rule in the third year if the alimony you pay in the third year decreases by more than $15,000 from the second year or the alimony you pay in the second and third years decreases significantly from the alimony you pay in the first year.

How can this recapture be needed if the divorce agreement is properly drafted? Gold-Bikin that this often happens when the alimony payments aren’t made on schedule. If several payments are missed in one year, then made up in another year, it’s easy to see that $15,000 swing take place. Or if payments are stopped altogether, and there haven’t been three years of regular alimony payments made – that would also trigger the recapture.

Why does this matter? Because the person paying the alimony will lose the deduction. And the person who received the money, may go back and file amended returns for the all the alimony years – and get refunds. Read that last sentence again, if you’re dealing with a deadbeat former spouse. You may have a refund coming!

How can you avoid this problem? Gold-Bikin recommends that you adhere to the payment schedule on the alimony.

Vague Assignments

When the divorce decree awards family support without spelling out which part is for child support and which is for spousal support – it’s all taxable to the recipient as alimony, and deductible to the payor, says Gold-Bikin. This the result of a 2005 Tax Court decision in Berry v. Commissioner

How can you avoid this problem? Be sure to spell out how much of the support is designated for each child, and how much is spousal support.

Beating Up the Kids

One of Gold-Bikin’s pet peeves is couples who are compelled to fight over every smidgen of every tax aspect associated with exemptions for their children – even if their income level causes them to lose 100% of all related tax benefits.

  • Hope and Lifetime Learning Credits are lost when single or head of household (HOH) incomes reach $45,000 - $55,000
  • You can’t deduct student loan interest when your income is over $50,000 - $65,000 if you’re single or HOH.
  • Child Tax Credits are lost when HOH income reaches $75,000
  • Itemized deductions start to phase out $150,500 for singles, HOH and married filing jointly
  • Personal exemptions phase out at incomes between $188,150 – $310,650 for HOH.

Landing in Tax Debtor’s Purgatory

You probably know and pity many people who are stuck with divorce tax debt, and you wonder how they could have been foolish or trusting. They sign a joint tax return, even though they’re getting divorced because they no longer trust each other. And they know better. But, “He promised to pay the whole tax!” is the usual refrain. Of course, he doesn’t.

Powell says she’s seen the most compelling and seductive behavior watching couples during divorce. The initiator of the divorce goes into courting mode, implying cooperation, an easy transition, or even a reconciliation – all the while, planning his/her wedding to the new love of their lives.

They effectively blindside their about-to-be ex-spouse into agreeing to practically anything, even to sign a joint tax return, when every fiber of their being is warning them away from this.

If you must sign that return, perhaps because it will reduce your own share of the tax liability, how can you best protect yourself?

Gold-Bikin says it’s as easy as 1-2-3.

  1. Get an indemnification letter as part of the divorce, making your ex-spouse responsible for his/her share of all taxes. And be sure that indemnification letter includes specific instructions for how any refunds are to be allocated. While IRS may not honor the agreement between the two of you, it does give you a basis to sue your ex-spouse, if you’re ever stuck paying his or her share of the tax.
  2. Don’t ever sign a balance due tax return without getting a certified check to pay your ex’s share in full. Don’t rely on promises from your ex-spouse or his/her attorney. They’re rarely fulfilled.
  3. If there is a refund coming, use IRS’s new Form 8888 that allows you to have the refunds split up in any pre-determined allocation, and deposited directly to two different bank accounts.

Tune in, Not Out

There are many, many more traps a divorcing couple can fall into.

But, you’re starting to get the idea. Even the simplest-seeming amicable divorce may have far-reaching financial implications, if there are assets and joint tax returns.

Sweat the details. And don’t just give up everything to get it all over with. You might think it’s worth the price at the time because you’re feeling so emotionally out of control. Later, you’ll realize just how badly you’ve been fleeced, and will spend years lamenting your decisions. If you can’t face up to making the hard decisions, get a trusted family member or friend to work with you and your attorney who can hold fast on your behalf and protect your interests.

Eva Rosenberg is the founder of TaxMama.com and an enrolled agent licensed to represent taxpayers before the IRS. She is the author of the new book, Small Business Taxes Made Easy - http://www.amazon.com/exec/obidos/tg/detail/-/0071441689/ , declared to be one of the best tax books of 2005 by Entrepreneur Magazine (Dec. 2005).

As originally published in www.marketwatch.com

© copyright 2006, Eva Rosenberg, re-print rights granted to AccountingWeb.com

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