Basic Tax Issues a Family Law Attorney Should Consider When Drafting a Marital Dissolution Agreement
by Miles Mason, Sr. JD, CPA
This article originally appeared in the Tennessee Bar Journal, November/December 1998 – Vol. 34, No. 6. Reprinted by permission. All rights reserved by Tennessee Bar Association.
The constant flux of income tax law often creates landmines for taxpayers that may explode into malpractice claims against lawyers if they do not warn the client of their existence. Yet maintaining expertise and providing technical advice on tax issues, if a lawyer’s primary practice lies elsewhere, would require an unreasonably large time commitment. This article highlights the more important tax issues for attorneys drafting marital dissolution agreements (MDA). Included here are common tax issues where family law attorneys have an opportunity to provide general tax advice, as well as those situations where attorneys should make a referral to a tax professional in order to avoid malpractice claims.
1997 Taxpayer Relief Act
Family law attorneys should be aware that major income tax law changes were enacted in 1997. This is especially true in the area of capital gains, including lowering the tax rate on long-term capital gains for individuals, estates, and trusts; lowering the applicable rates for determining alternative minimum tax; inherited property; capital losses; lowered maximum capital gains rates after year 2000; new universal exclusion for gain on sale of principal residence (discussed below); constructive sales of property; and short sales of property that become substantially worthless.(1)
For income tax purposes, a person is considered married for the tax year if he or she is married on midnight of Dec. 31 of the tax year in question. If the person is divorced on or before that time, the Internal Revenue Service (IRS) considers that person divorced for the entire year.(2)
If the client has had a marriage annulled, refer that client to his or her accountant to amend and refile all tax returns spanning the period of the marriage.(3)
An important opportunity for the parent having physical custody is the possibility of filing as Head-of-Household, instead of as Married-Filing-Jointly or Married-Filing-Separately. The benefits of obtaining Head-of-Household status are significant. The client will achieve a higher standard deduction, a lower tax bracket, and eligibility for certain tax credits.
The client may take advantage of this opportunity even if he or she is married at the end of the tax year. To qualify for Head-of-Household status, the client must file separately and must have paid more than half the costs for upkeep of the client’s home for that year. The client and the spouse also must not have lived together during the last six months of the year. Finally, the client’s home must have been the primary home of the child, step-child, or adopted child claimed as a dependent. The client does not need a formal order from the court granting legal custody of the dependent in order to meet this requirement.(4)
It is important to note that there are always exceptions to these requirements. The client should hire a CPA to review the return and determine whether any exceptions apply. However, filing as Head-of-Household is almost always worth the extra effort. In this situation and others, to preserve the attorney-client privilege, the attorney might consider hiring the CPA directly.
Always advise non-custodial clients to confer with their tax professional regarding requirements for the use or transfer of dependency exemptions. For example, in order for a non-custodial parent to claim a dependent, the client must attach IRS Form 8332 to the tax return. Failure to attach this form provides the IRS with grounds to disallow the deduction. Even though the IRS has been pressured by Congress to become a kinder and gentler agency, this black letter law requirement is a time bomb for many family law attorneys failing to advise clients regarding the necessity of filing Form 8332 along with the return.(5)
Child care credits
Only the custodial parent qualifies for this tax credit even if the dependency deduction is transferred as long as he or she has had custody for a longer period than the non-custodial parent.(6)
Child support payments are not deductible by the payor or includable in the payee’s gross income. However, when an MDA states that an amount is both alimony and child support, without apportioning the amount for each, the IRS considers the entire amount alimony.(7)
Alimony awarded by state courts is still subject to the requirements of federal income tax law. For a payor to deduct alimony payments, he or she must make payments in cash pursuant to a divorce decree or separate maintenance agreement. The decree may not provide that alimony payments are non-deductible or not includable as income. The payor may not file a joint return, and subsequent to the divorce, the payor and the payee may not live in the same residence. Further, the alimony payments may not be contingent upon future events relating to a child. Finally, alimony clauses creating obligations beyond death may be nondeductible. When an obligation to pay alimony is due from the estate of the payor spouse, the payments may be considered property settlement, which is non-deductible.(8)
