Tax tips for divorce lawyers so that they can help their clients keep more of their hard-earned cash away from the taxman.
Beware of the “Child Contingency Rule” Regarding Alimony
Internal Revenue Service Publication 504 warns that if alimony payments are reduced or end around the same time as the child-related event, all alimony payments that were deductible to the payor and taxable income to the payee may be reclassified as child support instead of alimony. The payor will lose the deduction and pay retroactive taxes and the payee will receive a refund of taxes paid.
According to the IRS, support payments that would have qualified as alimony may be treated as child support “to the extent that the payment is reduced or eliminated either on the happening of a contingency relating to the child; or, at a time that can be clearly associated with the contingency.” A contingency relating to that child refers to any event that is certain – or even or likely – to occur, including: the child reaching a specified age or income level, graduating from high school, becoming employed, dying, leaving the household, leaving school, or marrying. The reclassification may occur if alimony payments are reduced:
1. Not more than six months before or after the date the child will reach 18, 21, or the local age of majority;
2. On two or more occasions (applies when there are two or more children) that occur not more than one year before or after a different one of your children reaches a “certain age” from 18 to 24 when the age is that of the oldest child when the first step-down reduction occurs. The age must be the same for each child and can be less than a whole number of years.
IRS penalties may be avoided if you establish that any reduction in alimony was determined independently of a child-related contingency, or that the duration or any step-down is a “rule of thumb” as a generally-accepted practice in your state.
– Veralynn Morris (CDFA™), President of Divorce Financial Solutions, www.divorcefinancialsolutions.org
Consider the Circumstances of the Parties Before Committing to a Tax-Deductible/Taxable Alimony Order
Not every order for alimony must be tax-deductible to the payor and taxable to the payee. On occasion, a non-deductible/non-taxable order is a better fit than a deductible payment for a divorcing couple. If the parties are in the same tax bracket, it may not be advantageous to draft the spousal support order as tax-deductible to the payor and taxable to the payee. In situations where the order will run afoul of the recapture rules, you may choose to make the alimony order non-deductible/non-taxable.
A non-deductible/non-taxable order could be the right choice if the payor or payee is a non-resident alien; that party may not be filing tax returns in the United States, and the tax consequences of alimony are advantageous to neither party.
In cases where the parties need a retroactive order for support, it is not possible to make the order qualify as alimony (Ali v. Commissioner [2004] T.C. Memo. 2004-284), so it would make sense to write the order as non-deductible/non-taxable.
Before drafting an order for alimony think about the circumstances of the parties before committing to a tax-deductible/taxable support order.
– Peter M. Walzer (JD), Walzer Melcher, LLP. www.walzermelcher.com
Review the K-1s for Potential Undisclosed Cash Flow
The IRS Form K-1 is the Partner or Shareholder Share of Income, Deductions, Credits, etc. from either a partnership, an LLC, or an S-Corporation. Each of these entities “flow-through” the various items listed above to the taxpayer’s individual Form 1040 via the conduit that is the K-1 prepared for each partner, member, or shareholder.
The predominant items that flow through include the profit/loss of the venture, and dividends, interest, and capital gains. However, there is a section on each K-1 which lists Distributions in Cash or Property. These are not taxable income if given out in the form of a distribution. Instead, the cash distributed reduces the Partner or Shareholder Basis account. For support purposes, these are considered as cash flow even if they do not show up on the tax return. Refer to Line 19 on the Form 1065 for Partners and on Line 18 for all Forms 1120S.
Uncovering hundreds of thousands of dollars reported from distributions is not uncommon. Rather than take it in taxable salary, they reduce their basis accounts or report a new Loan to Shareholder.
– Peggy Tracy (CFP®, CDFA™, CFE), Priority Planning LLC. www.priorityplanning.biz
One of the Biggest Mistakes when Transferring a 401k to an IRA
A little-known tax law deals with Net Unrealized Appreciation (NUA) of employee securities (company stocks). When transferring a 401k to an IRA, you should always first check for NUA. If you have highly appreciated company stocks in your plan you may be able to get them out and pay long term capital gain rates instead of ordinary income tax rates. To do this there are three triggering events: 1) Separation of service (unless self employed); 2) Disability (only if self-employed); and 3) Attainment of 59 ½ or death.
If the cost basis of your company stocks is lower than the current value, you should consider NUA. To get NUA, you must transfer the entire 401k within one calendar year to separate IRAs: one holding the NUA Stocks and another holding all other funds.
Now, when you sell the company stocks, you pay ordinary income taxes on the basis and long-term capital gains rates on the growth, often a savings of more than 20% in taxes. It is important to understand this must be done correctly or you lose the NUA. Be sure to consult a competent advisor in this area.
The cost basis of the NUA distribution can be used to satisfy your RMD for the year of distribution if you have one.
