Divorce Taxation and
Bankruptcy Issues
Both areas are traps for the unwary
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Taxation: Not knowing how or if payments or
property transfers will be taxed can lead to
malpractice liability
Failing to anticipate an effort by the other
spouse to discharge property or other
obligations in bankruptcy can also lead to a
malpractice claim
General rules
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Alimony is deductible by payor and included
in taxable income of recipient
Child support is not deductible by payor nor
included in recipient’s income
Property transfers incident to divorce are not
usually taxable events
Tax return filing issues
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Marital status is determined as of the last day of the
year in question (12/31)
Not unusual to rush to have final judgment signed on
or before 12/31 so parties can file as “single” to
avoid higher rate of “married filing separately”
Equally common to hold settlement for several
months and finalize after New Year to permit parties
to file jointly and claim lowest tax rate
Filing Jointly - Risks
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Both parties are jointly and severally liable
for taxes, interest, and penalties on joint
return
“Innocent Spouse” status not easy to obtain
Often have negotiated “indemnify and hold
harmless” clauses to protect a spouse who
had little knowledge of the parties’ finances
Tax Treatment of Alimony
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26 USC § 71: Alimony deductible from
income of payor
26 USC § 215: Alimony included in income
of recipient
Section 71 Requirements
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The payment is in cash
The governing instrument does not designate the payment as
excludible from the gross income of the payee and
nondeductible by the payer
Spouses legally separated under a decree of divorce or
separate maintenance are not members of the same household
when the payment is made
–
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Exception for alimony paid under a temporary order
The payment is not treated as child support
The payer has no liability to make any payment after the death
of the payee (or to make any payment as a substitute for such
payment)
Anti-Front Loading Rule
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A series of payments must not be
excessively front-loaded
Payments scheduled over a period of years
may not be heavily skewed, or "bunched," in
the first three calendar years in which
payments are made pursuant to the divorce
judgment
Purpose of rule is to avoid transfer of cash
for payment of property interests via alimony
Recapture of Front-loaded Payments
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Excessively front-loaded payments must be
recaptured
The payer spouse who deducted the excess
payments must report them as income, and
the payee initially taxed on them is entitled to
a deduction retroactively
Recapture is determined according to when
payments are actually made, not when they
are scheduled
Recapture Rules
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The measuring period is the three successive
calendar years beginning with the year in which
payments commence.
– The total paid in the third calendar year is added
to a $15,000 statutory allowance. The sum is then
subtracted from the total paid in the second year.
Any difference is recapture.
– Then the average of payments made in years 2
(net of recapture, if any) and 3 is added to the
$15,000 statutory allowance. The sum is
subtracted from the total paid in year 1. Any
difference is recapture.
Result of recapture
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The total amount of recapture from years 1
and 2 is reported as income by the payer in
year 3
The total amount of the recapture is claimed
as a deduction by the payee in year 3
Alimony recapture rules of thumb
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$15,000 threshold: If payments do not exceed
$15,000 annually, there will never be recapture
Declining payments only: Recapture only applies
to a schedule of payments that decline from year to
year over the three-calendar-year measuring period.
It does not apply when payments are level or
increase
$10,000 safe harbor: There will never be recapture
if the decline in total payments between years 1 and
2 and then between years 2 and 3 do not exceed
$10,000 each
Example 1
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Year 1 - $25,000
Year 2 - $10,000
Year 3 - $5,000
Result: $2,500 recapture
Why? Year 2 and 3 average $7,500. Adding
the $15,000 statutory allowance result it
$22,500. The difference between that
amount and Year 1 payment must be
recaptured
Example 2
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Year 1 - $25,000
Year 2 - $15,000
Year 3 - $5,000
Result: No recapture
Why? This falls within the $10,000 “safe
harbor” rule
Free Web-Based Recapture Calculator
http://www.rosen.com/calculators/alimonyrecalc.asp
Exceptions to recapture
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If either spouse dies or alimony terminates
due to remarriage of the payee before the
end of the third year
Rules do not apply to temporary alimony
payments
Where alimony of three year’s or more
duration is based on a fixed proportion of the
payer’s income
Advantages of Payments under
Section 71
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Transfer what is actually property (i.e., part of
the marital estate) or pay the other spouse's
legal fees in a taxable/deductible way.
