Divorces, in and by themselves, do not usually create tax consequences. That is, the transfers of assets and liabilities between spouses do not create taxable events. However, there are tax consequences associated with payments made after a divorce (alimony/maintenance). There may also be tax consequences involved with sales of property that occur as a result of, or incident to, a divorce.
Alimony is normally a deduction from taxable income for the spouse paying it and an inclusion in the taxable income of the spouse receiving it.
However, the IRS has rules governing when payments made to an ex-spouse can be treated as alimony. Once a proposed plan for alimony has been developed or a tentative agreement on the terms of alimony has been reached, the payments can be assessed in light of current IRS regulations. Such assessments may indicate infeasibility, fine tuning, or specific wording that must be included in the divorce decree.
Assets such as real property (including the family home) or investments may have tax consequences when they are sold.
For example, if a party sells recreational property for $100,000 that the person purchased for $80,000, then there may be a tax liability due on the difference between the sales price and the purchase price. This difference is referred to as a capital gain. The rules governing when capital gains are recognized can be complex and reference to an expert is advised.
When properties are going to be sold as part of the divorce process or are expected to be sold immediately after a divorce, the tax consequences should be determined in order to assess their effect on the equity of the marital estate and its division. In addition, even if the sale of the properties is not imminent, parties may wish to understand the possible consequences of sale. However, courts can take the position that estimating the possible tax consequences of a property sale that is not immediately anticipated is speculative and not consider it in the division of the marital estate. The speculative assessment is probably caused by the inherent dynamics of the United States tax law.
In some cases, one or both of the parties in a divorce can own a part or all of a corporation. There can be significant tax consequences involved in transferring assets from corporations to divorcing parties in order to divide marital estates. Reference to financial experts is strongly advised if this type of arrangement appears likely.
If the parties plan to withdraw retirement funds as part of a divorce settlement, the tax consequences should be determined and the anticipated tax liability entered into the marital estate summary. If one party expects to receive retirement funds and is uncertain as to whether or not they will be withdrawn, the tax consequences should be determined for informational purposes. Whether or not the effect of such taxes is included in the marital estate is dependent upon the facts of the case, agreement of the parties, or determination by a court.
In cases involving children, the exemptions, child tax credit, daycare tax credit and earned income credit associated with the children will have tax consequences for the parents.
The parent who is allowed to claim the exemptions for the children (and the child tax credit which is assigned with it) can be designated by the parents by means of filing a Form 8332 with IRS, or specifying the designation in their divorce decree. The earned income credit and, to a lesser extent, the daycare tax credit are tax benefits that are allowed for the parent who has more than half of the parenting time. The party receiving these benefits may not be designated by the parties. The tax filing status (e.g., Married, Single, Head of Household, Married Filing Separately) of the parties will change after the divorce and perhaps even during the course of the divorce. Parents may wish to anticipate these changes for budgeting purposes or, in the case of the exemptions, for the purpose of including the effects as points of negotiation.
Negotiating the exemptions for the children may appear to violate the cardinal rule separating children from the divorce process. However, the assignment of exemptions is a financial decision, not a parenting decision. The earned income credit and the daycare credit are related to parenting time. However, as in the case of child support, the parenting plan should be developed first and the tax consequences anticipated. The parenting of the children should not be dependent on the associated tax consequences.
The filing of joint tax returns requires at least a minimum amount of cooperation between the filers. This type of cooperation during a divorce may be difficult to achieve. However, there is at least one very good incentive for the parties to file Jointly instead of Married Filing Separately. The tax rates for filing separately are significantly higher than those for joint filers.
Anticipating the amount of income taxes that should be withheld from paychecks or paid on a quarterly basis may not be something that divorcing parties address in light of the chaotic atmosphere of divorce. However, considering this issue may prevent a nasty surprise later.
There are times when a couple may be in dispute with the IRS over taxes that are due. In other cases, the couple may not have filed tax returns for one or more years. These situations create contingent tax liabilities.
In the dispute situation, contingency plans should be made in the divorce process. These plans can encompass what would happen in the worst and best cases. The plans could also require the return to negotiations if the ultimate outcome of the dispute falls outside of the range of what was predicted.
There are provisions to protect spouses who are, or have been, married to individuals who have filed fraudulent tax returns. The innocent spouse should discuss this with a qualified tax expert or legal counsel.