DIVORCE TAXATION

CHEAPER BY THE DOZEN: 12 TAX TIPS FOR
THE MATRIMONIAL PRACTITIONER

 November, 1998

 Rare indeed is the matrimonial case that does not have a tax ramification.   As “tax simplification” becomes increasingly oxymoronic, divorce lawyers must have a heightened sense of the  tax impact of various family law situations.

Here are twelve ideas intended to assist in sharpening the matrimonial practitioner’s focus.

1.  The Tax Return: divorce lawyers use tax returns as road maps for ferreting out useful material. But how often is the copy of the return being examined not genuine?  With a few well-placed additions and adroit photocopying, a dishonest litigant can produce copies of conveniently tailored tax returns. Particularly deserving of scrutiny are those returns prepared by hand, or those prepared by the taxpayer, as opposed to an independent certified public accountant.  A solution: obtain tax return copies directly from the Internal Revenue Service, by using Form 4506.  By obtaining certified copies, counsel can facilitate the evidentiary authentication process and ease the introduction of the returns into evidence.

2.  Children’s Dependency Exemptions: §152(e)(1) of the Internal Revenue Code deals with the dependency exemption of minor children of divorced or separated parents.  In a surprising number of matrimonial agreements, however, the issue is not addressed at all, or dealt with inadequately.  The best procedure: use Form 8332.  It requires the parties to denominate which parent will have the exemption for each child and in what applicable years.  Rather than having this form executed after the fact, insist on its execution along with the signing of the parties’ settlement agreement. 

3.  Dependency Exemptions (Part 2): even in those cases where dependency exemptions are specifically negotiated (and sometimes vigorously fought over), the effort may become insignificant or even irrelevant. This is because at certain income levels the exemption is phased out.  For 1998, the phase-outs are as follows:

a.  Head of Household - $155,650.

b.  Single - $124,500.

c.  Married Filing Separate - $93,400.

d.  Married Filing Joint - $186,800.

4.  Deductible Interest: the Internal Revenue Service typically takes the position that interest paid on divorce obligations is personal in nature, and therefore not deductible under Internal Revenue Code §163(h) (which renders personal interest expenses nondeductible).  Under this section, however, other types of interest are deductible, including those related to a trade or business and investment interest.  In a recent case, the husband successfully deducted the interest on a $250,000 promissory note to his ex-wife, payable over 20 years at 10% interest.  Although the IRS disallowed the deduction, the Tax Court subsequently sustained the husband’s argument that the interest paid on the note was deductible, because it was used to acquire the wife’s marital interest in the parties’ investment property (Armacost v. Commissioner (No. 19616-96, T.C. Memo 1998-150). 

5.  Inter Vivos Trust: pursuant to a recent ruling, the value of an inter vivos trust, established by a decedent husband to secure his obligations under his divorce decree, was includible in his gross estate for federal estate tax purposes, under §2036 of the Internal Revenue Code.  But the husband’s estate was successful in obtaining a deduction for the value of the trust, allowable from the gross estate, as a permissible claim, under §2053(a)(TAM 9826002, August 31, 1998). 

6.  Selling The House: under §1041 of the Internal Revenue Code, property transfers incident to a divorce have been nontaxable.  Until 1997, however, because of basis carryover, the spouse receiving the marital premises was exposed to the risk of hefty capital gain taxes, particularly under age 55.  Under new §121, applicable to sales after May 6, 1997, a single taxpayer can now exclude the first $250,000 of gain on the sale of his or her principal residence, and married taxpayers enjoy the benefit of a $500,000 exclusion.  Other rules address tacking provisions, time periods for prior ownership and occupancy and depreciation recapture. 

7.  Innocent Spouse: as part of the IRS Restructuring and Reform Bill, signed on July 22, 1998, §6015 of the Internal Revenue Code incorporates dramatic changes.  Innocent spouse status is now easier to obtain, primarily by removing the underpayment threshold, as well as the “grossly erroneous” requirement.  In addition, proportionate relief is allowed, if the taxpayer was unaware of a portion of any underpayment.  Not only can relief be afforded retroactively, but the allowable election can be made up to two years after the IRS begins collection activities. 

