Frank Agostino, Esq. Agostino & Associates, PC

TAX ISSUES RELATED TO DIVORCE Frank Agostino, Esq.Agostino & Associates, PC

Tax Issues in Divorce • Dividing Property • Paying/ Receiving Alimony • Paying/ Receiving Child Support

Filing Status – As of December 31 • Unmarried Person • Final decree of divorce has been entered by December 31. • Married Person • Taxpayer is married for the whole year if separated but does not have a final decree of divorce by the December 31. • Married Filing Jointly may result in lower overall tax for the divorcing couple; the IRS however can hold both parties liable jointly and severally for the tax liability. • A spouse may file an innocent spouse petition to request relief from a joint liability. §6015

Asset Transfers Between Spouses • Tax free if: • Consequent to a divorce, • transferred within a year, • not to a nonresident alien are generally tax-free. See IRC §1041 • There is no realization of gain or loss upon transfer of property • Transferrer’s basis

Sale of Personal Residence • If the parties sell the jointly owned residence, each party must report his/ her share of the recognized gain or loss on his/ her income tax return for the year of the sale. • Taxpayer may exclude up to $250,000 (up to $500,000 if parties file a joint return) of gain on the sale.

Property Settlements and Qualified Domestic Relations Orders (QDRO), cont. • The proper tax-free method to transfer IRA is a direct trustee-to-trustee transfer from one spouses’ IRA to the other spouse’s IRA pursuant to a divorce decree or separation agreement. • The transfer should only be made AFTER the final divorce decree or separation agreement.

Spousal Support & Child Support • Spousal Support (otherwise known as alimony) is taxable to the payee spouse, and tax deductible to the payor spouse. • The importance of an accountant during the negotiation of alimony is crucial when a client is trying to determine how much net income they will need on a monthly basis to pay their bills. NJSA 2A:34-23

Spousal Support & Child Support cont. • The following rules for alimony apply to payments under divorce or separation instruments executed after 1984. To qualify as alimony: • the payment is made in cash. See § 71(b)(1). • the payment is received by (or on behalf of a spouse) under a divorce or written separation instrument. See § 71(b)(1)(A) • if the spouses are divorced or legally separated, they reside in separate households when payment is made; See § 71(b)(1)(C);

Spousal Support & Child Support, cont. • the payments to a third party are evidenced by a timely executed writing; See Regs. § 1.71-1T(b), Q & A-6, 7. • the payor spouse’s liability to make the payment does not continue for any period after the payee spouse’s death; See § 71(b)(1)(D) and R.T. Reynolds v, CIR, TC Summary Opinion 2010-157 (Held that alimony payments received by ex-wife not includible as income because marital settlement did not indicate that the alimony payments would terminate upon taxpayer’s death. • the payor and payee (if married) do not file a joint return; and • the divorce or separation instrument does not designate non-alimony treatment.See § 71(b)(1)(B).

Spousal Support & Child Support, cont. • Payment must be in cash: the following do not qualify as alimony • Transfers of services or property • Execution of a debt instrument by the payer • The use of the payer’s property • Pendente Lite Support (Allocated v. Unallocated): In a divorce action, support paid while the divorce is pending prior to Final Judgment is called Pendente Lite Support but it can not be deducted or reported as spousal support unless specifically allocated as such in an Order.

Spousal Support & Child Support, cont. • Legal fees incurred in collecting alimony for the dependent spouse are deductible pursuant to § 212(3). • Child Support • Child support payments are not deductible by the paying spouse or taxable income to the recipient spouse. • Includes payments specifically designated as child support as well as payments which otherwise might qualify as alimony but are linked to an event related to a child such as a child turning 18. • Such disguised child support payments are recharacterized as nondeductible /non taxable child support.

Dependency Exemptions • Dependent is defined under §§152 and 152(e) with respect to divorced parents. • Custodial Parent is the parent with whom the child lived for the greater number of nights. • Noncustodial parent is the other parent.

Dependency Exemptions, cont. • The custodial parent can waive his or her right to the exemption and allow the noncustodial parent to claim the exemption. • The exemption should be taken by the parent who can extract the greatest tax benefit from the exemption. • If the parties can agree as to who takes the exemption, it would be a win-win situation since the tax savings would be passed along to the children in the form of child support.

Dependency Exemptions, cont. • Waiver of Exemption filed on IRS Form 8332. • Effective with 2009 tax returns, if the divorce decree went into effect after 2008, waiver must be requested on Form 8332. • Waiver can be requested on an annual basis or for all future years. • Tax credits such as Hope and Lifetime Learning are only available to the claiming parent. • The custodial parent may still claim the child care credit for qualifying expenses for children under 13 years of age.

Custodial Parent Refuses to Sign Form 8332 • Court of Appeals 8th Circuit • Armstrong v. Comm’r • Hanson v. Comm’r • Practice Tip: • Obtain Form 8332 for each year from custodial parent and hold in escrow when non-custodial parent meets his/her child support obligations.