This is advantageous when the payer
spouse's tax bracket is significantly higher
than that of the payee spouse.
Example
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Payer spouse is in 35% tax bracket
Payee spouse is in 15% tax bracket
Transfer of $20,000 to pay attorney fees for
payee spouse shifts tax burden to payee
spouse at just 15%.
Taxes on the $20,000 reduced from $7,000
to $3,000.
Net gain to the parties of $4,000.
Temporary Alimony
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Payments during the pendency of a divorce qualify
as taxable/deductible if made:
– (1) pursuant to a temporary support order or a
written separation agreement, and
– (2) in a year for which the parties do not file a joint
return. IRC 71(b)(2)(e)
Since payments must be pursuant to an order or
separation agreement, only those made after such a
document is in effect qualify.
Property Transfer Upon Divorce – Tax
Consequences
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No taxable gain or deductible loss is
recognized on transfers of property between
spouses or between former spouses incident
to a divorce
A transfer is "incident to a divorce" if it occurs
within one year after the marriage is
terminated or if it is related to the cessation
of the marriage
What about the tax “basis” of property
transferred pursuant to divorce?
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The transferee spouse treats the property for
tax purposes as if acquired by gift
Therefore, the transferee takes the transferor
spouse's tax basis and holding period
Areas of concern – sales to third
parties
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Nontaxable treatment under IRC Section 1041
applies to transfers between spouses but not to
sales of marital property to third parties even if
pursuant to the divorce judgment
It is not uncommon for a property settlement to
provide that the parties will split the proceeds from
the sale of a marital asset
It is important to know that the sale will be taxable
according to how title is held, not how the proceeds
are divided
Example of “tax tracks with title”
problem
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H and W own each own one-half interest in
real estate
Property is sold pursuant to divorce judgment
which provides that W gets 75% and H gets
25%
Husband stuck with half of capital gain on
property even though he received only 25%
of sale proceeds
This rule also applies to other types of
property
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Exercise of stock options triggers taxable
gain for the employee spouse even if
proceeds must be shared with other spouse
When agreeing to divide stock options, make
sure that the “net after tax” proceeds are
what is divided, not the gross pre-tax
proceeds
Be wary of “low basis” traps
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If a spouse is awarded a disproportionate
share of assets with a low tax basis (usually
the original purchase price), that spouse will
pay higher capital gain taxes when that
property is eventually sold, skewing the
fairness of the property settlement
Need to plan ahead an build-in some
offsetting compensation for a spouse who
takes low basis property in the settlement
Considering tax consequences when
valuing marital property
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It is generally not appropriate to lower the value of
property by the amount of tax that would result if it
were sold unless it is likely such a sale will in fact
occur.
The prevailing majority view of courts across the
country is that adjustments should be made when
the tax liability is reasonably foreseeable, not
highly speculative or conjectural
Consider only those tax liabilities that are likely to
arise in the near future, most notably those resulting
directly from the settlement itself (e.g., the sale of
appreciated stock provided for in the judgment)
Need to prove the tax consequences
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A request to take taxes into account should
be supported by evidence of the tax
consequences, typically with expert
testimony
Need to demonstrate that they are
foreseeable and not merely speculative
The problem of interest on installment
payments of property
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Interest on property settlement installment payments
is treated as non-deductible consumer interest for
the payer
But although not deductible by the payer, it is
considered taxable income to the payee
Need to calculate interest and include it in the base
payment (called “baked in” – don’t mention interest
separately in the agreement)
May need to come up with a prepayment discount if
the payer wants to pay off his/her obligation before
the expiration of the term used to calculated the
“baked in” interest
Tax consequences of sale of marital
home
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IRC Section 121 provides for the exclusion of
up to $250,000 of gain - $500,000 for
married taxpayers - on the sale of a home
that has been owned and used as a principal
residence by the taxpayer for two of the five
years ending on the date of the sale
How to qualify for the exclusion
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Married taxpayers qualify for the $500,000 exclusion
if the following conditions are satisfied:
– They file a joint return for the year of sale.
