Tax Considerations When Filing for Divorce

Who gets to claim the children on their taxes is a frequent debate between parties. Though some states allow their courts or domestic relations offices to assign exemptions between the parties, others are reluctant to make such a determination, and instruct the parties to follow IRS regulations.

The parsing of definitions becomes critical to understanding how child exemptions or child tax credits may be claimed. First, a child must be a dependent to qualify as an exemption. The IRS defines “dependent” as a “qualifying child.” To be considered as such, the child must pass tests of relationship (any one of the identified familial relationships, including sibling); age (under 19 or 24 if a student); residency (resided with the taxpayer for more than half the tax year); support (child could not have provided more than half of his/her own support); and no joint return with anyone else.

The custodial parent is typically the default beneficiary of the exemption. However, the non-custodial parent may claim the child exemption where the parents are divorced by agreement or physically separated. In such instances, the child must pass the support and residency tests, and the custodial parent needs to sign an agreement that he or she will not claim the child as a dependent for that year.

For those individuals who were not separated for the entire year, the custodial parent is determined by which person has the majority of post-separation nights where the child slept at his or her house (regardless of whether the parent was home during that time) or where the child spent time with the parent, even if the child did not sleep there. This would include vacations or where the child was sleeping at a location other than the parents' homes, but was still seeing one parent the majority of the time.

Child Tax Credit

The Child Tax Credit is perhaps the most easily identifiable tax issue that arises during a divorce. It offers a maximum credit of $1,000 for each qualifying child. The credit is reduced if the combined tax and alternative minimum tax is less than the credit, or where the taxpayer's adjusted gross income is more than $110,000 for parties filing jointly or $55,000 for married parties filing jointly.

Who may claim the child is a major area of dispute between parties. Similar to the tests for exemptions, the child must be a “qualifying child” to the taxpayer and have a familial relationship, such as being the taxpayer's biological, adopted, or step-child, or a sibling or a descendent ( i.e., grandchild). He or she must be under the age of 17 at the end of 2014 and have lived with the taxpayer for more than half the year.

Not unlike determining whether an individual may be considered a dependent, the residency test is applied to children for determining the child tax credit, and an exception exists when parties are divorced or separated. The IRS will allow the non-custodial parent to claim the child tax credit where the custodial parent signs Form 8832, which relinquishes the credit to the non-custodial parent and affirms that he or she will not claim the child as a dependent for that particular tax year. Such a waiver is applicable only to the tax year for which it is filed.

It is possible that the child could be considered the qualifying child of more than one person. For parents who both wish to claim the child, the parent with whom the child lived the greater portion of the year may claim the credit. Where the child lived with each parent equally, the parent with the higher AGI will be able to claim the child.

Sale of the Marital Residence

The sale of a marital residence or, in the parlance of the IRS, the “main home,” is a common occurrence in divorce cases. When a main home is sold, the IRS allows capital gains to be excluded from income taxes; a benefit that, when planned correctly, can create a significant opportunity for both parties to maximize their portion of the sale proceeds.

The exclusion for married couples filing jointly is $550,000, and $250,000 for those filing separately. For the majority of cases, these exclusions would be sufficient to cover any gains realized on the sale of the home, but for larger marital estates, these exclusions can be maximized to great effect within an agreement. In order to exclude the gain, the taxpayer(s) must have owned and lived in the home for at least two years during a five-year period ending on the date of the sale. If multiple homes are owned, the exclusion can only be applied to one “main home.”

To determine whether a residence is the “main home,” the IRS considers, among other factors, the taxpayer's place of employment; location of family members' main home; address on the tax return, and driver's license. Designating a “main home” is an important consideration for parties who maintain multiple homes and plan to derive a significant payout from the sale of one of the properties. With appropriate planning and foresight, the parties can ensure that the house that is needed for the exclusion is applied to the appropriate tests by the claiming party.

The tests the IRS applies to the exclusion are the ownership test (claiming party owns the home for at least two years); the use test (lived in the home as main home for at least two years), and; that the exclusion was not claimed on another home within a two-year period ending on the date of the sale.

A home transferred from one spouse to another, which often occurs in a divorce, will consider the transferee as having owned it during the period of the other spouse. Transferring a home in this way helps to avoid any problems from the use test that may exist during a long separation. If a divorce or separation agreement can be reached by which a spouse or former spouse is allowed to live in the property and uses it as his/her main home, all of the requisite tests will be satisfied.

