Tax filing implications of divorce.by Persoff, Ilene Leopold
The first concern for tax preparation of people involved in a divorce proceeding is determining appropriate filing status. The filing status depends on whether the parties are in fact married, living together, and if there are children. Table 1 summarizes the filing status according to these factors.
From a tax standpoint, the marital status is determined as of the last day of the tax year. If there is a final decree of divorce or a decree of annulment by December 31, the parties are no longer in fact married and they are precluded from filing tax returns as married persons. In situations where the marriage has not been legally dissolved, the filing status is determined by whether the parties are married but considered unmarried.
If the parties are legally separated and have a final decree of separate maintenance, they are considered unmarried. Taxpayers must follow state law to determine if they are divorced or legally separated. An interlocutory decree is not definitive of legal separation for tax return preparation purposes. Although taxpayers may consider themselves as separate and no longer living as a married couple, and although there may be payments of maintenance and/or child support pursuant to a written agreement, the absence of a final decree of separate maintenance requires that the taxpayers continue filing tax returns as married individuals. If there is a child involved, head of household status is available to one of the parties provided that certain conditions are met. If they were legally separated, the other party would file as single. If the parties are not legally separated, the party not claiming head of household status must file as married filing separately. To qualify as head of household, the following conditions must be met.
The taxpayer is legally separated or did not live with his or her spouse during the last six months of the year;
The taxpayer is not filing a joint tax return with his or her spouse;
The taxpayer paid for more than one-half the cost of upkeep of the household for the whole year; and
For more than half the tax year the taxpayer's home was also that of the taxpayer's child, stepchild, adopted child, or foster child who qualifies as his or her dependent, even if the other parent claims the child as a dependent for tax purposes.
The cost of maintaining the home of the taxpayer and child includes rent, mortgage interest, real estate taxes, insurance, repairs, utilities, domestic help, and food. If the parties are legally separated and there is no child, both parties would file as single taxpayers. If the parties are not legally separated and have not lived together during the last six months of the year, the taxpayer not filing as head of household will file as married filing separately.
Normally, taxpayers who file a joint return will satisfy the support test for a child's dependency if more than half of the child's support came from one or both spouses. In all likelihood however, separated parents will not likely be filing joint returns unless they have lived together at any time during the last six months of the year and they can agree to file a joint rather than a separate return. A child is considered a dependent of both parents for purposes of the support test if all the requirements are met according to the following special rules.
The special rules of support are for parents who are divorced or legally separated under a decree of divorce or separate maintenance, who are separated under a written separation agreement, or who did not live together at any time during the last six months of the calendar year. One or both of these parents must have had custody of the child for more than half the calendar year and one or both parents together must have provided more than half the child's total support that year.
The rule for parents providing more than half the support can be satisfied after a divorce by including support given by a spouse of a parent who has remarried. The support however, given by a relative or friend of a divorced or separated parent can not be included to satisfy the provision of parental support. Remember that tax rules often differ from legalities, such as computational child support guidelines under state laws and regulations. It should also be noted that support for dependency is quite different from the head of household requirement for keeping up a home of a dependent child. Support includes all amounts paid for the benefit of, or items used by, the child. This includes food, clothing, shelter, health care, recreation, and education.
Exemption for Dependent Child
When all the tests for dependency are satisfied, the next question is which parent will claim the exemption. The custodial parent is allowed to claim the exemption for the child; but there are situations where the noncustodial parent may also claim the exemption. The significant factor is the determination of which parent is custodial and which parent is noncustodial.
Legal documents usually name the custodial parent. The determining factor is the pertinent section of the most recent document. A finalized custody contest would supersede a decree of divorce or separate maintenance. A written separation agreement will suffice when there is no finalized decree. If the ruling document is silent as to establishing custody, the custodial parent is deemed to be the one who had physical custody for a longer time during the year. In the year of divorce or separation, the remainder of the year after such an event occurs is the time period to be used in determining which parent had custody for a longer time.