– At least one of the spouses satisfies the two-outof-five-years ownership requirement.
– Both spouses satisfy the two-out-of-five-years use
requirement.
– Neither spouse is ineligible to use the exclusion
due to using it within the two years preceding the
date of sale.
Sale after divorce?
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If other qualifications are met, each former
spouse can claim his/her $250,000 individual
capital gain exclusion
Property tax and mortgage interest
deductions in divorce cases
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The joint owner who makes the payment is
entitled to the deduction
If payments are made by both spouse, the
deduction is divided based on a ratio of
payments
If payment is made from a joint bank
account, it is presumed that the deduction
will be divided equally (presumption may be
rebutted by evidence of source of funds in
joint account)
Dependency Exemptions
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IRC Section 152(e):
– the parent who has physical custody of a
child for more than half the year (the
custodial parent) is automatically entitled
to claim the dependency exemption
– This applies regardless of which parent
provided more than half the child's
support.
Exception
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The custodial parent may execute a written
waiver releasing the exemption to the
noncustodial parent for a single year, a
specified number of years (e.g., alternate
years), or for all future years
To do this, the custodial parent executes IRS
Form 8332, which the noncustodial parent
must attach to his or her income tax return.
Related issues
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Can the court order a custodial parent to sign
a Form 8332 surrendering the exemption?
Should there be a clause that surrenders the
exemption to the noncustodial parent only if
he/she is current in support by the last day of
the year in for which the exemption is being
surrendered?
Child Care Tax Credit
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Qualifying taxpayers are allowed a tax credit of 35
percent of expenses paid for the care of a dependent
child who is under age 13
To qualify for the credit, the taxpayer must provide
more than half the cost of maintaining a household
for the dependent child
The taxpayer must be entitled to claim a dependency
exemption for the child to qualify, except that any
agreement to allow the noncustodial parent to claim
the child is disregarded
Child Tax Credit
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IRC Section 24 provides a $1,000 tax credit
to taxpayers with qualifying children under
age 17 for 2004
A "qualifying child" is defined as a child,
descendent, stepchild or eligible foster child
for whom the taxpayer may claim a
dependency exemption who is less than 17
years old
Attorney Fee Deductions
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Attorney fees for divorce or other family law matters
are not generally deductible
However, that portion of the fee related to the
production or collection of taxable alimony are
deductible by the recipient spouse as a nonbusiness
deduction under IRC Section 212
Fees either spouse incurs and pays for tax advice
relative to the marital settlement are deductible
under IRC Section 212(3). Most divorces involve
some level of tax advice concerning the income,
estate, or gift tax ramifications.
Bankruptcy issues
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Bankruptcy all too often follows or leads to
divorce, so family law attorneys need to have
some familiarity with bankruptcy law
If you don’t do bankruptcy work yourself, it
helps to form a relationship with a lawyer
who handles consumer bankruptcy cases
New law impacts discharge
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2005 bankruptcy reform effective 10/17/05
makes divorce-related obligations nondischargeable, whether support or property
Eliminates battles to determine whether a
particular obligation was support or property
division.
Beware the Section 362 Automatic Stay
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Does not apply to child support, alimony, or
granting the divorce itself
Does bar state court from hearing or deciding
property issues
Party wanting to move forward with property
during pending bankruptcy must ask the
bankruptcy court to lift the stay. Note:
Bankruptcy court could decide to hear the
property issues itself and apply state law, but
that is rarely done
Penalties for violation of 362 stay
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Actions taken in violation of the stay are void
Willful violations are punishable by contempt,
and may include damages, costs, attorney
fees, and punitive damages
Penalties often run into the thousands of
dollars