Tax Considerations and Issues Relating to Divorce

If the divorce is final by the last day of the year, then the taxpayer is treated as unmarried for the entire year (assuming the taxpayer has not remarried by the end of the year). Divorcing couples may want to decide in which year to get divorced. The couple may save money if they file jointly; or it may save them more to be divorced and each file as unmarried.

If the divorce has not been finalized by the end of the year, the taxpayer is married for tax purposes. The taxpayer can file a joint return with the spouse or a separate return (married filing separately). If the spouses live apart for the last six months of the year and maintain a household for a dependent child, the taxpayer may qualify to file as head of household.

Legal separation has the same tax effect as divorce. Thus, if a couple is legally separated on the last day of the year (e.g., there is a decree of separation), then the taxpayer is treated as unmarried for the year. Merely living apart and considering themselves to be separated is not a legal separation for tax purposes.

Alimony

Payments to a former spouse are taxable to the recipient and deductible by the payor spouse only if all of the following conditions are met:

• Payments are made pursuant to a divorce decree or separation agreement;
• Payments are made in cash;
• The divorce decree or separation agreement does not designate the payments as nontaxable to the recipient and nondeductible by the payor;
• The spouses live apart;
• There is no liability to make payments after the death of the recipient-spouse;
• The payments are not support.
• Voluntary payments, such as amounts paid prior to a final decree of divorce, are not treated as alimony (see, e.g., Milbourn, TC Memo 2015-13). Payments do not have to be made to the former spouse as long as they are made elsewhere to benefit him or her. Thus, for example, paying health insurance premiums to cover the former spouse may be deductible alimony (assuming all the other conditions are met).

The IRS requires the payor spouse to report the Social Security number (SSN) of the recipient spouse to ensure that amounts deducted align with amounts reported as income. Nonetheless, the Treasury Inspector General of Tax Administration in 2014 found that there was a $2.3 billion gap between the amount of alimony deducted and the amount reported as income (TIGTA-2014-09). The report observed that currently there is no way to know whether the SSN reported is valid. The report makes recommendations to the IRS to help close the tax gap here.

Children

Having a child complicates the divorce process, including the tax consequences. There are two key issues that are raised: child support and the dependency exemption.

Payments to support a child are not taxable to the recipient-spouse or deductible by the payor spouse (Code Sec. 71(c)). These include payments labeled as child support, as well as payments construed as child support because they are related to a contingency involving the child. For example, a payment to a spouse is treated as child support, and not alimony, if the amount is reduced or eliminated when the child attains majority.

If there is a delinquency in both alimony and child support, payments are applied first toward child support before being applied toward alimony (see e.g., Becker, TC Summary Opinion 2015-2). If a parent fails for some time to pay required child support, the IRS can apply a federal tax refund to the delinquency (Code Sec. 6402(e)). Past-due support for this purpose means a delinquency for which the IRS has been notified by a state in accordance with Section 464(c) of the Social Security Act.

Now, to the dependency exemption. Consideration must be given to the tax breaks that can ensue when parents break up. The dependency exemption for a child of the marriage can be claimed automatically by the custodial parent, who is the parent with physical custody for the greater part of the year (Reg. '1.152-4). Claiming the dependency exemption may also entitle the parent to claim the child tax credit (Code Sec. 24) and the earned income tax credit (Code Sec. 32).

However, the custodial parent can waive the dependency exemption to allow the noncustodial parent to claim it. This is done by having the custodial parent sign Form 8332, Release/Revocation of Release to Claim Exemption for Child, and attaching the signed form to the tax return of the noncustodial parent. The waiver can be annual or permanent. A divorce decree can require the custodial parent to sign the waiver, but the decree itself is not a waiver for tax purposes.

Which parent should receive the exemption? It depends on the financial status of each one. For example, it is usual for the higher-income parent to claim the exemption. However, if such parent is a high-income taxpayer subject to the phase-out for exemptions, then it makes more sense for the other parent to claim the exemption. Financial negotiations during the divorce process must take this tax break into account.

Property Settlements

No gain or loss is recognized on the transfer of property incident to divorce (Code Sec. 1041). The recipient-spouse steps into the shoes of the transferor-spouse for basis purposes (Code Sec. 1041(b)). Thus, when the recipient-spouse sells the property, he or she recognizes gain or loss on the transaction at that time. As a result of this carryover basis rule, property settlements should factor in tax results. For example, stock worth $10,000 with a basis of $2,000, presents the recipient spouse with a potential gain of $8,000; the stock is not really worth $10,000 to this spouse.

