Any lawyer who dispenses divorce advice should include in their initial consultation checklist a directive to the client to consult a tax professional before developing any strategy. Issues including timing of divorce, dependency exemptions, characterization of support payments, and division of assets and the consequences of various transfers must all be considered in determining what really constitutes an equitable financial divorce. This article will provide a starting point, but is in no way a complete list of tax issues and considerations.
First and foremost, the timing of divorce, and how each spouse will file before the divorce, should be considered. Before the court enters a final decree of divorce, this decision must be made since the filing status can materially affect the amount of the income tax liability. Generally, selecting “married filing jointly” allows for the smallest tax liability. Where both spouses have similar incomes, this is likely the way they should file. However, where there is a lack of trust or concerns about underreporting or other fraudulent activity, it is prudent to advise your client to seek advice from a professional independent of the soon-to-be ex-spouse.
Likewise, decisions will need to be made about the division of dependency exemptions, as well as characterization of support payments. Pre-divorce child and spousal support payments are not deductible by the paying spouse or includable in the receiving spouse’s income. However, post-divorce alimony payments are deductible by the payor and includable in the payee’s income. Thus, in deciding the final terms of a divorce, you must consider the true net effect of support payments. Additionally, depending on the income and tax bracket of each spouse, the ability to utilize dependency exemptions should also be considered.
Ultimately, there is a “most financially advantageous” division of assets, sharing of dependency exemptions and characterization of support payments as alimony versus child support. This is especially true where there is a wide disparity in the respective incomes of the spouses. It may very well be beneficial to allow the higher earning spouse to claim one or more of the parties’ children as dependents, thus allowing for an ability to pay less in taxes and correspondingly provide a greater amount of support to the lower earning spouse.
At the same time, you must determine the tax consequences associated with the transfer or sale of each asset in the community. Generally, transfers incident to divorce are not taxable events, but certain transfers may trigger tax consequences, including the division of certain retirement assets. A qualified domestic relations order may be required to ensure a tax-free transfer. However, these must be negotiated and drafted carefully, before a final decree is entered, so that each party fully understands the nature and extent of all retirement assets and each plan’s peculiarities. You should review previous year’s tax returns to identify not only assets and income, but also for any available loss carry forwards which may be equitably divided. Finally, you must compare like assets in determining an equitable division. The dollars in a 401(k) are not equal to the dollars in an investment account. Similarly, the stocks in an investment account may have different bases and, as such, better or worse tax consequences when eventually liquidated. A truly equal division of the community estate is only possible after the tax impact of each dollar in the community estate is considered.
Finally, whether the divorce is settled or presented to a judge at trial, you must be prepared to present this information to opposing counsel or to a judge or mediator. I recommend preparing a proposed decree of divorce or marital settlement agreement well in advance of the trial or mediation date. Your client should present this draft to their tax advisor, as the verbiage in an order can be just as important as the underlying concepts. In the event you must try the case, be prepared to present your proposal and to explain the underlying tax considerations. Some judges may not take judicial notice of the Internal Revenue Code or current tax rates. Don’t assume your judge understands all of these considerations, and be prepared to educate him or her with admissible evidence.
There are literally thousands of resources which provide comprehensive checklists on the tax considerations in divorce. Being familiar with these considerations is a must for competent family law practitioners. Nevertheless, since we are lawyers and not accountants, and likely not qualified to dispense tax advice, instructing a client to consult a tax specialist before proceeding with the divorce should occur the first time you meet a prospective client.
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