The Innocent Spouse and Relief from Joint Liability

Marriage and relationships lend themselves to developing divisions of labor and responsibilities between the partners. Consequently, one person will know, but not really know, how their finances work, and the common refrain of “I just signed my name” becomes the first defense when a joint tax return is examined and found to be problematic. For separated and divorced individuals, there is relief available through the IRS to alleviate a joint tax liability under certain circumstances. The IRS recognizes three forms of relief: innocent spouse relief; separation of liability; and equitable relief. Among these three forms of the relief, the most commonly known, though perhaps not completely understood, is the innocent spouse relief.

Form 8857 is used by someone claiming innocent spouse relief. Though not without some exceptions, Form 8857 usually must be filed within two years of the IRS's initial attempt to collect the tax. Worth noting is that this form specifically states that the IRS will not necessarily recognize an agreement between the parties where one spouse is responsible for paying all taxes. This is important to remember because though parties may allocate the liability for taxes between them, the IRS has no obligation to accept such an arrangement. It is not a party to that agreement and received no consideration for alleviating joint tax liability against one party. Instead, the remedy for the aggrieved party is in the family court to enforce any agreement related to the payment of taxes. Comprehensive indemnification language should be applied to such agreements.

The IRS identifies four criteria for those allowed to apply for innocent spouse relief. The two most subjective criteria require the innocent spouse to show that at the time the return was signed, he or she did not know that the “understated” tax existed or, if aware of the tax, did not know the full extent of the understatement. The IRS then considers, based on the totality of the facts, whether it would be unfair to hold the spouse liable for the understated tax. Whether one will succeed on those arguments will depend on a determination of whether or not the innocent spouse had “actual knowledge” ' in other words, whether he or she knew of the understated tax or a reasonable person in similar circumstances would have known of the understated tax. This is the IRS' way to apply a certain reasonableness standard to the innocent spouse analysis.

Separation of liability relief is similar to the innocent spouse rule except it allows for the allocation of the tax liability between the parties rather than completely alleviating one spouse of the liability. Relief in the form of a proportionate share of the tax liability may be granted where a joint tax return has been filed, the parties are no longer married or are legally separated, and the parties have not been members of the same household at any time during the 12-month period ending on the date someone files the Form 8857.

Deducting Legal Fees Related to Divorce

One of the most difficult realities of litigating a divorce case with significant or complicated assets is that the parties are responsible for paying those legal fees with their post-tax income. Unlike the business-owner who can categorize his commercial litigation legal fees as a business expense, litigants in the divorce case feel every dollar spent litigating their case. As a general premise, people cannot deduct legal fees related to their divorce. However, the IRS does allow for the deduction of fees related to the taxpayer's obtaining taxable alimony. The benefit can be significant, as well, provided the taxpayer reaches the necessary threshold of 2% of his or her adjusted gross income.

Under the itemized deductions, alimony legal fees can be claimed as a miscellaneous deduction if they exceed two percent of the taxpayer's adjusted gross income. This deduction is not independent of other deductions that fall under the available “miscellaneous deductions.” The taxpayer would itemize the deductions, determine whether the combined value exceeds 2% of his or her AGI, and be able to claim the deductions in excess of the two percent limit.

Specific and segregated billing for alimony litigation allows attorneys to easily produce billing records related to their receipt of alimony. This deduction is not reliant upon the entry of a decree and also includes temporary alimony or alimony pendente lite .

Conclusion

The above tax issues and concepts are only a few of many that can affect a divorce case. Incorporating the expertise of a financial planner or accountant who can help to develop an effective strategy for allocating and addressing tax liabilities not only protects your client, but could also produce a benefit to both parties and lead to a settlement.

Aaron Weems is an attorney with Fox Rothschild LLP. Reach him at 610-397-7989 or aweems@%20foxrothschild.com.

Most people do not base their separation or divorce around their tax-planning options. Rare is the individual who moves out of the marital residence knowing the impact of losing half the accumulated mortgage interest, or whether he or she will be filing tax returns jointly or separately from his or her spouse. Instead, tax issues are often left until an asset is sold, or the end of the year approaches without the prospect of a divorce decree being issued.