8. Tax Indemnification Agreement: the joint filing of income tax returns usually represents significant savings for divorcing couples.  However, the joint filing exposes each party to the other’s (perhaps unknown) tax irregularities, even with the liberalized innocent spouse provisions.  Therefore, it often behooves the divorce attorney to require the execution of a tax indemnification agreement, along with the signing of the joint returns.  The following language is proposed:

The undersigned do hereby agree to indemnify each other, and hold each other harmless from any interest, penalty, or deficiency resulting from or imposed against the joint federal and state income tax returns to be filed by us for the year 1998.  We further acknowledge that each of us is signing said income tax returns without necessarily having any knowledge as to the truth or falsity of any statements contained therein, except as may be furnished by each of us with reference to his or her own income and expenses.  We also agree to indemnify each other and hold each other harmless for any accounting or counsel fees or costs arising out of or attributable to any such interest, penalty or deficiency.  The execution of this agreement shall be without prejudice to the right of either party to assert any position or claim with respect to the pending matrimonial action between the parties.

9.   On the Web: did you know that the Internal Revenue Service maintains its own web site?  The URL is http:// www.irs.ustreas.gov.

10.  Asset Valuations: one of the most frequently litigated issues in matrimonial cases is the extent to which the value of a given asset can be reduced, because of hidden potential capital gains tax.  In a new decision, the Second Circuit Court of Appeals has allowed a reduction in valuation because the asset in question (a highly appreciated building owned by a “C” corporation) was subject to the capital gains tax, in view of its indisputable and substantial increase in value (Eisenberg v. Commissioner, No. 97-4331, August 18, 1998). 

11.  Individual Retirement Accounts: it is common knowledge that early (pre 59½) withdrawals from IRA accounts are subject to a 10% early withdrawal penalty.  However, less known is the fact that early withdrawals can be effected, without regard to the 10% penalty, at any time.  This is done by “annuitizing” the IRA, by calculating the annuitant’s current age, a projected life expectancy and an actuarial computation of an annual distribution.  These “annuitized” payments are then made over the participant’s life, free of the otherwise applicable 10% penalty.  While divorce litigants may or may not want to avail themselves of this option, it is another source for available funding, when liquidity is a problem. 

12.  Audits: many factors go into the initiation and investigation of a federal or state income tax audit.  Sometimes audits are occasioned by accusations or allegations made during divorce proceedings.  For such purposes, matrimonial practitioners should be aware of whether their clients’ tax filings are aggressive, on the one end of the spectrum, or conservative, on the other.  One useful benchmark is the total amount of deductions taken by the taxpayer; the higher the total amount of deductions taken, the greater the likelihood that audit attention may be drawn.  The Research Institute of America has released figures drawn from income tax returns submitted to the Internal Revenue Service by the April 15, 1997 deadline.  For returns reflecting adjusted gross income of between $30,000 and $50,000, the average of the total itemized deductions was $11,052.  For returns reflecting adjusted gross income of between $50,000 and $100,000, the average of the total itemized deductions was $14,627.  For returns reflecting adjusted gross income of between $100,000 and $200,000, the average of the total itemized deductions was $23,301.  For adjusted gross incomes in excess of $200,000, the average of the total itemized deductions was $63,058.  Awareness of this information, coupled with appropriate prudence, might be valuable advice to the divorcing litigant.

As the arrival of the 21st century approaches, family lawyers are using tax advantages to benefit their clients in ever increasing ways.  The resulting financial advantages help to mitigate some of the expenses and other stressors of the divorce process. 

Charles C. Abut practices in Hackensack, New Jersey.  He was board certified by the New Jersey Supreme Court as a Matrimonial Attorney in 1998 and as a Civil Trial Attorney from 1984 to 1998.  He is also a Fellow of the American Academy of Matrimonial Attorneys.