Divorce Law Journal

Wife Not Eligible For Innocent Spouse Status

From Charlie Abut at New Jersey Family Law:

The wife was not eligible for the benefits of "Innocent Spouse" treatment under Internal Revenue Code Section 6015. Thus, the tax penalties, interest and liabilities in question were not solely attributable to the husband. The wife was deemed to have had actual knowledge of the understatements of income. This was because she was college-educated, she had access to the parties' joint bank accounts, she balanced the parties' checkbook, she admitted to her status as a member of the parties' Limited Liability Partnership, and she failed to satisfy her duty to make diligent inquiry. Golden et ux., v Commissioner, TC Memo 2007-299, October 8, 2007.

Innocent Spouse Relief

The IRS revised its Request for Innocent Spouse Relief Form 8857 this year, online here. Charlie Abut at New Jersey Family Law offers the good suggestion that the detailed form be used as a basis for a client interview when tax problems rear their ugly head in divorce.

To Be Tax Deductible Alimony Must Terminate On Death Of Recipient

You can read Hinson v. Commissioner, US Tax Court Summary Opinion 2007-92 (June 7, 2007) here. The code is quite clear that to be taxable income/tax deductible, alimony (maintenance) must terminate on the dearth of the payee. The Family Law Prof Blog reports:

The tax court, in a recent summary opinion, provides a good example for our students of the importance of careful drafting in light of the interrelationship between the tax code and state law when determining the tax consequences of divorce. In this case, the divorce decree provided that Husband would pay Wife $1200 a month in “rehabilitative alimony” and an additional $72,000 in “lump-sum alimony”, payable in installments of $600 a month. The decree did not indicate whether this lump sum
award would terminate upon Wife’s death.

Under section 71(b) of the tax code, alimony is not deductible if it does not terminate upon the payee spouse’s death. Because the Florida courts have held that an award of lump-sum alimony survives the death of both the obligor and the obligee, the alimony was not properly deductible.

Deductibility Of Attorneys' Fees In Connection With Divorce

It’s that time of year again. Of course, the general rule is that lawyers’ fees and costs in connection with obtaining a divorce are not tax deductible. As with many general rules, there are exceptions:

1. Attorneys’ fees related to tax advice. I.R.C. §212(3). Areas having tax implications upon which an attorney may offer advice include the tax effect of the distribution of property, including retirement plans, tax deductibility of interest payments or installments to effectuate an equitable distribution of property, the allocation of the dependency exemption and child tax credit, whether a joint tax return should be filed, the tax effect of unallocated maintenance and child support, the tax implications of the form of alimony, and advice regarding the recapture of front end loaded maintenance in the first three years following separation.

Practice tip: it is not helpful for the client wishing to tax deduct some attorney fees to have a provision in the marital settlement agreement that no tax advice was given.

2. Attorneys’ fees related to the production or collection of taxable income may be deductible. I.R.C. §212(1). For example, the payee of taxable alimony may be entitled to a deduction for attorney fees in generating the production or collection of this taxable income and fees in connection with securing an increase in taxable alimony may also be deductible. Attorney fees for obtaining income producing property are not deductible, but could arguably be added to the tax basis of the property.

A taxpayer may deduct only fees paid to his or her own attorney, unless the fees of the other party are paid as alimony.

Any attorneys’ fees that are legitimate income tax deductions are deductible only to the extent that all of the miscellaneous deductions in the aggregate exceed 2% of the taxpayer’s adjusted gross income. There is also an “applicable amount” which may reduce the otherwise allowable deduction.

Lawyers must be very careful not to overstate the amount or portion of attorneys’ fees that relate to tax deductible advice or legal efforts. I.R.C. §6701, Penalties for Aiding and Abetting Understatement of Tax Liability.