Some tax liabilities cannot and should not be afterthoughts, while others offer unique opportunities to address an issue in the distribution of the parties' marital estate creatively. The following tax issues can be of particular importance during a divorce, and have meaningful impacts on the estate and tax liabilities of the parties.

Child Exemptions

Who gets to claim the children on their taxes is a frequent debate between parties. Though some states allow their courts or domestic relations offices to assign exemptions between the parties, others are reluctant to make such a determination, and instruct the parties to follow IRS regulations.

The parsing of definitions becomes critical to understanding how child exemptions or child tax credits may be claimed. First, a child must be a dependent to qualify as an exemption. The IRS defines “dependent” as a “qualifying child.” To be considered as such, the child must pass tests of relationship (any one of the identified familial relationships, including sibling); age (under 19 or 24 if a student); residency (resided with the taxpayer for more than half the tax year); support (child could not have provided more than half of his/her own support); and no joint return with anyone else.

The custodial parent is typically the default beneficiary of the exemption. However, the non-custodial parent may claim the child exemption where the parents are divorced by agreement or physically separated. In such instances, the child must pass the support and residency tests, and the custodial parent needs to sign an agreement that he or she will not claim the child as a dependent for that year.

For those individuals who were not separated for the entire year, the custodial parent is determined by which person has the majority of post-separation nights where the child slept at his or her house (regardless of whether the parent was home during that time) or where the child spent time with the parent, even if the child did not sleep there. This would include vacations or where the child was sleeping at a location other than the parents' homes, but was still seeing one parent the majority of the time.

Child Tax Credit

The Child Tax Credit is perhaps the most easily identifiable tax issue that arises during a divorce. It offers a maximum credit of $1,000 for each qualifying child. The credit is reduced if the combined tax and alternative minimum tax is less than the credit, or where the taxpayer's adjusted gross income is more than $110,000 for parties filing jointly or $55,000 for married parties filing jointly.

Who may claim the child is a major area of dispute between parties. Similar to the tests for exemptions, the child must be a “qualifying child” to the taxpayer and have a familial relationship, such as being the taxpayer's biological, adopted, or step-child, or a sibling or a descendent ( i.e., grandchild). He or she must be under the age of 17 at the end of 2014 and have lived with the taxpayer for more than half the year.

Not unlike determining whether an individual may be considered a dependent, the residency test is applied to children for determining the child tax credit, and an exception exists when parties are divorced or separated. The IRS will allow the non-custodial parent to claim the child tax credit where the custodial parent signs Form 8832, which relinquishes the credit to the non-custodial parent and affirms that he or she will not claim the child as a dependent for that particular tax year. Such a waiver is applicable only to the tax year for which it is filed.

It is possible that the child could be considered the qualifying child of more than one person. For parents who both wish to claim the child, the parent with whom the child lived the greater portion of the year may claim the credit. Where the child lived with each parent equally, the parent with the higher AGI will be able to claim the child.

Sale of the Marital Residence

The sale of a marital residence or, in the parlance of the IRS, the “main home,” is a common occurrence in divorce cases. When a main home is sold, the IRS allows capital gains to be excluded from income taxes; a benefit that, when planned correctly, can create a significant opportunity for both parties to maximize their portion of the sale proceeds.

The exclusion for married couples filing jointly is $550,000, and $250,000 for those filing separately. For the majority of cases, these exclusions would be sufficient to cover any gains realized on the sale of the home, but for larger marital estates, these exclusions can be maximized to great effect within an agreement. In order to exclude the gain, the taxpayer(s) must have owned and lived in the home for at least two years during a five-year period ending on the date of the sale. If multiple homes are owned, the exclusion can only be applied to one “main home.”

To determine whether a residence is the “main home,” the IRS considers, among other factors, the taxpayer's place of employment; location of family members' main home; address on the tax return, and driver's license. Designating a “main home” is an important consideration for parties who maintain multiple homes and plan to derive a significant payout from the sale of one of the properties. With appropriate planning and foresight, the parties can ensure that the house that is needed for the exclusion is applied to the appropriate tests by the claiming party.

The tests the IRS applies to the exclusion are the ownership test (claiming party owns the home for at least two years); the use test (lived in the home as main home for at least two years), and; that the exclusion was not claimed on another home within a two-year period ending on the date of the sale.

