Tax traps in high-asset cases many attorneys overlook.
By David Sarif, Family Lawyer, and Laurie Dyke, Forensic Accountant
Experienced divorce attorneys realize that high-asset divorce cases involve unique issues with potentially significant tax implications. In high-asset cases, one word in the right (or wrong) place of an agreement or court order could have implications that benefit (or hurt) your client to the tune of millions of dollars. Below are four unique issues many attorneys overlook in high-asset divorce cases.
1. Pay Attention to the Title
Most family law attorneys know that transfers between spouses pursuant to a divorce are non-taxable events per IRS §1041. However, assets that need to be transferred in a divorce may be titled in the name of another legal entity, such as a business or Trust. Most commonly, these assets include cars and real estate, but they can be anything: furniture, artwork, or even animals. Any time a legal entity other than the individual parties themselves is involved in an asset transfer, there is the potential for significant tax ramifications that must be carefully analyzed.
2. All Assets Are Not Created Equal
Investment accounts that hold securities, mutual funds, and bonds may be divided in a divorce; you must take care to transfer the assets in a way that will not result in unequal income tax burden on the parties when the assets are sold. Stocks that are purchased over time may each have a different tax basis and, therefore, different unrealized gains or losses – which may result in significantly different capital gains taxes. For example, married couple John and Jane purchased 500 shares of Apple stock in January 1981 for $34.50; the stock has split several times since then, resulting in 28,000 shares today with a cost basis of $.61/share. They purchased another 500 shares in January 2013 for $555/share; the stock split 7:1 in 2014, resulting in 3,500 shares with a cost basis of about $79/share. If the current stock price is $125/share, the 28,000 shares resulting from the original purchase in 1981, will have unrealized gains of $124.39 per share and the 3,500 shares resulting from the 2013 purchase will have unrealized gains of $46/share. Let’s assume that they have agreed to split the 31,500 shares equally, with each receiving 15,750 shares. If John receives 12,250 shares resulting from the 1981 purchase and 3,500 shares resulting from the 2013 purchase, while Jane receives all 15,750 shares from the 1981 purchase, they will receive equal market value, based on $125/share. However, the net value (assuming a 20% capital gains rate) will be approximately $55,000 different: Jane would pay approximately $55,000 more in capital gains taxes than John if all of the shares were sold at date of transfer.
This is why it’s so important to divide investment assets on a pro-rata tax-neutral basis. It’s also very important to realize that $3M market value in an investment account, which may have unrealized gains that will be subject to capital gains taxes, is not equal to $3M cash or equity in a principal residence, which has unrealized appreciation that will not be subject to capital gains taxes. Simply put, “All assets are not created equal.”
3. Understanding Capital Loss Carryforwards
Capital losses in excess of capital gains may not be deductible by taxpayers in the year incurred, but may be carried forward to future years and used to offset future income. These are called “capital loss carryforwards” and generally can be found on Schedule D of the parties’ income tax return. Unlike dependency exemptions, allocation of capital losses to individual taxpayers cannot be assigned or transferred pursuant to a divorce. The party who is entitled to use the capital loss carryforward is determined by the Internal Revenue Code (IRC), not by agreement of the parties or order of the court in a divorce. If the assets that generated the loss were held in a joint account, each party is entitled to claim 50% of the loss against future income. However, if the assets that generated the loss were held in an account that was titled in only one party’s name, that party will be entitled under the IRC to claim the loss – even though the assets were technically marital assets for purpose of the divorce. Valuation of the benefit derived by the party entitled to use the loss may be difficult to determine, as it is difficult to predict both future income and income tax rates. However, a capital loss carryforward of $500,000 attributable to one of the parties could easily result in real tax savings of $100,000, assuming a 20% capital gains rate. Clearly, this benefit can be valuable and it should not be overlooked.
4. Net Operating Losses Matter
Similar to capital loss carryforwards, net operating losses (NOLs) can result in future income tax benefits to one or both parties. In general terms, NOLs result from business losses that exceed business income in any given year. These losses may be carried forward to future years and used to offset future income, and they may also be carried back to prior years, resulting in refunds for those prior years. The rules regarding carryforwards and backs of NOLs are complicated and the tax treatment is determined in part by how the parties filed their income taxes during the years they were married (i.e., joint or separate), the proportionate income of the parties, whether the loss was active or passive, and how the entity that generated the loss was titled. If NOLs exist at the time of the divorce (or if they’re likely to occur in the future), and if the NOLS could be carried back to previously filed joint tax returns, then the potential benefit to each party should be reflected in the divorce settlement.
If even one of these four issues is likely to arise in a high-asset divorce case, a prudent attorney should consider engaging a forensic accountant or similar tax expert early in the divorce process. This financial expert can recognize these issues, and help the attorney to avoid the expensive mistakes outlined above.
David Sarif is a partner at Naggiar & Sarif in Atlanta, GA. He has been honored as a Georgia Super Lawyers Rising Star, recognized in Georgia Trend Legal Elite, and represents many high-profile clients. He devotes his practice to divorce and family law. www.nsfamilylawfirm.com
Laurie Dyke, CPA/CFF, CFE is the Founder and Managing Partner of the Investigative Accounting Group, a CPA firm that specializes in forensic accounting, fraud investigation, business valuation and litigation support. www.iagforensics.com