When dealing with income taxes in divorce matters, instead of “whistleblowing”, we should identify key areas to focus on when reviewing individual tax returns. After all, no one wins with an IRS audit.
By Joseph Petrucelli, Forensic Certified Public Accountant
Given the often-heightened emotions that can accompany a divorce, I thought an article explaining some of the complexities surrounding tax returns would help remove some of the stress. Having been an expert in many divorce proceedings, I have found a common theme: let’s blow the whistle. With Sheridan-like case law, which requires judges to disclose potential taxes, the threat is used as a leveraging tool to bring the parties together. Unfortunately, all that strategy does is jeopardize the marital estate, create further distrust, and raise the already heightened emotions. No one wins with an Internal Revenue Service or State Agency audit.
In my opinion, a better approach is to gain an understanding of the important divorce tax planning considerations that need to be addressed. To do this, we need to identify some key areas to focus on when reviewing individual tax returns. Once we have established the “as of a date”, which in divorce is typically the date of the complaint, the parties will seek five years of filed tax returns that surround that date. The main issue with five years is that the Statue of Limitations for federal purposes has the following rules:
- Three years from the later of the date the tax return was filed or the due date
- Six years if the taxpayer omits items of gross income that in total exceed 25%
- Indefinite if a fraudulent return was filed or no return was filed
States differ: for example, New Jersey has a four-year general rule and similar rules for not filing.
Income Taxes in Divorce Matters: New Legislation
So, now that we know the time periods we can face, what are some of the tax considerations associated with divorce? Let’s start with the dreaded question of who gets the dependency deduction and/ or the child care credit deductions. The spouse with primary custody of the children is entitled by law to claim all of the children in his or her custody. However, there are times when it may be more beneficial to one spouse than another depending on taxable income levels. With the recent legislative changes, there is no longer a dependency exemption. However, the child tax credit was raised to $2,000 for each qualifying child under age seventeen. You can only claim the child tax credit if you can claim the child as a dependent. Accordingly, for a non-custodial parent to receive this benefit, the custodial parent must agree and assign that right using Form 8332, which can be obtained by going to www.irs.gov and searching forms.
The new tax legislation made significant changes to the taxability and deductibility of alimony. For divorce settlements finalized in 2019, alimony is no longer taxable to the recipient and no longer deductible to the payor. With the changes to the tax treatment of alimony and the elimination of the dependency deduction, the child tax credit will have more value to the payor of alimony than it has in the past.
Another issue that must be considered is that tax rates change year to year. For example, the new tax legislation for individuals is slated to revert back to current law in 2025. Alimony is not taxable in 2019 but divorce settlement can easily extend well beyond 2025 as a simple example.
The new tax legislation caps the State Income and Property Tax deductions at $10,000. This will impact the net available cash flow. This deduction can be found on Schedule “A” of Individual Federal Tax Form 1040, line 5 through 9 of the 2017 federal tax forms.
The Mortgage Interest and Property Tax Deductions are also found on Schedule “A”. Like the state tax limitation, the mortgage interest deduction has been limited by the new tax legislation as well. You were previously able to deduct interest on a mortgage up to $1,000,000, but that amount has been reduced to $750,000 of the loan balance.
Income Taxes in Divorce Matters: Marital Property
A significant tax consideration revolves around the transfers of marital property because of divorce. All the property in the marital estate needs to be classified on an asset by asset basis. Typically, we break them down into two main categories: liquid cash assets and non-liquid assets, like retirement which results in varying tax implications. Using a Qualified Domestic Relations Order (QDRO) to transfer certain retirement assets is one strategy that can avoid triggering a taxable event.
Sale of stock results in capital gain treatment, which has separate tax rates and is reported on Schedule D of Individual Federal Tax Form 1040. The sale of a marital residence can exclude up to $500,000 for married filers and $250,000 for single filers of gain for federal tax purposes. All of these situations need to be calculated on a case by case basis to determine net proceeds available to be distributed to the parties.
Spousal Buyouts in a divorce, known as equitable distribution, are typically exempt under IRS Section 1041. However, the payment, in order to be considered a payment “incident to a divorce,” must be paid in full within 6 years after the date of the divorce decree.
Another important consideration is that once a joint return is filed, an amended return to file separately is not permitted under IRC code section 1.6013-1(a). However, we have utilized Form 8857 Innocent Spouse Relief to relieve one spouse from a jointly filed tax return liability, should a tax liability exist during a divorce settlement. Even if the parties agree on who is liable or the court deems a party responsible, the IRS can still seek to recover from either of the parties on the jointly filed return.
Circular 230 ( https://www.irs.gov/tax-professionals/circular-230-tax-professionals is a useful resource in understanding the standards associated with the preparation of income taxes. One important area to review is the compliance section of the Circular 230. It indicates that preparers inform clients of positions that may be contrary to the Internal Revenue Code. It is good practice to retain a tax professional that adheres to Circular 230. If there is an suspected tax evasion or avoidance, to avoid this potential reporting conflict it is prudent for the tax professional to be retained through the attorney to maintain attorney-client privilege.
It is important to inform your clients when you become aware of a potential tax fraud. While it is not a requirement to notify the IRS, failing to document these instances can lead to consequences, should an audit later occur. A simple letter to the client stating that there appears to be potential errors and irregularities that need to be addressed can go a long way.
Joseph Petrucelli (CPA/CFF/CGMA/ABV, FCPA, CVA, MAFF, PSA, CFE) is a partner at Petrucelli, Piotrowski, & Co. in Woodbridge, NJ. He has been qualified and has testified as an expert in many types of litigations. He is the author of Preventing Fraud and Mismanagement in Government: Systems and Structures (Wiley, 2016). www.ppdaccounting.com
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