Decrees and Agreements Made
After 1984. Decrees and agreements made after 1984 should not only name the custodial parent but state which parent can claim the dependency exemption. (Both parents are entitled to itemize their payments for medical expenses of a dependent child regardless of who claims the exemption.) It is presumed that the custodial parent gets the dependency exemption; but the parents may agree to give the exemption to the parent who had custody for the shorter time of the year. Regardless of a written or unwritten agreement, the noncustodial parent who claims a dependency exemption must attach evidence of such entitlement for each year in which the claim is used. Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, is signed by the custodial parent and states his or her agreement not to claim the child's exemption. This form may be completed once to release only the current year, to include specific years of release, or to release all years. Alternatively, a new form may be completed every year of release. The release, for however long it is stated, is irrevocable. A purposeful statement signed by the custodial parent may be substituted for the IRS form. Copies of the cover page of the ruling legal document with the custodial parent's Social Security number, the page that asserts the noncustodial parent's claim to the exemption, and the page showing the signatures and date of agreement are acceptable. Whichever format is chosen, the release must be attached to the noncustodial parent's tax return. For multiple years of release, the original Form 8332 or statement should be attached for the first year with copies attached thereafter.
Decrees and Agreements Made
The rules for decrees and agreements made before 1985 are quite different. The noncustodial parent of children may take the exemption if the decree or agreement so states, as long as that parent provided at least $600 for each child's support during the tax year, whether or not the recipient used the money for the child's support. Child support payments in arrears may not be counted toward the $600 if not paid in the year in which they belong. They also may not be applied to the $600 requirement for the subsequent year in which they are paid. A custodial parent may use Form 8332 or a similar statement to allow the noncustodial parent to claim the exemption. The noncustodial parent who claims a child's exemption under a pre-1985 decree or agreement must check the appropriate box on the front page of Form 1040 or 1040A.
A deduction may be claimed toward adjusted gross income for the payment of alimony, or, as it often referred to, maintenance payments. The amount of alimony received should be included in the recipient spouse's gross income. Of course, these amounts should be the same for each spouse. However, very often, the spouses disagree. There is a $50 penalty if the payor does not enter the payee's name and Social Security number on his or her tax return, and the alimony deduction may be disallowed. The IRS attempts to match a payor's deduction with the payee's reported income.
The rules which define alimony for post-1984 separation and divorce situations must be clearly understood. Alimony payments must be made with money and not property, and they are not to be made for the use of property. A separation or divorce agreement may specifically designate payments as being excludable from income and not deductible. The recipient spouse should attach documentary evidence as proof that receipts otherwise qualifying as alimony are excludable for tax purposes.
In order for payments to be deemed payments for alimony, they must not he required to continue after the death of the payee spouse and must terminate upon the death of the payee. The purpose of alimony/maintenance is to provide for a spouse who is not working or who is attempting to raise his or her standards through education and/or finding appropriate employment. Accordingly, these payments for the welfare of the spouse are unnecessary if the spouse is no longer living. Alimony will not be allowed for tax purposes in any year if payments are to cease upon death of the payee.
Alimony is not deductible from or includible in income if the spouses are filing joint tax returns. If the spouses are filing as unmarried, the amount deemed to be reportable alimony may differ from actual payments depending on whether the spouses are legally separated. If the spouses are legally separated under a court decree, payment will not qualify as alimony if the taxpayers are members of the same household when made. The spouses must reside in separate households. Separate rooms in a home do not qualify as separate households. If the spouses do live in the same household when payments are made, the only payment which will qualify for alimony is the one made within one month of a spouse moving out of such household. For example, a separation decree may state alimony is to begin on February 1 and be paid on the first of each month. if the spouse does not move out of the household until June 15, alimony is only includible in and deductible from gross income for payments beginning on June 1 of that year, regardless of the statement of alimony in the legal document.
Not Legally Separated
There is a quirk in the IRC where alimony payments to a spouse can be deemed alimony if the spouses are members of the same household. In this situation, the spouses can not be legally separated or divorced but may be voluntarily separated with a written agreement. It is possible, then, for a spouse to receive alimony deductions even if there is an eventual reconciliation of the parties without divorce. As previously noted, a written separation agreement requires the filing of married tax returns. To deduct alimony payments, the status must be married filing separate returns.
