Divorce Taxation and Bankruptcy Issues

1. Divorce Taxation and Bankruptcy Issues

2. Both areas are traps for the unwary • Taxation: Not knowing how or if payments or property transfers will be taxed can lead to malpractice liability • Failing to anticipate an effort by the other spouse to discharge property or other obligations in bankruptcy can also lead to a malpractice claim

3. General rules • Alimony is deductible by payor and included in taxable income of recipient • Child support is not deductible by payor nor included in recipient’s income • Property transfers incident to divorce are not usually taxable events

4. Tax return filing issues • Marital status is determined as of the last day of the year in question (12/31) • Not unusual to rush to have final judgment signed on or before 12/31 so parties can file as “single” to avoid higher rate of “married filing separately” • Equally common to hold settlement for several months and finalize after New Year to permit parties to file jointly and claim lowest tax rate

5. Filing Jointly - Risks • Both parties are jointly and severally liable for taxes, interest, and penalties on joint return • “Innocent Spouse” status not easy to obtain • Often have negotiated “indemnify and hold harmless” clauses to protect a spouse who had little knowledge of the parties’ finances

6. Tax Treatment of Alimony • 26 USC § 71: Alimony deductible from income of payor • 26 USC § 215: Alimony included in income of recipient

7. Section 71 Requirements • The payment is in cash • The governing instrument does not designate the payment as excludible from the gross income of the payee and nondeductible by the payer • Spouses legally separated under a decree of divorce or separate maintenance are not members of the same household when the payment is made • Exception for alimony paid under a temporary order • The payment is not treated as child support • The payer has no liability to make any payment after the death of the payee (or to make any payment as a substitute for such payment)

8. Anti-Front Loading Rule • A series of payments must not be excessively front-loaded • Payments scheduled over a period of years may not be heavily skewed, or "bunched," in the first three calendar years in which payments are made pursuant to the divorce judgment • Purpose of rule is to avoid transfer of cash for payment of property interests via alimony

9. Recapture of Front-loaded Payments • Excessively front-loaded payments must be recaptured • The payer spouse who deducted the excess payments must report them as income, and the payee initially taxed on them is entitled to a deduction retroactively • Recapture is determined according to when payments are actually made, not when they are scheduled

10. Recapture Rules • The measuring period is the three successive calendar years beginning with the year in which payments commence. • The total paid in the third calendar year is added to a $15,000 statutory allowance. The sum is then subtracted from the total paid in the second year. Any difference is recapture. • Then the average of payments made in years 2 (net of recapture, if any) and 3 is added to the $15,000 statutory allowance. The sum is subtracted from the total paid in year 1. Any difference is recapture.

11. Result of recapture • The total amount of recapture from years 1 and 2 is reported as income by the payer in year 3 • The total amount of the recapture is claimed as a deduction by the payee in year 3

12. Alimony recapture rules of thumb • $15,000 threshold:If payments do not exceed $15,000 annually, there will never be recapture • Declining payments only:Recapture only applies to a schedule of payments that decline from year to year over the three-calendar-year measuring period. It does not apply when payments are level or increase • $10,000 safe harbor: There will never be recapture if the decline in total payments between years 1 and 2 and then between years 2 and 3 do not exceed $10,000 each

13. Example 1 • Year 1 - $25,000 • Year 2 - $10,000 • Year 3 - $5,000 • Result: $2,500 recapture • Why? Year 2 and 3 average $7,500. Adding the $15,000 statutory allowance result it $22,500. The difference between that amount and Year 1 payment must be recaptured

14. Example 2 • Year 1 - $25,000 • Year 2 - $15,000 • Year 3 - $5,000 • Result: No recapture • Why? This falls within the $10,000 “safe harbor” rule

15. Free Web-Based Recapture Calculator http://www.rosen.com/calculators/alimonyrecalc.asp

16. Exceptions to recapture • If either spouse dies or alimony terminates due to remarriage of the payee before the end of the third year • Rules do not apply to temporary alimony payments • Where alimony of three year’s or more duration is based on a fixed proportion of the payer’s income

17. Advantages of Payments under Section 71 • Transfer what is actually property (i.e., part of the marital estate) or pay the other spouse's legal fees in a taxable/deductible way. • This is advantageous when the payer spouse's tax bracket is significantly higher than that of the payee spouse.

18. Example • Payer spouse is in 35% tax bracket • Payee spouse is in 15% tax bracket • Transfer of $20,000 to pay attorney fees for payee spouse shifts tax burden to payee spouse at just 15%. • Taxes on the $20,000 reduced from $7,000 to $3,000. • Net gain to the parties of $4,000.

19. Temporary Alimony • Payments during the pendency of a divorce qualify as taxable/deductible if made: • (1) pursuant to a temporary support order or a written separation agreement, and • (2) in a year for which the parties do not file a joint return. IRC 71(b)(2)(e) • Since payments must be pursuant to an order or separation agreement, only those made after such a document is in effect qualify.

