Financial advisers are often the first to know when a client’s marriage is in trouble and a separation or divorce is planned. While the client may be too distraught to consider the tax effect of the situation, the failure to properly plan can increase the financial cost of the break-up to the family. Financial advisers who are familiar with the following tax issues may provide invaluable assistance to their clients:
- Filing Status
- Alimony and Child Support
- Professional Fees
- Tax Withholding and Estimates
- Tax Overpayments and Carryovers
Joint filing status is typically used for married couples because it generally results in the lowest tax burden. However, couples filing a joint return may be held responsible, jointly and individually, for the tax and any interest or penalty due. To avoid the liability for the other’s taxes, divorcing spouses may choose to file separate returns, even though doing so will likely result in a higher combined tax burden for the couple. If separate filing status is used, clients should be aware that if one spouse itemizes deductions, then the other spouse must do so.
If either spouse files a separate return, they can generally change to a joint return within 3 years from the date the returns were filed. This is not the case in reverse. After the due date of a return, spouses cannot file separate returns if they previously filed a joint return. Divorcing spouses should strongly consider their filing status during divorce negotiations.
The timing of a divorce matters. If a couple obtains a final decree of divorce or separate maintenance by the last day of the tax year, then they are considered unmarried for the whole year. This means they cannot file a joint return, and would lose any tax savings available under joint status. Clients divorcing near the end of the year should consider whether tax savings are achieved by delaying the final decree until January 1 of the following year.
If your client is unmarried at the end of the year, they should consider filing as head of household. This status is available for an unmarried person who paid more than half the cost of keeping up a home for the year, and had a qualifying person (usually a child) living with them for more than half the year. Filing as head of household usually means lower tax rates than filing as single or married filing separately. The standard deduction is also higher, and available even if the spouse itemizes on their return. Certain credits are available that cannot be claimed if your filing status is married filing separately.
There are two types of exemptions that are claimed on an individual tax return: personal and dependency. The dependency deduction is typically subject to negotiation and controversy in divorce proceedings. The custodial parent is usually entitled to take the dependency exemption for a child. However, the tax code allows for a non-custodial parent to take the exemption under certain conditions. One of the conditions is that the custodial parent has to agree in writing not to take the dependency exemption. The parent claiming the dependency exemption, under current law, is also eligible to claim other potentially significant tax benefits such as the child care credit, the child tax credit and/or education credits. These credits can generate significant tax savings so the dependency exemption should not be given up without review of the individual’s tax situation.
ALIMONY AND CHILD SUPPORT
Alimony is deductible by the one who pays it, and must be included in the reported income of the one who receives it. However, not all payments from one former spouse to another qualify as alimony. Generally, alimony does not include child support, noncash property settlements, payments to keep up the payer’s property, or use of the payer’s property. Alimony must be paid in cash, and the divorce decree must not designate the payment as not alimony.
Child support is not deductible by the one who pays it, and is not included in the reported income of the one who receives it. Therefore, the payer generally prefers alimony over child support because the alimony is deductible while the child support is not. Conversely, the payee generally prefers child support over alimony.
Clients should know that if alimony payments decrease or end during the first 3 calendar years, then the recapture rule may apply. The rule requires the spouse paying alimony to include part of the payments previously deducted in income. The rule may come into play if there is a change in the divorce or separation instrument, a failure to make timely payments, a reduction in ability to provide support, or a reduction in support needs.
Recipients of alimony are eligible to make IRA contributions based on alimony income, even if there are no other sources of earned income. Your clients can defer taxes and save for retirement by creating and funding an IRA based on alimony.
Taxpayers cannot deduct legal fees and court costs in connection with a divorce. However, they may be able to deduct legal fees paid for tax advice rendered in connection with a divorce and legal fees to get alimony. Also, deductions may be available for fees paid to appraisers, actuaries, and accountants for services in determining tax or obtaining income. Clients should request a breakdown showing the amount charged for each service performed by their professional advisers in connection with a divorce.
TAX WITHHOLDING AND ESTIMATES
After your client becomes divorced or separated, they should file a new Form W-4 with their employer to adjust the amount of income tax withheld from their paycheck. Your client may also need to make estimated tax payments, especially if they are collecting alimony and not otherwise working at a job that withholds income tax.
TAX OVERPAYMENTS AND CARRYOVERS
The allocation of overpayments of federal or state tax from a jointly filed return must also be negotiated. These amounts can be either applied to the next year’s tax liability or refunded, but divorcing clients should always consider how to apply the funds. In reviewing their tax situation, post-divorce, the client should also understand which of the carryovers from the most recently filed joint return (such as capital or passive losses) are eligible to carry to their own separate individual tax return. These carryovers can result in significant tax savings.
This information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Please contact our office (603-627-3838) for more information on this subject and how it pertains to your specific tax or financial situation. Howe, Riley & Howe, PLLC would be happy to answer your tax and financial questions regarding these issues or other matters that may be of interest to you or your business