The couple's marital home also often becomes a prime issue in divorce. Both spouses may continue to own the property even though only one is given possession of the residence. Sometimes, the spouse living in the home is directed or desires to sell the home when the couple's child has grown and is no longer living there. For purposes of the home sale exclusion, two special rules apply:

1. A spouse who receives title to the home can treat the period of ownership by the other spouse as his/her own. This can help such spouse meet the two-out-of-five-year ownership test for the exclusion (Code Sec. 121(d)(3)(A)).
2. A former spouse who continues to own the home occupied by the other spouse is treated as having used the home during the period that the other spouse uses it; again, this enables the former spouse to claim the home sale exclusion (Code Sec. 121(d)(3)(B)).

Legal Fees for Divorce

Generally, legal fees to obtain a divorce are not taxable. For example, a business owner whose ownership is at stake in a divorce settlement cannot deduct legal fees even though they relate to his/her business and, arguably, are for the conservation of income (see, e.g., Melat, TC Memo 1993-247).

However, the spouse who obtains alimony may deduct the portion of legal fees related to the production or collection of income (Code Sec. 212(1)). The attorney handing the divorce for this spouse should itemize the services so that the spouse can deduct the applicable portion of the fees.

Retirement and Benefits

Benefits from qualified retirement plans, IRAs, and other employee benefit programs are important considerations during divorce. Divorcing spouses may want to change beneficiary designations to plans, as well as to life insurance policies, so that former spouses do not inherit benefits.

The divorce settlement may award retirement plan benefits accrued by the working spouse (the participant) to the other spouse (the alternate payee). As long as this is done by a qualified domestic relations order (QDRO), the participant is not taxed on benefits transferred to the alternate payee (Code Sec. 414(p)). And the early distribution penalty does not apply (Code Sec. 72(t)(2)(C)).

The QDRO cannot compel the distribution of benefits to the alternate payee; it merely awards them to this spouse. Benefits are payable on the earliest retirement date, even if the participant has not separated from service, which is (Code Sec. 414(p)(4)(B)):

• The date on which the participant is entitled to a distribution under the plan, or
• The later of the date the participant attains age 50, or the earliest date on which the participant could begin receiving benefits under the plan if the participant separated from service.

The alternate payee is not taxed if, when benefits are payable, they are rolled over or directly transferred to a qualified retirement plan or IRA of this spouse.

The IRS and the Department of Labor have sample language for a QDRO at http://1.usa.gov/1OF5CtM.

Funds in an IRA transferred to a former spouse incident to divorce are not taxable to the owner (Code Sec. 408(d)(6)). The transfer is also exempt from the 10% early distribution penalty (Code Sec. 72(t)). However, if an IRA owner uses funds from the account to pay alimony, child support, or anything else related to the divorce, the funds are taxable and not exempt from the early distribution penalty (see, e.g., Bunney, 114 TC 259 (2000)). (There may be an offsetting alimony deduction where applicable.) The IRA owner must transfer the interest in the IRA, and not the funds themselves, in order to escape tax on the transfer.

Medical Considerations

If a spouse is covered under the other spouse's employer's health plan and the employer is subject to COBRA, the spouse may opt to continue on the plan for up to 36 months (29 USC Sec. 1161). The Department of Labor has FAQs on COBRA at http://1.usa.gov/1Pjp4IS.

Medical FSAs

Usually, an employee commits to contributions for the year. However, upon divorce, the employee can change his/her contributions for the balance of the year (Reg. '1.125-4(c) (2)(i)).

Miscellaneous Issues

Divorce can impact other tax-related matters. For instance, if a couple opts to receive on an advance basis the premium tax credit (Code Sec. 36B) for health insurance purchased through a government Marketplace, they should notify the Marketplace about the change in status. This changes the taxpayer's advance payment amount.

And what happens if the IRS audits a joint return filed prior to divorce and finds that taxes are owed? The divorce can address this issue by providing which spouse is liable for any deficiency or whether the amount should be split between them.

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink. This article also appeared in the New York Law Journal, an ALM sibling publication of this newsletter.