20. Property Transfer Upon Divorce – Tax Consequences • No taxable gain or deductible loss is recognized on transfers of property between spouses or between former spouses incident to a divorce • A transfer is "incident to a divorce" if it occurs within one year after the marriage is terminated or if it is related to the cessation of the marriage

21. What about the tax “basis” of property transferred pursuant to divorce? • The transferee spouse treats the property for tax purposes as if acquired by gift • Therefore, the transferee takes the transferor spouse's tax basis and holding period

22. Areas of concern – sales to third parties • Nontaxable treatment under IRC Section 1041 applies to transfers between spouses but not to sales of marital property to third parties even if pursuant to the divorce judgment • It is not uncommon for a property settlement to provide that the parties will split the proceeds from the sale of a marital asset • It is important to know that the sale will be taxable according to how title is held, not how the proceeds are divided

23. Example of “tax tracks with title” problem • H and W own each own one-half interest in real estate • Property is sold pursuant to divorce judgment which provides that W gets 75% and H gets 25% • Husband stuck with half of capital gain on property even though he received only 25% of sale proceeds

24. This rule also applies to other types of property • Exercise of stock options triggers taxable gain for the employee spouse even if proceeds must be shared with other spouse • When agreeing to divide stock options, make sure that the “net after tax” proceeds are what is divided, not the gross pre-tax proceeds

25. Be wary of “low basis” traps • If a spouse is awarded a disproportionate share of assets with a low tax basis (usually the original purchase price), that spouse will pay higher capital gain taxes when that property is eventually sold, skewing the fairness of the property settlement • Need to plan ahead an build-in some offsetting compensation for a spouse who takes low basis property in the settlement

26. Considering tax consequences when valuing marital property • It is generally not appropriate to lower the value of property by the amount of tax that would result if it were sold unless it is likely such a sale will in fact occur. • The prevailing majority view of courts across the country is that adjustments should be made when the tax liability is reasonably foreseeable, not highly speculative or conjectural • Consider only those tax liabilities that are likely to arise in the near future, most notably those resulting directly from the settlement itself (e.g., the sale of appreciated stock provided for in the judgment)

27. Need to prove the tax consequences • A request to take taxes into account should be supported by evidence of the tax consequences, typically with expert testimony • Need to demonstrate that they are foreseeable and not merely speculative

28. The problem of interest on installment payments of property • Interest on property settlement installment payments is treated as non-deductible consumer interest for the payer • But although not deductible by the payer, it is considered taxable income to the payee • Need to calculate interest and include it in the base payment (called “baked in” – don’t mention interest separately in the agreement) • May need to come up with a prepayment discount if the payer wants to pay off his/her obligation before the expiration of the term used to calculated the “baked in” interest

29. Tax consequences of sale of marital home • IRC Section 121 provides for the exclusion of up to $250,000 of gain - $500,000 for married taxpayers - on the sale of a home that has been owned and used as a principal residence by the taxpayer for two of the five years ending on the date of the sale

30. How to qualify for the exclusion • Married taxpayers qualify for the $500,000 exclusion if the following conditions are satisfied: • They file a joint return for the year of sale. • At least one of the spouses satisfies the two-out-of-five-years ownership requirement. • Both spouses satisfy the two-out-of-five-years use requirement. • Neither spouse is ineligible to use the exclusion due to using it within the two years preceding the date of sale.

31. Sale after divorce? • If other qualifications are met, each former spouse can claim his/her $250,000 individual capital gain exclusion

32. Property tax and mortgage interest deductions in divorce cases • The joint owner who makes the payment is entitled to the deduction • If payments are made by both spouse, the deduction is divided based on a ratio of payments • If payment is made from a joint bank account, it is presumed that the deduction will be divided equally (presumption may be rebutted by evidence of source of funds in joint account)

33. Dependency Exemptions • IRC Section 152(e): • the parent who has physical custody of a child for more than half the year (the custodial parent) is automatically entitled to claim the dependency exemption • This applies regardless of which parent provided more than half the child's support.

34. Exception • The custodial parent may execute a written waiver releasing the exemption to the noncustodial parent for a single year, a specified number of years (e.g., alternate years), or for all future years • To do this, the custodial parent executes IRS Form 8332, which the noncustodial parent must attach to his or her income tax return.

35. Related issues • Can the court order a custodial parent to sign a Form 8332 surrendering the exemption? • Should there be a clause that surrenders the exemption to the noncustodial parent only if he/she is current in support by the last day of the year in for which the exemption is being surrendered?

36. Child Care Tax Credit • Qualifying taxpayers are allowed a tax credit of 35 percent of expenses paid for the care of a dependent child who is under age 13 • To qualify for the credit, the taxpayer must provide more than half the cost of maintaining a household for the dependent child • The taxpayer must be entitled to claim a dependency exemption for the child to qualify, except that any agreement to allow the noncustodial parent to claim the child is disregarded

37. Child Tax Credit • IRC Section 24 provides a $1,000 tax credit to taxpayers with qualifying children under age 17 for 2004 • A "qualifying child" is defined as a child, descendent, stepchild or eligible foster child for whom the taxpayer may claim a dependency exemption who is less than 17 years old

38. Attorney Fee Deductions • Attorney fees for divorce or other family law matters are not generally deductible • However, that portion of the fee related to the production or collection of taxable alimony are deductible by the recipient spouse as a nonbusiness deduction under IRC Section 212 • Fees either spouse incurs and pays for tax advice relative to the marital settlement are deductible under IRC Section 212(3). Most divorces involve some level of tax advice concerning the income, estate, or gift tax ramifications.

39. Bankruptcy issues • Bankruptcy all too often follows or leads to divorce, so family law attorneys need to have some familiarity with bankruptcy law • If you don’t do bankruptcy work yourself, it helps to form a relationship with a lawyer who handles consumer bankruptcy cases

40. New law impacts discharge • 2005 bankruptcy reform effective 10/17/05 makes divorce-related obligations non-dischargeable, whether support or property • Eliminates battles to determine whether a particular obligation was support or property division.

41. Beware the Section 362 Automatic Stay • Does not apply to child support, alimony, or granting the divorce itself • Does bar state court from hearing or deciding property issues • Party wanting to move forward with property during pending bankruptcy must ask the bankruptcy court to lift the stay. Note: Bankruptcy court could decide to hear the property issues itself and apply state law, but that is rarely done

42. Penalties for violation of 362 stay • Actions taken in violation of the stay are void • Willful violations are punishable by contempt, and may include damages, costs, attorney fees, and punitive damages • Penalties often run into the thousands of dollars