Copyright 2010 by the American Institute of Certified Public Accountants, Inc. All rights reserved. Reprinted with permission.
A QUICK REFERENCE GUIDE
Filing Status
● Marital status for tax filing is set as of the last day of the year – December 31.
● If you are divorced as of December 31, you must file as single taxpayers (or head of household) for that year – even if you lived together as a married couple more than half the year.
● If you are married as of December 31, you must file as married - either joint return or separate returns.
● If you are still married as of December 31, you can file joint, separate, or as head of household (if you lived apart for the last 6 months of the year and otherwise qualify).
● Caution: Filing separate and use of the standard deduction or itemized deductions - the first one to file establishes requirement that the other do the same.
● Caution: Joint return = Joint liability no matter what the divorce agreement says.
Filing Status
● Head of Household Status• To qualify as head of household, you must be
divorced or legally separated on December 31.• You must have paid more than half the cost of
maintaining a home for the year for a child or other qualifying person for whom you or the other parent is entitled to claim the dependency exemption and that person lived with you in the home for more that half the year.
• Tax rates are in between married filing joint and married filing separate rates.
Filing Status
Year of Divorce Return – Community Property State
● Since divorced as of December 31, must file separate returns as single or head of household.
● Community income and expenses of both parties from January 1 through the date of divorce split 50/50 on their separate returns.
● 100% of entire year’s separate income and 100% of individual income and expenses from date of divorce through December 31 reported on separate returns.
● These rules do not apply if: ● Enter into Tex. Family Code §7.002(c)
agreement - avoids splitting partial year income in the year of the divorce for tax purposes, OR
Year of Divorce Return – Community Property State
Year of Divorce Return – Community Property State
● The parties live apart the entire year, and they do not transfer more than a de minimis amount of earned income to each other or for benefit of children, OR
● One spouse acts as if solely entitled to such income and fails to notify the other of it before the due date for filing his return, OR
● Spouse has no reason to know of income and inequitable to include it in her income.
Children/Dependency Exemptions
● Custodial parent is entitled to the dependency exemption.
● Parents, together or separately, must provide at least one-half of the child’s support.
● Two exceptions to the general rule that the custodial parent is entitled to the dependency exemption:
1. A Multiple Support Agreement is in place – IRS Form 2120.
2. The custodial parent relinquishes the right to the exemption - either annually or permanently - IRS Form 8332.
Children/Dependency Exemptions
Transfers Of Assets
● Under IRC §1041, no gain or loss is recognized on transfers if incident to divorce.
● The transferee’s tax basis is equal to the transferor’s tax basis immediately before the transfer.
● A transfer is “Incident to Divorce” if it:• Occurs within one year after the divorce, or
• Is related to the cessation of the marriage, meaning• Pursuant to a divorce or separation
agreement, and• Occurs within six years after the date on
which the marriage ended. • Property acquired after the marriage ends
qualifies for this treatment if all the other requirements are met.
Transfers Of Assets
Costs of Getting Divorced
● Legal and professional fees as well as court costs related to getting a divorce are generally not deductible.
● Payments of your former spouse’s attorney or other professional fees are also not deductible, unless they meet the requirements of deductible alimony payments.
● Nondeductible Costs:• Expenses paid for arranging child custody and
support.
• Expenses paid for arriving at a financial settlement and retaining income-producing property.
• Expenses paid to resist alimony.
Costs of Getting Divorced
● Deductible Costs (Legal and/or Accounting): Fees paid for tax advice related to a
divorce.• Fees paid to determine or collect alimony.• Fees paid to determine estate tax
consequences of property settlement.
Costs of Getting Divorced
• Fees paid to professionals such as appraisers and actuaries if the services were performed to determine the correct amount of tax or to assist in obtaining alimony.
• Fees paid to obtain deductible breakdown from the attorney or accountant.
Costs of Getting Divorced
• Deductible expenses will be treated as miscellaneous itemized deductions subject to the 2% limitation, and
• They are also preference items for Alternative Minimum Tax (AMT) purposes.
Costs of Getting Divorced
Alimony vs. Child Support
● Qualifications for Alimony Treatment• Cash payments or third-party payments required
under divorce or separation agreement.• Payments must be required by written agreement
or decree.• Agreement may not designate the payments as
“not alimony.”• Parties may not be members of the same
household.
• Payments may not be treated as child support.
• Payments MUST cease upon death of the recipient or payer.
• Parties may not file a joint return.
Alimony vs. Child Support
● Tax Treatment of Alimony: Includible For Adjusted Gross Income by
Recipient. Deductible From Adjusted Gross Income by
Payer.
