By Jeff Pannell, CPA
Becoming separated or divorced is a time fraught with many emotions, all while dealing with a myriad of issues. Among those issues are tax implications that need to be addressed. Familiarity with the tax consequences of your financial and personal decisions might cause you to alter your plans in some areas.
The issues you should be aware of and understand include:
- The tax impact of your filing status
- How a married couple’s income and expenses may be divided for tax purposes
- The tax treatment of pensions, alimony, and child support,
- The significance of dependency exemptions.
- The tax treatment of property settlements and the redemption of a spouse’s stock in a family business
Why filing status is so important
Your filing status determines, in part, the deductions and credits available to you, the amount of standard deduction that you may be entitled to, and your correct amount of tax. Therefore, you should know which filing statuses are available to you and which one will best fit your needs. There are five possible filing statuses:
- Married filing jointly
- Married filing separately
- Head of household, or
- Qualifying widow(er) with dependent child
For tax purposes, whether you’re considered married or unmarried isn’t as obvious as it may seem. It depends on a number of rules and your legal status as of the last day of the tax year (December 31 for most individuals). In order to minimize your income tax liability when you’re contemplating divorce, it may be possible for you to plan the timing of any changes in your filing status.
If you’re separated or considering a divorce, you and your spouse might wish to continue filing your tax returns jointly for as long as possible. If this is the case, you should be aware of the advantages and disadvantages of this filing status. Particular attention should be paid to the impact that joint filing may have on your right to all or a portion of any tax refunds and how the liabilities of your spouse may affect you. For example, signing a joint return obligates you and your spouse to be jointly and severally liable for any errors (intentional or otherwise) on your tax return.
Furthermore, you should be aware that if your spouse is delinquent on certain debts to government agencies (such as student loans), the entire refund due on your joint return might be diverted by the IRS to the appropriate agency.
Allocating income and deductions
Along with the division of assets and the assignment of debt during divorce proceedings, tax-related issues involving income and expenses (deductions) must be resolved. For example, division of interest and dividends on jointly held assets must be discussed, as should the deduction for real estate taxes paid and the allocation of tax carryovers.
What should you know about the taxation of pensions and alimony?
A retirement plan is a form of property and can be divided by spouses at the time of a divorce, as can houses, cars, and bank accounts. If you (or your spouse) have a retirement plan, you should understand what a qualified domestic relations order (QDRO) is and whether a QDRO applies to your retirement plan. You should also know the income tax ramifications when retirement plans are divided pursuant to a court order.
Alimony is a support payment made to a former spouse under a divorce decree that is intended to make it possible for the recipient to maintain his or her pre-divorce lifestyle. For a payment to be considered alimony for tax purposes, it must meet a number of requirements. You should know the tax ramifications of alimony for the spouse who pays it and for the spouse who receives it.
What about child support and dependency exemptions?
You should know not only the legal rules surrounding child support but also the tax ramifications of child support for the parent who pays it and for the parent who receives it.
If a separated or divorcing couple has children, another important tax decision involves assignment of the child dependency exemption. Although several tests must be met for you to claim a dependency exemption, special rules apply for separated or divorced parents.
What should you know about property settlements?
When marital separation occurs and a divorce is contemplated, spouses must decide how to divide their property. A formal property settlement agreement is usually drawn up, assigning assets to one spouse or the other. In some cases, the couple may decide to sell one or more assets to a third-party, splitting the proceeds.
Although it’s important for divorcing spouses to understand the property laws of their state regarding the division of marital property, it’s also essential for spouses to understand the tax implications of their decisions. The tax effects of property dispositions can vary greatly, depending on whether you decide to transfer property immediately to your spouse, sell the property to a third-party, or sell it to your spouse at some future point.
A family business is also a piece of property that may be subject to division at the time of a divorce. Because each spouse may have a stake in the business, it’s typical for one spouse to buy out the other’s share in the business or to trade assets of equal value for that share. If you’re considering a stock redemption incident to your divorce, you should appraise the business, evaluate alternative methods of dividing the business, and become familiar with the tax consequences of stock redemptions and other methods of apportioning the business.
There are many decisions that need to be made – and their effects understood – during a time of separation or divorce. We urge you to reach out to your tax advisor or Clark Nuber representative for more information.
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