Payment for Property
Payments in money may qualify for alimony even if they are for the release of property incident to the divorce. They must be disguised as payments for the welfare of the recipient spouse. This is a sticky point in the negotiation process of separation and divorce. Such payments may be negotiated so that the payor spouse is given an alimony deduction in return for the recipient spouse receiving a larger amount, includible in income, than was originally planned as part of the nontaxable division of marital property. Since alimony payments must cease upon the death of the recipient spouse, an early death could result in the recipient spouse receiving less marital property than was intended. If the payment were deemed a payment for the release of property, the beneficiaries of the spouse's estate could continue to receive payment. Alimony and Child Support. If a taxpayer is to receive payments that have both alimony and child support components and the payor is in arrears in payment, whatever payments have been received by the payee are deemed to cover child support payments first. There is no deduction and no income for alimony on amounts not paid/received. Indirect Alimony. It has been previously stated that payments must be made in money to qualify as alimony. Ordinarily the payments will be made directly to the payee spouse. The payments may, however, be paid to a third party and be deemed alimony, albeit indirect alimony, as long as they are made on behalf of the payee spouse and are not for property owned by the payor spouse but used by the payee spouse. Additionally, if they are not required under the terms of the separation or divorce document to be made directly to a third party, the payments will only qualify as alimony if certain requirements are met. The payee spouse must make a written request of the payor spouse for payment to be made to a third party and the request must state the parties agree the payments will be treated as alimony. The payor spouse must receive this request before he/she files an income tax return for the year in which the payments were made.
Payments for Home. Attention is required in calculating alimony (assuming other alimony requirements are satisfied) and itemized deductions when a payor spouse pays for the home in which the former spouse lives. Table 2 shows three situations of ownership: the first where the payor owns the home, the second where the payee owns the home, and the third where both former spouses own the home as tenants in common. The payor directly pays the mortgage principal and interest, real estate taxes, insurance, repairs, and utilities. In the first situation, since the mortgage is for the payor's debt, and the taxes, insurance, and repairs are for keeping up property owned by the payor, none of these items will qualify as alimony. In the second situation, all these items will qualify for alimony because the payor does not own the property. In the third situation, the amounts paid representing the percentage share of the payor's ownership will not qualify for alimony and the amount representing the percentage share owned by the payee will qualify. Itemized deductions for mortgage interest and real estate taxes are also considered according to ownership. Utilities payments are alimony in all situations because they are a cost of housing and not a cost of ownership For other than utilities, the payor is entitled to either an alimony deduction or an itemized deduction, and the payee is entitled to either no income and no deduction or income and an itemized deduction with a potential zero net effect on taxable income. The payor may deduct all real estate taxes for property he or she owns but may be limited as to the deduction allowed for mortgage interest. Mortgage interest would not be deductible if it is not qualified residence interest or is not investment interest subject to limitations. When the home is owned as tenants by the entirety or joint tenants with right of survivorship, one-half of the mortgage debt is usually attributable to each party. Therefore one-half, paid on half of the payee, may be alimony and one-half of the interest payments would be deductible by party as an itemized deduction. The payor may deduct real estate taxes to the extent paid and the payee would not have taxable alimony for that amount. Clearly, the payor must account to the payee for amounts of all payments made to third parties which qualify as alimony, including those for medical care, education, income taxes, etc. so that the payee's alimony income matches the payor's alimony deduction.
As explained previously, taxpayers may still be considered married at December 31, and the filing status options would be married filing joint or married filing separate returns (see Table 1). Most often, the combined tax liability from both spouses filing separately will be greater than the liability from filing jointly. The sharing of the tax savings might be an inducement for an unwilling party to sign a joint return.
The parties should be alerted to the fact they are both jointly and individually liable for all taxes, penalties, and interest associated with a joint return. This liability extends beyond the date of divorce or agreement to any previously filed joint return. Taxpayers are frequently urged to sign indemnification clauses which state a spouse's or former spouse's responsibility for joint tax liabilities. They do not always understand that these agreements are strictly for recourse between themselves and do not absolve either party from liability to the taxing authority. If married returns are filed separately, each party is responsible solely for amounts due with regard to his or her own tax return. If one spouse would not otherwise be required to file a return and is unwilling to sign a joint return (having not filed separately for him or herself), the other party might file a joint tax return with only one signature. Such a return without both signatures will revert to a return as married filing separately. Sometimes a spouse illegally signs the other spouse's name on a joint return. The spouse who is not willing to sign a joint return and whose income does not require a separate return to be filed should file a separate return anyway. This may alert the government to a joint return having been improperly filed and would relieve him or her from contesting a joint liability assessment that had been asserted without this taxpayer's knowledge.