Alimony vs. Child Support
● Payments that do not qualify as alimony:• Child support, including payments that vary with
the status of a child, e.g., educational attainment, disability, or marital status.
• Non-cash transfers.• Payments that are the spouse’s part of community
property income. • Payments for the use of property.• Payments to keep up the payer’s property.
Alimony vs. Child Support
● Recapture of Alimony• To prevent excess front-loading of alimony.• Recapture rules may apply if there is a decrease
or termination of alimony during the first three calendar years of payment.
• Recapture rules apply if alimony paid in the second or third calendar year is $15,000 less than in the prior year.
Alimony vs. Child Support
• Payer party must include the excess in Adjusted Gross Income (i.e. “recapture” it) for the third calendar year of payment.
• The same amount is deductible by the payee party For Adjusted Gross Income for the payer’s third calendar year of payment.
• However, no recapture if either party dies or the payee party remarries before the end of the third calendar year of payment or if reduction is beyond control of payer, e.g., disabled or laid off.
Alimony vs. Child Support
● Child Support Before Alimony• If obligated to pay both alimony and child support,
but pays less than monthly amount due, payments first applied to satisfy the child support obligation.
• Child support obligation must be met before any amount of alimony is deductible.
Alimony vs. Child Support
Personal Residence
● Capital gain exclusion of $250,000 (single) and $500,000 (married) from sale of principal residence.
● “Principal Residence” – home where you lived for any two of the last five years.
● If ownership is transferred incident to divorce, the time of the former spouse’s ownership is added to the recipient’s period of ownership for calculating the two year requirement.
Retirement Plans and IRAs
● Qualified Domestic Relations Order (QDRO) – Court can allocate an interest in a qualified retirement plan to a non-employee spouse (alternate payee).
● To qualify as a QDRO, funds must be distributed to the alternate payee or his or her designee directly from the retirement plan.
● Payments made to the alternate payee under a QDRO have no effect on the participant in the retirement plan.
● Benefits are taxed to the alternate payee when payments are received (however, not subject to the 10% early withdrawal penalty).
● Or, funds may be rolled over tax-free into an IRA or other qualified retirement plan.
Retirement Plans and IRAs
● QDROs can be very complicated and costly to set up; a specialist is typically hired to do them.
● IRA transfers pursuant to a divorce or separation agreement are not taxable. Methods of transfer include:• Changing the name on the account, and• Making a direct trustee-to-trustee transfer of
IRA assets.
Retirement Plans and IRAs
● Divorce or separation agreement should state that the IRA transfer is intended to be tax-free under IRC §408(d)(6).
● QDROs do not apply to IRAs.● Spousal IRA Contribution – if final decree is
obtained by the end of the tax year, a spouse cannot deduct contributions made to a former spouse’s IRA unless it qualifies as alimony.
Retirement Plans and IRAs
● Withdrawing funds from an IRA to satisfy a divorce judgment causes the IRA owner to be taxed on the distribution, and if applicable, to also incur the 10% early withdrawal penalty.
Retirement Plans and IRAs
Stock Options & Deferred Compensation
● Revenue Ruling 2002-22
1. A taxpayer who transfers an interest in non-qualified stock options and non-qualified deferred compensation to his or her former spouse incident to divorce is not required to include an amount in gross income upon the transfer.
2. The former spouse, and not the taxpayer, is required to include an amount in gross income when he or she exercises the non-qualified stock options or when the deferred compensation is paid or made available to him or her.
Stock Options & Deferred Compensation
● The same treatment would apply in a case in which an employee transfers a qualified stock option contrary to its terms to a spouse or former spouse incident to divorce.
● The qualified stock option would become disqualified and be treated in the same manner as other non-qualified stock options.
● This ruling does not apply to transfers of property between spouses other than in connection with a divorce.
Stock Options & Deferred Compensation
Stock Options & Deferred Compensation
● This ruling also does not apply to transfers of non-qualified stock options, unfunded deferred compensation rights, or other future income rights to the extent such options or rights are unvested at the time of transfer or to the extent that the transferor’s rights to such income are subject to substantial risks of forfeiture at the time of the transfer.
Transferring/Redeeming Stock of A Closely Held Company
● Often there is insufficient cash and other property to satisfy a division of marital assets when there is a closely-held corporation in the marital estate.
● When the desired result is the sole ownership of the business by one of the parties, the transfer of stock ownership for cash in a divorce may involve two steps:
1. Transfer of stock from one spouse to the other incident to the divorce, followed by
2. The recipient spouse transferring the shares to the corporation in redemption of all the shares received from the soon-to-be ex-spouse.
● Can be accomplished with the corporation redeeming for an installment note, but special rules may apply so careful planning is required.