– James W. Johnson, All Mark Insurance Services, www.yoursafemoneypeople.com
How to Access IRA Money Without the Early Withdrawal Penalty
Ever had a client who had the majority of their assets in an IRA – which they needed to access immediately, but they were under age 59 ½? If your client has a 401k, you can transfer the assets that need to be liquidated and withdrawn into that 401k; the money then falls under ERISA rules rather than IRS rules, so your client can withdraw the funds and not have to pay the 10% penalty for being under age 59 ½. It’s as simple as filling out the paperwork and transferring the IRA into their current 401k. This strategy has saved my clients up to $15,000 in tax penalties. Many divorcing clients need money to pay off debt, put a down-payment on a new home, or pay their attorney or other professional fees. The amount to transfer from the IRA should be determined through proper financial planning. Taking money from retirement accounts is a last resort – but all too often, it’s the only option.
– Jennifer Ray Bertheussen-Chapman (CFP®, CDFA™), Jenco Financial Services, www.jencofinancial.com
Factor in the Property’s Basis for Qualifying § 1041 Transfers
26 U.S. Code § 1041 (“Transfers of property between spouses or incident to divorce”) prohibits a taxable event (a gain or a loss) when property is transferred from one spouse to another spouse if it’s done pursuant to an award of property under the terms of a divorce decree. However, the recipient of the property will still be stuck with the tax basis of the underlying property when they go to sell the asset. Practitioners have to take into account tax basis when dividing or exchanging similar property pursuant to a divorce. While two pieces of property might be valued at the same exact value, if the tax bases are wildly different, then it’s not an in-kind exchange of property. It’s all too easy to use the same value in the spreadsheet and not take into consideration tax basis which conceivably would be a mistake.
– Michael P. Granata (JD). www.dallasdivorcelawyer.com
Hire a CPA to Create Post-Tax Cash Projections in Spousal Maintenance Cases
While it is easy to argue to the court that alimony payments are taxable to the recipient and deductible to the payor, the judge is not likely to run the numbers for your client. Nor will the court view you, or your FinPlan projections, as an authority on the issue.
The tax implications associated with alimony significantly impact the actual need for, or ability to pay, spousal maintenance. Given the amount of money in play, you should hire an accountant to run post-tax cash-flow projections on behalf of your client.
If you are filing a motion for spousal maintenance, attach the summary to an affidavit signed by the accountant. For purposes of trial, call the accountant to testify and offer the cash-flow projections into evidence.
Judges are not tax experts – nor do they have a lot of spare time. Spoon-feeding the information to them will enhance the credibility of your argument, and is likely to result in the outcome your client seeks.
– Jason C. Brown, Brown Law Offices, P.A. www.brownlawoffices.com
Home-Related Payments, Alimony, and Taxes
How payments of certain home-related expenses are treated for tax purposes depends on how the property is owned (titled) and the type of payment. For example, if the Husband is ordered to pay the mortgage for the home in which the Wife is residing, what can he deduct? If the Husband owns the home, none of the payments are deductible as alimony – but the interest expense can be claimed as an itemized deduction. If the home is jointly owned, however, the Husband can deduct half of the total payment as alimony and claim half of the interest as an itemized deduction. The rule is similar for real estate taxes and home insurance, but is more specific depending upon the type of joint ownership. If held as tenants in common, half of the total payments can be deducted as alimony and half of the real estate taxes can be claimed as an itemized deduction. However, if held as tenants by entirety or joint tenants, none of the payments can be deducted as alimony, but all of the real estate taxes can be claimed as an itemized deduction.
– Jean J. Han (CPA/ABV/CFF, JD), Partner and Stacy A. Statkus (CVA, CDFA, MBA, JD), Senior Manager, Baker Tilly Virchow Krause, LLP. www.bakertilly.com
Consider “Head of Household” Tax Filing Status to Minimize Your Client’s Tax Burden
If you approach tax planning during divorce based on the common options of Married Filing Separately (MFS) or Married Filing Jointly (MFJ), you may be limiting your client’s options.
The Head of Household (HOH) filing status strategy is a simple way to reduce overall tax bills without having to finalize the divorce by year end. Filing HOH can put your client in a better tax bracket, can save him/her money, and allows the spouses to file separate returns.
For example, a Husband and Wife each have $100,000 in taxable income. They have two dependent children. Depending on their tax filing status, they could have one of the following outcomes regarding federal income taxes:
- Choosing Married Filing Joint or Married Filing Single results in a tax bill of $43,051.
- Choosing Head of Household results in a tax bill of $38,645.
By simply choosing HOH, the couple can save $4,406 or 10% on federal taxes alone. They will also save money on state income taxes.
Involve a tax preparer to ensure the clients are eligible and meet the HOH filing requirements, which include:
1. The couple lived apart for more than half of the year.
2. The couple can’t file a joint return.
3. The HOH’s home was his/her child’s for more than half the year – and the HOH paid more than half the costs of keeping up the home.
4. Each party must have a qualifying child dependent.
– Sandi Gumeson (CPA, CDFA), Wellspring Divorce Advisors. www.wellspringdivorce.com
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