Tax Law Updates – Medicaid Payments for Foster Care of Related Individuals Excluded from Income • IRS Notice 2014-7 • Certain payments received by an individual care provider under a statement Medicaid Home and Community-Based Services Waiver are difficulty of care payments excludable under IRC §131. • Effective for payments received on or after January 3, 2014. • Before the Notice • A handicapped adult’s guardian (his mother) was not entitled to use IRC §131 to exclude from income care payments from the state Dept. of Developmental Disabilities. • A foster care relationship is the provision of care in one’s home to an individual in the absence of an existing legal duty to provide care to that individual. • The mother’s claim that she had no legal duty to provide care for her son once he attained the age of majority was rejected. • Robert and Elaina Ray v. U.S., 2014-1 U.S. Dist. Ct.

Child Support Arrears Due to a Divorcee Belong to Her Estate • New Jersey Appeals Court held that child support arrears due to a divorcee at the time of her death belonged to her estate, not to her emanicipated son. • Roder v. Roder

Types of Innocent Spouse Relief • Classic Innocent Spouse - §6015(b) • Must file request for relief within 2 years of first collection action (i.e., refund offset) • Requesting spouse has burden of proof that she did not know or had no reason to know about understatement of tax • Separation of Liability - §6015(c) • Must file within 2 years of first collection action. • Requesting Spouse must be separated, divorced, or widowed. • IRS has burden of proof that requesting spouse had knowledge about understatement of tax.

Innocent Spouse Relief:Types of Relief, cont. • Equitable Relief - § 6015(f) • Requesting spouse does not qualify for relief under (b) or (c). • No knowledge or understatement or underpayment • It would be inequitable to hold requesting spouse liable. • Generally, requesting spouse is separated, divorced, or widowed from non-requesting spouse. • The understatement or underpayment is due to items on the non-requesting spouse’s return.

Classic Innocent Spouse Relief: • Joint tax return was filed • Understatement of tax due to erroneous items of the other spouse • Underpayment of tax –Equitable Relief is available • At the time requesting spouse signed the return, she did not know and had no reason to know that there was an understatement of tax. • Inequitable to hold requesting spouse liable for tax liability.

Changes to Innocent Spouse: Equitable Relief • Rev. Proc. 2013-34, issued by the IRS in September of 2013, supersedes Rev. Proc. 2003-61. • This new procedure modifies and clarifies the criteria for equitable relief in three ways. • First, it broadens the types of tax liabilities for which relief is available. • Next, it provides an extended deadline to file the request for innocent spouse relief. • Finally, it mandates a simpler test for determining relief based on evaluating the number of equitable factors in favor of and against the taxpayer. Most importantly, the IRS now gives greater deference to the presence of abuse in a marriage than was afforded under the earlier revenue procedure.

Misappropriated IRA Distribution Not Included in Income of Spouse • The Tax Court found that IRA distributions were not includable in taxpayer’s gross income because they had been fraudulently withdrawn and used by his ex-spouse. • The taxpayer had not requested, received or derived any economic benefit from the distributions. • Roberts v. Comm’r, 141 TC No. 19 (2014)

Property Settlements and Qualified Domestic Relations Orders (QDRO), • Qualified retirement plans and pension benefits are often part of a property settlement and are generally handled through a court assigned qualified domestic relations order or QDRO. • A QDRO gives one spouse the right to share in the pension benefits of the other and ensures that the tax liability falls on the spouse receiving the benefits. • Without a property structured QDRO the spouse who earned the benefits will be taxed on them even though they are paid to the former spouse.

The Offset of Alimony Against Assets in Equitable Distribution-A Wise Tax decision • Present day values v. Retirement Assets-A client’s accountant can be extremely useful when determining a fair distribution of the assets during a divorce especially if: • An individual is trying to make a wise decision regarding the division of assets he/she must consider the tax consequences with respect to each asset. • For example, retirement assets do not have a present day value but can be easily appraised as such by having an accountant analyze the assets and determine the present day value based on tax consequence and penalties. Alternatively, a DRO or QDRO can be utilized to divide the retirement assets. • Spousal Support offset Against Assets: When an individual is trying to make a wise decision as to whether or not to pursue an alimony claim or waive all or a portion of alimony in exchange for assets some which may be present day value and others retirement, they will need to turn to a financial advisor/accountant in order to determine the net result of the offset.

The Offset of Alimony Against Assets in Equitable Distribution-A Wise Tax decision, cont. • William R. Randall v Commissioner, TC Summary Opinion 2010-163 (10/28/10): A husband and wife were divorced in 2007, in its final Order the divorce court found that the husband was due a $69,000.00 property equalization payment from his ex-wife but instead awarded the ex-wife a like amount as spousal support. The court offset the amounts ordering that spousal support be considered paid in full by forgiveness of the $69,000.00 equalization payments due to husband by ex-wife in the division of assets. • As such, on husband’s 2007 form 1040, US individual tax return, he claimed as a deduction $69,000.00 for alimony paid. The IRS examined the return and disallowed the alimony deduction stating he did not remit a cash payment to his ex-wife. The court concluded that husband’s satisfied his spousal support obligation with a cash payment pursuant to Section 71(b) which requires that alimony be a payment in cash but does not limit the terms to bills and notes. The court considered the deduction as alimony agreeing with the Husband’s argument that if he and his ex-wife had followed the statute literally they would have exchanged written checks and he would have been entitled to the alimony deduction despite the fact that they are in the same economic condition by the offset less the transactions cost.

Frank Agostino, Esq. Agostino & Associates, PC