Innocent Spouse Rule
There may be a situation where a separated taxpayer agrees to sign a joint return but does not know, and has no reason to know, the estranged spouse has omitted an item of gross income or has claimed a deduction, credit, or property basis for which there was no factual or legal basis. IRC Sec. 6013(e) includes an innocent spouse rule which will alleviate that party's responsibility for additional tax, interest, and penalties arising from such omissions or claims. If the additional amount assessed is more than $500, the innocent spouse would not be responsible for payment if it is also unfair, under all the facts and circumstances, to hold that spouse liable for the additional tax, interest, and penalties. This requirement of unfair to hold liable" is extremely difficult to prove. The innocent spouse would need to receive absolutely no direct or indirect significant benefit from the understatement of the tax, even for years after a divorce is finalized.
The exception to liability of an innocent spouse is further mitigated if the additional tax, penalties, and interest are caused by the overstated claim of deduction, credit, or basis and not to the omission of an item of gross income. If this occurs, the spouse may only be relieved if the liability exceeds 10% of his or her adjusted gross income (AGI) if that income is less than or equal to $20,000, or if the liability exceeds 25% of his or her AGI if that income is more than $20,000. These limits are calculated using AGI in the "preadjustment year" which is the taxable year completed most recently before the IRS mailed the deficiency notice of tax due. If the spouse has remarried, the income of the current spouse is included in the innocent spouse's AGI for computation of exception to the liability from the joint return of the former marriage. All things considered, (since 100/o of $20,000 is $2,000 and 25% of $20,004 is $5,001) a spouse with $20,004 AGI would still be responsible jointly and individually for a very large dollar amount relative to income (assuming nontaxable income is not significant). Again, it is stressed that a separated spouse should consider filing a married separate return in a year when he or she does not know how an estranged spouse's income, deductions, credits, and basis should appropriately be reported. Often one spouse will dangle a shared refund to the other spouse in return for signing a joint return. The taxpayer should weigh the alternatives of such bait because the minimum liability can be steep before innocent spouse protection becomes a reality. Additionally, a joint return cannot be amended to separate returns, but the spouses could later amend to joint returns any time within three years from the original due date of the separate returns filed.
New Spouse Liability. A person who is divorced and subsequently remarried can put a new spouse in an undesirable situation regarding the liability and payments on joint income tax returns filed. A former spouse may have a judgment for child support and/or maintenance payments in arrears and may have attached the nonpayor's income and/or income tax refunds. If a joint return is filed with the new spouse, that spouse's own portion of tax refund may end up being used to pay the delinquent payments to the former spouse. The new spouse can be protected by attaching Form 8379, Injured Spouse Allocation, to the front of the joint return filed. This would allocate the total refund to the new spouse's share of his or her own tax liability and payments. An injured spouse is one who is not liable for the debtor spouse's obligation and who had income reported on a joint tax return; withheld income tax, estimated tax payments and/or a refundable credit reported on that return; and an overpayment that is to be applied to the spouse's debt.
Responsibilities for Preparers
The filing implications of divorce require a certain degree of specialization on the part of the preparer. The preparer must possess knowledge of the tax aspects, know what documents to request, and what to look for in them. A command of the entire divorce process will benefit both the taxpayer and the preparer. Service to the client can result in referrals and extra business, for involvement in the entire divorce planning and negotiation process.
Ilene Leopold Persoff, CPA is Associate Professor at the School of Professional Accountancy at C. W. Post Campus of Long Island University. Ms. Persoff has served as Chairperson of the Cooperation with Attorneys and the Cooperation with Educational Institutions committees for NYSSCPA, Suffolk and Nassau chapters. She has frequently lectured for the NYSSCPA and other professional groups. Ms. Persoff is a member of the NYSSCPA and AICPA. She has an accounting practice in Huntington, New York.
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