Divorce Tax Tips

Tax errors in divorce agreements are costly: Here's how to avoid them is the title of an article by Eva Rosenberg, in Dow Jones MarketWatch.
Lynne Gold-Bikin from Norristown, Penn, and an AAML Fellow, points out some frequent tax problems in divorce.
"Alimony recapture can be a common problem, cautions Gold-Bikin.
IRS Publication 504 explains what the recapture is: "You are subject to the recapture rule in the third year if the alimony you pay in the third year decreases by more than $15,000 from the second year or the alimony you pay in the second and third years decreases significantly from the alimony you pay in the first year."
Why is this recapture needed if the divorce agreement is properly drafted? Gold-Bikin said this often happens when the alimony payments aren't made on schedule. If several payments are missed in one year, then made up in another year, it's easy to see that $15,000 swing take place. Or if payments are stopped altogether and there haven't been three years of regular alimony payments, that would also trigger the recapture.
Why does this matter? Because the person paying the alimony will lose the deduction. And the person who received the money may go back and file amended returns for all the alimony years - and get refunds. Read that last sentence again if you're dealing with a deadbeat former spouse. You may have a refund coming!
How can you avoid this problem? Gold-Bikin recommends you adhere to the alimony payment schedule.
When the divorce decree awards family support without spelling out which part is for child support and which is for spousal support, it's all taxable to the recipient as alimony, and deductible to the payer, says Gold-Bikin. This the result of a 2005 Tax Court decision in Berry v. Commissioner.
What about a spouse who is asked to sign a joint return while the divorce action is pending?
"Gold-Bikin says it's as easy as 1-2-3.
• Get an indemnification letter as part of the divorce, making your ex responsible for his/her share of all taxes. And be sure that indemnification letter includes specific instructions for how any refunds are to be allocated. While IRS may not honor the agreement between the two of you, it does give you a basis to sue your ex, if you're ever stuck paying his or her share of the tax.
• Don't ever sign a balance-due tax return without getting a certified check to pay your ex's share in full. Don't rely on promises from your ex or his/her attorney. They're rarely fulfilled.
• If there is a refund coming, use IRS's new Form 8888 that allows you to have the refunds split up in any pre-determined allocation, and deposited directly to two different bank accounts."
Another frequent problem is that "assets appear to be evenly split based on fair market value. Everything looks all nice and equitable, but one person just got stuck with all the taxable assets, while the other walked off tax-free."

Tax: Offers In Compromise

OFFERS IN COMPROMISE ARE NOW MORE TAXING: New Federal Law Requires Down Payment With Offer in Compromise Submission; 20% Down Payment or First Installment Required; Source: Family Law Taxation Blog.The new law applies to Offers in Compromise submitted after July 16, 2006.

Tax Issues Related to Qualified Domestic Relations Orders

Alan Pearlman, who writes the Chicago Family Law Blog, has a great article on the tax side of dividing retirement assets upon divorce:

Tax Issues Related to Qualified Domestic Relations Orders and Divorce

It is reprinted below. Thanks, Alan.

Waiver of Tax Advice in Agreements?

The Tax Code is law. We are lawyers. Why, then, do we see so many agreements that say "The parties acknowledge that their attorneys have not provided any tax advice, blah, blah, blah?" Yes, it is an attempt at an exculpatory clause for the attorneys. However, did you know that such language could be used to preclude your client from tax deducting legal fees in the instances where fees are tax deductible in divorce? We learned tax law in law school. It was on the bar exam. If you practice family law, you need to keep up a working familiarity with it, and even so, should consider consulting with tax experts so you can be sure you and your client understand all tax implications.

I have touted Mel Frumkes and his book, Divorce Taxation, in this blog. Another resource is the Family Law Taxation Blog. While it hasn't been updated the past few weeks, I have been assured it was only because of these "taxing times" and it will be up and running again soon.

Just as important, and probably more so to your client, is to make sure your client has a tax professional to follow though after the agreement. Such expert assistance can be valuable to both of you though the divorce, and your client will benefit long after he forgets about you.

Dobson v. Dobson, 159 SW3d 335 (Ky.App., 2004)

Dobson v. Dobson, 159 SW3d 335 (Ky.App., 2004)
Spouse granted innocent spouse relief by the IRS is
not entitled to res judicata and trial court assignment
of tax deficiency 40% to innocent spouse was upheld.
Tax audit has uncovered a tax deficiency, but trial court
reasoned that the parties benefited from the lower tax burden
and innocent spouse was later required to pay the share of
taxes for which she would have been responsible had the
deductions not been disallowed.

Innocent Spouse Tax Relief

The Family Law Taxation Blog has a recent posting about innocent spouse tax relief: http://www.familylawtaxation.com. However, even if the IRS absolves a sopuse from tax liability, in a KY divorce, the trial court can assess some of the burden of the tax to the innocent spouse.
Dobson v. Dobson, 159 SW3d 335 (Ky.App., 2004)
Spouse granted innocent spouse relief by the IRS is
not entitled to res judicata and trial court assignment
of tax deficiency 40% to innocent spouse was upheld.
Tax audit had uncovered a tax deficiency, but trial court
reasoned that the parties benefited from the lower tax burden
and innocent spouse was later required to pay the share of
taxes for which she would have been responsible had the
deductions not been disallowed.
.

Alimony Recapture

When maintenance is front-end-loaded, the payor may be required to recapture in the third year excess alimony. Two calculations are necessary.The first compares the second year payments to the third year payments. If the amount paid in year three plus $15,000 is less than paid in the second year, the excess will be recaptured. The second computation compares the first year payments to the adjusted average of the second and third year payments.  If this average plus $15,000 is less than the payments in the first year, the excess is recaptured. I have always used an appendix to Melvyn B. Frumkes' excellent Divorce Taxation, James Publishing, Inc. to manually figure whether a settlement poses a recapture problem. There is now an online free calculator available to make the computations:http://www.smartmoney.com/divorce/basics/index.cfm?story=alimonycalc. There are numerous caveats, however, so the prudent practioner will always want to consult Frumkes, a tax attorney, or a CPA.