The IRS may consider alimony payments that increase significantly in the years immediately following the divorce to be a part of the property division. Divorce attorneys should pay special attention to this alimony recapture situation, as it may not provide a viable means for clients to obtain a large alimony deduction without severe tax consequences.(9)
Alimony and child support arrearages
A client who regularly pays alimony, but not child support, may not receive the deduction for alimony when he or she is delinquent on child support payments.(10)
Alimony secured by insurance
When the payor of alimony secures payments with a life insurance policy, the life insurance premiums may be deductible in certain circumstances. Because of the complex rules regarding such a deduction, the recipient spouse should consider accepting a higher amount of alimony instead. This will allow the recipient spouse to purchase and pay the premiums for the insurance policy directly, and gain the added benefit of deducting the cost of the policy.(11)
IRS collection of alimony and child support
In certain circumstances, the IRS must assist a recipient spouse in the collection of child support and alimony. For example, if a delinquency is certified by the Secretary of Health and Human Services and the amount of the delinquency is set by court order, the IRS will collect the debt in the same manner as an unpaid employment tax that would be jeopardized by delay. However, collection of the certified amount will be stayed for 60 days immediately subsequent to notice and demand if the delinquency is the first assessment against the taxpayer.(12)
No gain or loss is recognized on property transferred among the parties “incident to a divorce.” Family lawyers may erroneously assume these transfers take place without tax effect; however, the transfer of an asset is accompanied by the transfer of its basis. Therefore, exercise caution with assets with significant unrecognized gain (i.e., assets with a low tax basis, but significantly higher fair market value).(13)
One of the best examples of assets with significant unrecognized gain in divorce is stock. If the parties have jointly owned stock for a number of years and the stock has experienced a significant increase in value, there is a hidden tax impact for the recipient of the stock upon divorce. Although the transfer of the stock at the time of the divorce may not have an immediate tax impact, the sale of the stock triggers potential capital gain tax. Without proper planning, the effect could cause significant cash flow problems to the client. Therefore, when a client has an unrecognized gain situation, strongly advise that he or she seek professional tax assistance.
Property not transferred pursuant to MDA
No gain or loss is recognized in a property transfer “incident to a divorce.” If property is transferred more than one year after the final decree and is not referred to in the MDA, immediately check with a tax professional.(14)
One-time exclusion on gain from sale of principal residence
Repealed by 1997 Taxpayer Relief Act. See NEW, below.
Sale and split of marital residence
If the parties intend to retain joint ownership of the marital residence and sell the property subsequent to the divorce, the old tax laws no longer apply.
NEW: Universal exclusion for gain on sale of principal residence
A taxpayer can exclude up to $250,000 of capital gain for a sale of a principal residence after May 6, 1997, if the taxpayer used the home as the taxpayer’s residence for at least two of the five years before the sale. This is not limited to once in a lifetime, and the amount can be doubled if filed in conjunction with a joint tax return. The key in this situation is using the home as a principal residence for two years in the previous five years. The two-year requirement does not have to involve consecutive years. This new exclusion replaces the prior rollover rules for the one-time exclusion of $125,000 for taxpayers over 55. It is important to note that there are a number of options and elections under the new law that will require the tax professional’s advice. Like everything else in the Internal Revenue Code, these capital gains requirements for special tax treatment have numerous exceptions.(15)
Non-resident alien spouse exception
Even though no gain or loss is recognized in a property transfer “incident to a divorce,” this rule does not apply if one spouse is a nonresident alien. Refer the client to a tax professional to determine the special rules applying in this situation.(16)
U.S. Savings Bonds
When the parties transfer U.S. Savings Bonds, the transferor must report accrued interest for the current tax year on his or her tax return. The transferee reports the interest thereafter.
Special tax rules apply to passive activities. Income and losses for passive activities most commonly appear on Schedule E tax returns. Common examples of passive activities are property rental, partnerships, S-corporations, and trusts in which the taxpayer is not a material participant. If there are significant gains or losses from passive activities, strongly advise your client to consult a tax professional on special rules for these activities and the effects of an MDA on future tax returns.
