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 .

IRS Offers Four Tips on Unemployment Benefits IRS Tax Tip 2012-31

Unemployment can be stressful enough without having to figure out the tax treatment of the unemployment benefits you receive.

Unemployment compensation generally includes, among other forms, state unemployment compensation benefits, but the tax implications depend on the type of program paying the benefits. You must report unemployment compensation on line 19 of Form 1040, line 13 of Form 1040A, or line 3 of Form 1040EZ.

Here are four tips from the IRS about unemployment benefits.

1. You must include all unemployment compensation you receive in your total income for the year. You should receive a Form 1099-G, with the total unemployment compensation paid to you shown in box 1.

2. Other types of unemployment benefits include:
•Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund
•Railroad unemployment compensation benefits
•Disability payments from a government program paid as a substitute for unemployment compensation
•Trade readjustment allowances under the Trade Act of 1974
•Unemployment assistance under the Disaster Relief and Emergency Assistance Act

For complete information on each of the benefits listed, see chapter 12 in IRS Publication 17, Your Federal Income Tax, or Publication 525, Taxable and Nontaxable Income.

3. You must report benefits paid to you as an unemployed member of a union from regular union dues. However, if you contribute to a special union fund and your payments to the fund are not deductible, you only need to include in your income the unemployment benefits that exceed the amount of your contributions.

4. You can choose to have federal income tax withheld from your unemployment compensation. To make this choice, complete Form W-4V, Voluntary Withholding Request, and give it to the paying office. Tax will be withheld at 10 percent of your payment. If you choose not to have tax withheld, you may have to make estimated tax payments throughout the year.

For more information on unemployment compensation see IRS Publications 17 and 525. Forms and publications can be downloaded from the IRS Website at www.irs.gov or can be ordered by calling 1-800-829-3676.

Considerations for a US Domestic LLC with Foreign Members by Carolyn Flaherty

Below are some requirements that should be considered when foreign investors are members in a US limited liability company (LLC):

Individual Taxpayer Identification Numbers Required: A foreign individual invested in a U.S. LLC is required to apply for an individual taxpayer identification number (ITIN). The ITIN is required for the Form 1065 filing of the LLC. Form W-7 is used to apply for an IRS ITIN.

LLC withholding Requirements: Under withholding rules, the LLC must calculate its income and remit withholding for the foreign investors on a quarterly basis. The withholding is required regardless of cash flow and even if no actual distributions are made to the foreign members. The payment can be up to 30% of the foreign member’s allocated income and is made on Form 8813. The LLC must also file Form 8804, reporting the total withholding tax required to be withheld and paid, and Form(s) 8805, reporting the payment attributable to each foreign partner on whose behalf the tax was withheld, by the 15th day of the 4th month after the close of the partnership’s tax year.

If prior year losses exist, the withholding can potentially be adjusted, but the procedures for approval are cumbersome. The foreign investor may be entitled to a reduced rate of withholding or an exemption from withholding. A valid Form W-8 must be provided by the foreign member to the LLC to avoid any unnecessary withholding.

If a member’s investment in the partnership is the only activity producing effectively connected income and the IRC section 1446 tax is less than $1,000, the partnership is not required to withhold. However, certification requirements apply.

Form W-8: A partner that is a foreign person should provide the appropriate Form W-8 to the partnership. The partnership may not rely on the certification if it has actual knowledge or has reason to know that any information on the form is incorrect or unreliable. The partnership must keep the certification for as long as it may be relevant to the partnership's withholding requirements.

Foreign Member Filing Requirements: A domestic LLC causes a foreign member to have effectively connected income as a result of the US LLC’s business operations within the United States. Said differently, the member’s ownership interest in the LLC is considered by the Internal Revenue Code to be engagement in a trade or business within the United States.

Therefore, Non-U.S. resident individual members are required to file Form 1040NR to report their respective income of the LLC. They may also be required to file state income tax returns, depending on the laws of the state in which the LLC operates.

Disclosure Requirement: The LLC must file a Form 8886 disclosure statements with the IRS if it has participated in certain transactions such as a sale, exchange, retirement or other taxable dispositions considered reportable transactions under the Internal Revenue Code’s tax shelter provisions. Failure to disclose a reportable transaction can incur a penalty of $10,000 to $50,000.