Transferring/Redeeming Stock of A Closely Held Company
● Carryover rules related to tax basis and holding period of the transferred shares apply in determining amount and nature of gain on redemption.
● This can result in a tax trap for the unsuspecting spouse.
● Structured properly, redemption at capital gain rates to the recipient spouse can be accomplished.
Transferring/Redeeming Stock of A Closely Held Company
Transferring/Redeeming Stock of A Closely Held Company
● Structured improperly, the spouse retaining the business can be deemed to have received a constructive dividend • Historically taxed at ordinary income rates – currently the
same as capital gains (15%) – but this favorable rate expires in a few weeks on December 31, 2010.
• Future tax rate on dividends is uncertain at this time.• Since cash went to the former spouse, spouse retaining the
business would receive no cash with which to pay the tax on the constructive dividend.
● IRS Reg. §1.1041-2 states that if a divorce or separation agreement between spouses or former spouses includes the following, the recipient spouse will be taxable:• Both spouses or former spouses intend for the
redemption to be treated, for federal income tax purposes, as a redemption distribution to the recipient spouse; and
Transferring/Redeeming Stock of A Closely Held Company
• Such agreement supersedes any other agreement concerning the purchase, sale, redemption, or other disposition of the stock subject to the redemption.
● However, if the divorce or separation agreement sets forth the following agreements of the parties, the transfer will be treated as a constructive dividend to the spouse retaining the business:
Transferring/Redeeming Stock of A Closely Held Company
• Both spouses or former spouses intend for the redemption to be treated, for federal income tax purposes, as resulting in a constructive dividend to the spouse retaining the business; and
• Such agreement supersedes any agreement concerning the purchase, sale, redemption, or other distribution of the stock that is subject to the redemption.
● So, there is a choice, but you have to draft the agreement properly to reflect your choice.
Transferring/Redeeming Stock of A Closely Held Company
Innocent Spouse & Separate Liability Relief
● Relief from joint tax liability is available to qualified individuals under three alternatives – IRC §6015
1. Innocent Spouse - IRC §6015(b) and IRS Pub. 971
• Filed a joint return which has an understatement of tax due to erroneous items of the other spouse.
• Establish that at the time of signing did not know, or have reason to know, there was an understatement.
• Considering all the facts and circumstances, it would be unfair to hold the innocent spouse responsible.
Innocent Spouse & Separate Liability Relief
2. Separation of Liability - IRC §6015(c)• Filed a joint return.• Divorced or legally separated, or• Not a member of same household for the past 12 months.• Can prove which items of income and deductions
attributable to tax understatement are his or hers.• Easier burden: only have to prove lack of actual knowledge
3. Equitable Relief - IRC §6015(f) and Rev. Proc. 2003-61
• Based on all facts and circumstances, it would be unfair to hold the innocent spouse liable for the understatement or underpayment. Only remedy for underpayment.
● Factors considered for relief by the IRS and Courts (Rev. Proc. 2000-15, Sec. 4.03)
• Knowledge (trumps all equities).• Economic hardship.• Significant benefits to the person seeking
innocent spouse relief.• Later compliance with Federal tax laws.
Innocent Spouse & Separate Liability Relief
• Tax liability attributable to non-requesting spouse.
• Non-requesting spouse responsibility for the tax pursuant to the divorce decree.
• Current marital status.• Spousal abuse.• Innocent spouse characteristics: education,
sophistication, participation, reliance.
Innocent Spouse & Separate Liability Relief
● Burden of proof for relief is on the taxpayer - IRC §6015(c)(2) and Shafman v. United States 267 B.R. 709 (2001).
● Joint tax returns signed under duress are not joint returns – Reg. §1.6013-4(d).
● IRS tax form for requesting relief under any of the three provisions – Form 8857.
Innocent Spouse & Separate Liability Relief
Innocent Spouse Deadline
● 2-years from IRS’s initial collection activity to request Innocent Spouse relief for Sec. 6015 (b) and (c).
● Conflict among Circuits whether 2-year deadline for Sec. 6015(f). Lantz v. Commissioner, 607 F.3d 479 (7th Cir. 2010), Hall v. Commissioner, 135 T.C. No. 19 (2010)
● No later than 6 months before the expiration of the period of limitations on assessment.
Innocent Spouse: Traps and Tips, TIMING
● Requesting innocent spouse relief tolls the collection statute of limitations. Delay requesting in inactive collection cases where the IRS has made no effort to collect from the innocent spouse.
● If close to 2-year or 6-month deadlines, file a protective Form 8857 with a disclaimer that it’s based on incomplete data, assumptions and subject to amendment.