Deducting tax advice
Expenses for tax advice and research relating to the client’s divorce and property settlement may be deductible. Refer the client to a tax professional regarding these rules.(17)
Deducting legal costs of the divorce
Legal costs relating to the collection of alimony are deductible.(18) Costs incurred in defending an action to collect alimony or child support are not deductible. Generally, legal expenses relating to a divorce are not deductible.(19)
The transfer of an IRA pursuant to a divorce decree is not a taxable event if transferred correctly. Generally, there are forms available from brokerage houses or banks to complete this transfer. Also, ask the client to check with the tax professional concerning “qualified” company savings plans and determine if a QDRO is required.(20)
Qualified Domestic Relations Orders (QDRO)
Always transfer interests in pension plans with a QDRO. Failure to do so could immediately render the payor spouse’s entire pension benefits taxable. This issue becomes significant when an employer’s pension plan fails to allow for QDROs. The state of Tennessee is one such employer that prohibits QDROs, thereby rendering the transfer of interests in pension plans under an MDA immediately taxable.(21)
Remind clients to file new W-4 forms with their employer reflecting their change in status after the divorce.
Advise clients receiving alimony for the first time (even pendente lite) that they may be required to make estimated tax payments before the divorce in order to avoid underpayment of taxes and resulting penalties.
Every family lawyer should have a working relationship with a CPA and a tax attorney. Their advice may improve the quality of your representation of clients. In addition, they are an excellent source of referrals.
Before returning a draft or revised version of an MDA to a client, consider writing a letter documenting the fact that you have strongly suggested the client obtain the services of a tax professional to review the MDA before the client signs it. Such a letter may or may not affect a possible malpractice claim, but it is a helpful precaution.
Overall, developing a working knowledge of the basics of divorce and separation income tax law can help a family lawyer’s practice by protecting the firm from malpractice claims and by providing an added service that clients will both appreciate and remember.
- Taxpayer Relief Act of 1997; H. R. 2014 signed by Pres. Aug. 5, 1997.
- See Reg. S1.6013-1.
- Rev. Rul. 76-255.
- IRC S7703(b).
- See Temp Reg. S1.152-4T(a).
- IRC S21(e)(5)
- IRC S71(c).
- “If a divorce settlement may later require a claim against the payor spouse’s estate, the agreement should be expressly conditioned on court approval. Deductibility of claims arising from the transfer will then be assured because they will be based on the court’s decree, rather than a promise or agreement that must be supported by full consideration before they’re deductible.” Reprinted with permission from Tax Aspects of Divorce and Separation at 32, by Research Institute of America, 90 Fifth Ave., New York, NY 10011. For more information about RIA services, call (800) 431-9025, ext. 4; IRC S71 (a); IRC S215(a).
- IRC S71(f).
- IRC S71(c)(3).
- RIA, supra, note 8, at 11; Rev. Ru1.70-218.
- RIA, supra, note 8, at 21; IRC S6305; Reg. S301.6305-1.
- IRC S1041 (a),(b).
- IRC S1041(c).
- IRC S121 (as amended by Taxpayer Relief Act of 1997 S312(a)); IRC S1034 (repealed by Taxpayer Relief Act of 1997 S312(b)).
- IRC S1041(d).
- IRC S212(3); Reg. 1.212-1(1).
- 18. IRC S212; Reg. S1.262-1 (b)(7).
- 19. U.S. v. Gilmore, 372 U.S.39 (1963).
- 20. IRC S408(d)(6); Reg. 1.408-4(g); see also IRC S219(f)(1).
- 21. IRC S414(p).
About the Author
Memphis family lawyer, Miles Mason, Sr., JD, CPA, practices family law exclusively and is founder of the Miles Mason Family Law Group, PLC. Miles is the author of The Forensic Accounting Deskbook: A Practical Guide to Financial Investigation and Analysis for Family Lawyers, published by the American Bar Association.
Reprinted with permission. Copyright 1998 © Tennessee Bar Association 1998.