A home transferred from one spouse to another, which often occurs in a divorce, will consider the transferee as having owned it during the period of the other spouse. Transferring a home in this way helps to avoid any problems from the use test that may exist during a long separation. If a divorce or separation agreement can be reached by which a spouse or former spouse is allowed to live in the property and uses it as his/her main home, all of the requisite tests will be satisfied.

The Innocent Spouse and Relief from Joint Liability

Marriage and relationships lend themselves to developing divisions of labor and responsibilities between the partners. Consequently, one person will know, but not really know, how their finances work, and the common refrain of “I just signed my name” becomes the first defense when a joint tax return is examined and found to be problematic. For separated and divorced individuals, there is relief available through the IRS to alleviate a joint tax liability under certain circumstances. The IRS recognizes three forms of relief: innocent spouse relief; separation of liability; and equitable relief. Among these three forms of the relief, the most commonly known, though perhaps not completely understood, is the innocent spouse relief.

Form 8857 is used by someone claiming innocent spouse relief. Though not without some exceptions, Form 8857 usually must be filed within two years of the IRS's initial attempt to collect the tax. Worth noting is that this form specifically states that the IRS will not necessarily recognize an agreement between the parties where one spouse is responsible for paying all taxes. This is important to remember because though parties may allocate the liability for taxes between them, the IRS has no obligation to accept such an arrangement. It is not a party to that agreement and received no consideration for alleviating joint tax liability against one party. Instead, the remedy for the aggrieved party is in the family court to enforce any agreement related to the payment of taxes. Comprehensive indemnification language should be applied to such agreements.

The IRS identifies four criteria for those allowed to apply for innocent spouse relief. The two most subjective criteria require the innocent spouse to show that at the time the return was signed, he or she did not know that the “understated” tax existed or, if aware of the tax, did not know the full extent of the understatement. The IRS then considers, based on the totality of the facts, whether it would be unfair to hold the spouse liable for the understated tax. Whether one will succeed on those arguments will depend on a determination of whether or not the innocent spouse had “actual knowledge” ' in other words, whether he or she knew of the understated tax or a reasonable person in similar circumstances would have known of the understated tax. This is the IRS' way to apply a certain reasonableness standard to the innocent spouse analysis.

Separation of liability relief is similar to the innocent spouse rule except it allows for the allocation of the tax liability between the parties rather than completely alleviating one spouse of the liability. Relief in the form of a proportionate share of the tax liability may be granted where a joint tax return has been filed, the parties are no longer married or are legally separated, and the parties have not been members of the same household at any time during the 12-month period ending on the date someone files the Form 8857.

Deducting Legal Fees Related to Divorce

One of the most difficult realities of litigating a divorce case with significant or complicated assets is that the parties are responsible for paying those legal fees with their post-tax income. Unlike the business-owner who can categorize his commercial litigation legal fees as a business expense, litigants in the divorce case feel every dollar spent litigating their case. As a general premise, people cannot deduct legal fees related to their divorce. However, the IRS does allow for the deduction of fees related to the taxpayer's obtaining taxable alimony. The benefit can be significant, as well, provided the taxpayer reaches the necessary threshold of 2% of his or her adjusted gross income.

Under the itemized deductions, alimony legal fees can be claimed as a miscellaneous deduction if they exceed two percent of the taxpayer's adjusted gross income. This deduction is not independent of other deductions that fall under the available “miscellaneous deductions.” The taxpayer would itemize the deductions, determine whether the combined value exceeds 2% of his or her AGI, and be able to claim the deductions in excess of the two percent limit.

Specific and segregated billing for alimony litigation allows attorneys to easily produce billing records related to their receipt of alimony. This deduction is not reliant upon the entry of a decree and also includes temporary alimony or alimony pendente lite .

Conclusion

The above tax issues and concepts are only a few of many that can affect a divorce case. Incorporating the expertise of a financial planner or accountant who can help to develop an effective strategy for allocating and addressing tax liabilities not only protects your client, but could also produce a benefit to both parties and lead to a settlement.

Aaron Weems is an attorney with Fox Rothschild LLP. Reach him at 610-397-7989 or aweems@%20foxrothschild.com.