The Tax After “math” of Divorce by Carolyn Flaherty

Perhaps the last thing on the mind of a recently divorced couple is tax considerations. However, when you sit down to prepare your taxes separately there are several important issues that will likely arise. Though many items may be spelled out in your settlement, others will need to be negotiated prior to the filing of either return.

First and foremost is your filing status. This is an important consideration because there are major advantages to certain filing status options. In the year the divorce is final you are considered divorced for the entire year and therefore your filing options are generally restricted to head of household or single.

Filing status needs to be carefully distinguished from dependency exemptions. While a dependency exemption and the child tax credit can be released by a custodial parent to the noncustodial parent, (a formal release on Form 8332 must be signed and attached to the tax return); the filing status cannot be released. Only the custodial parent can claim a child for head of household status, the credit for dependent care expenses, the exclusion for dependent care benefits and the earned income credit.

The custodial parent by definition is the parent with whom the child lived for the greater number of nights during the year. If the child lived equally with both parents, the custodial parent is the parent with the higher adjusted gross income. Typically the custodial parent is defined as part of your divorce agreement.

Filing as head of household gives you the following advantages over filing single:

• Your standard deduction is higher
• Your tax rate will usually be lower
• You may be able to claim certain credits (such as the dependent care credit and the earned income credit) that you cannot claim if you file as single
• Income limits that reduce your child tax credit and retirement savings contributions credit are higher

Once you have determined your filing status, a common question relates to the taxability of child support and alimony. Child support is not taxable to the recipient nor deductible by the payer. On the other hand alimony is taxable to the recipient and deductible for the payer. There are specific rules for what qualifies as alimony and therefore those rules and your divorce instrument should be carefully reviewed to ensure payments are being properly classified.

Another common inquiry is whether the legal fees of divorce are deductible. Unfortunately, legal fees and court costs for getting a divorce are not deductible. However, you may be able to deduct legal fees paid for tax advice in connection with a divorce and legal fees incurred specifically to get alimony. In addition, you may be able to deduct fees paid to appraisers, actuaries and accountants for services incurred to determine your correct tax or in helping you to get alimony.

Something most people don’t consider is how to “split” items such as last year’s tax refund that may need to be claimed as income this year, or an alternative minimum tax credit carryover that arose during marriage. The guidance on how to treat such joint items after your tax status has separated is unclear.

Based on our practice, we have found that you should not split a tax refund 50/50 on each spouses return. The IRS will not be able to match the split refund and therefore, you are likely to get IRS notices which will be tedious to resolve especially because both spouses will have to be involved. Instead, you should choose one spouse to claim said income and then work out the financial impact to equalize any tax due as a result.

The alternative minimum tax credit is more complex. In fact, in researching the issue I ran across several instances in which people had contacted the IRS to determine how to claim the credit and were unable to obtain guidance. In fact, one preparer asserted that he called three times and got three different answers! Some sources say that you should determine the reason the alternative minimum tax was due and hence the source and then attribute the credit back to the source spouse. This could be a complex and time consuming calculation. Other advisors assert that, like the taxable refund scenario above, you should select a spouse on whose return to claim the credit and equalize the tax impact in an outside agreement. Whatever you decide, it would be prudent to consult a tax advisor, document your position and make sure you have taken a defensible position.

The financial considerations of a divorce and the resulting tax issues are complex and this blog is not intended to be all inclusive. Furthermore, community property states have complex regulations of their own. Additional information can be found in IRS Publication 504 “Divorced or Separated Individuals” at http://www.irs.gov/pub/irs-pdf/p504.pdf .