Innocent Spouse Timing
● Assess timing requirements immediately because of strict 2-year filing deadline and 12 month separation requirements of IRC 6615 and 66.
● Client may need to accelerate separation or wait until anniversary of separation to file Form 8857 to qualify.
● Obtain innocent spouse relief before entering into non-TEFRA closing agreements or submitting offers in compromise. Regs. § 1.6015-1(c)(1).
Litigation Tax General Rule #1: Origin of Claim Determines Taxability
● Origin of Claim: Tax treatment depends on origin of transaction or event giving rise to the item. What does the claim substitute?
● E.g., Recovery for lost profits are ordinary income; for damage to capital: adjust basis
● Significance: IRS considers character & allocation of items in judgments & settlements.
General Tax Law Rules
No tax deduction unless authorized in IRC:
● Ordinary & necessary business expense.● Collection or maintenance of income.● Miscellaneous expenses, subject to 2% of
AGI haircut and for AMT.
General Tax Law Rules
● Tax advice.● Significance: consider alternatives of
characterizing, e.g., alimony.● No current deduction if there is a pending
right of reimbursement.● Significance: Contingent fee attorneys cannot
deduct reimbursable expenses until conclusion of case.
General Tax Law Rules #2: Can’t Avoid Tax By Assigning Income
● Cannot assign income to reduce taxable income:
● Significance: Unless statutory exception (e.g. employment discrimination) plaintiffs must include contingent fees in income.
● Individuals’ deductions for fees subject to AMT and 2% of AGI haircut.
● Avoid assigning interest in contingent fee (double tax).
General Tax Law Rule #3: Tax matters in drafting settlements/judgments
● If judgment or settlement agreement does not address tax treatment or reasonably allocate items with preferred tax treatment, courts will usually not respect later tax arguments.
● Reasonable tax characterizations and allocations reached by adverse parties in an arms’ length manner, and treated consistently, are generally respected.
SO, CHARACTERIZE AND ALLOCATE.
Qualified Settlement Agreements, IRC Sec 468
● Defendants get immediate deduction.● Plaintiffs get time to work out remaining issues,
e.g. allocations, liens.● Income earned on QSF funds can be tax-free to
Plaintiffs.● Plaintiffs must avoid “constructive receipt.”● 3 Requirements: court order, “claim,” “trust.” ● If litigants can’t agree on tax language, use tax
language in QSF’s release.
Preserving Deductibility of Clients’ Fees
● Characterize and itemize deductible items in bills
● Business expenses > personal.● Collection or production of income.● Determination and collection (but not
defending) alimony.● Segregate fees for Exempt PI vs. Taxable,
Capital vs. Ordinary, Recovery of Basis. ● Tax Advice.
Preserving Clients’ Deductions
● May be possible to settle non-deductible Fines and Penalties as deductible restitution.
- Is statute “remedial” rather than punitive?
● Only payer gets deduction. Payer must pay for its own benefit.
● 1099s
Malpractice / Grievance Prevention
● Engagement letters: ID clients, scope, scope limitations, allocation of responsibility among advisers, fee obligations.
● Issue “declined case” and termination of representation letters.
● Since many clients won’t take advice to “consult your tax adviser,” assist them in obtaining timely, competent tax advice.
● Don’t get in too deep – don’t sue clients.
Pre-Trial Tax Checklist
● Clients current on tax filings.● Expert prepared to address Rem. C. 18.091
(net tax) and to argue against double tax.
Physical Injury-Illness Claims Are Tax Exempt, IRC 104
● Injury must be visible or sexual abuse.● Emotional injury requires physical injury.● Spousal consortium & lost earnings exempt if
from PI.● Statutory recoveries, e.g., workers comp.● Exceptions: punitives, no “claim,” interest,
virtually all non-PI employment claims, union contract payment, severance, disability.
Defendants’ Tax Withholding Obligations
● Payroll Tax● Payments to Resident Aliens● Real Estate Sales To Aliens● Excise Tax
IRS can collect against individual Responsible Persons, who participated in decision.
- non-dischargeable
1099s
Currently, any payment > $600K. Need payees’ tax ID#s, IRS name, address. Co-counsel, Plaintiffs, Plaintiffs’ ats, Aty PCs,
Non-corp vendors, independent contractors. Exceptions: payments to clients, non-attorney
corporations. Middleman Regs if attorney exercises
significant control & oversight of funds.
Conclusion
● Multiple claims may have different tax treatment.
● Document tax preferred items.● Allocate.● “Reverse Miranda”: What you don’t say about
tax, will be used against you.● Attorneys (like all self-employed) are IRS