Foreign Investment Real Property Act: FIRPTA withholding rules were enacted to impose tax payment and reporting liability on the transferee of real property, (and certain others involved in the transaction), to ensure collection of a foreign transferor’s tax on the disposition of U.S. real property. Unless a transaction is exempt from withholding, the transferee must report the transaction and pay the required FIRPTA withholding to the IRS usually within 20 days.

The FRPTA rate is generally 10% of property’s fair market value at the time of the transfer regardless of the amount of gain. A reduced rate withholding certificate can be obtained when the 10% withholding is expected to substantially exceed the actual liability, (the certificate should be requested well in advance of the transaction). The foreign investor will need to file a US tax return to determine the correct amount of income tax on the gain if there was any, and if not to obtain a refund.

Six Tips on a Tax Credit for Retirement Savings IRS Tax Tip 2012-36

If you make eligible contributions to an employer-sponsored retirement plan or to an individual retirement arrangement, you may be eligible for a tax credit, depending on your age and income.

Here are six things the IRS wants you to know about the Savers Credit:

1. Income limits The Savers Credit, formally known as the Retirement Savings Contributions Credit, applies to individuals with a filing status and 2011 income of:
•Single, married filing separately, or qualifying widow(er), with income up to $28,250
•Head of Household with income up to $42,375
•Married Filing Jointly, with incomes up to $56,500

2. Eligibility requirements To be eligible for the credit you must be at least 18 years of age, you cannot have been a full-time student during the calendar year and cannot be claimed as a dependent on another person’s return.

3. Credit amount If you make eligible contributions to a qualified IRA, 401(k) and certain other retirement plans, you may be able to take a credit of up to $1,000 ($2,000 if filing jointly). The credit is a percentage of the qualifying contribution amount, with the highest rate for taxpayers with the least income.

4. Distributions When figuring this credit, you generally must subtract distributions you received from your retirement plans from the contributions you made. This rule applies to distributions received in the two years before the year the credit is claimed, the year the credit is claimed, and the period after the end of the credit year but before the due date - including extensions - for filing the return for the credit year.

5. Other tax benefits The Retirement Savings Contributions Credit is in addition to other tax benefits you may receive for retirement contributions. For example, most workers at these income levels may deduct all or part of their contributions to a traditional IRA. Contributions to a regular 401(k) plan are not subject to income tax until withdrawn from the plan.

6. Forms to use To claim the credit use Form 8880, Credit for Qualified Retirement Savings Contributions.

For more information, review IRS Publication 590, Individual Retirement Arrangements (IRAs), Publication 4703, Retirement Savings Contributions Credit, and Form 8880. Publications and forms can be downloaded at www.irs.gov or ordered by calling 800-TAX-FORM (800-829-3676).


Links:
•Form 8880, Credit for Qualified Retirement Savings Contributions (PDF 46K)
•Form 1040, U.S. Individual Income Tax Return (PDF 176K)
•Form 1040A, U.S. Individual Income Tax Return (PDF 136K)
•Publication 590, Individual Retirement Arrangements (IRAs) (PDF 449K)
•Tax Topic 610

Have you ever dreamed of watching your own horse race in the Kentucky Derby? Tax Considerations of the Equine Industry by Carolyn Flaherty

Owning a race horse can be a thrilling and potentially lucrative investment. However, the initial purchase of a horse and subsequent expenses such as boarding, transportation and veterinary care are substantial. Therefore, many equine enthusiasts choose to pool resources and purchase the animals through a partnership or a limited liability company (LLC). Hence, the cost to each individual is reduced while still enabling the experience of owning a race horse.

Ownership as a partner or LLC member may allow an investment in a higher quality animal than you could otherwise afford or perhaps allow the purchae of multiple horses and hence spread the risk therefore minimizing the impact of potential financial and emotional disappointments. If a management company is involved, you will gain access to effective professional management of the venture.

However you choose to own your race horse: there are also potential tax advantages to your investment.

Returns on your investment will be derived from race earnings, potential breeding fees or syndication of stud fees and perhaps upon the ultimate sale of your horse. Race horses are generally depreciated over a three year period. Therefore, significant depreciation, losses and expenses are available to offset income of the LLC and perhaps other income of LLC members.

As such, significant tax deductions may inure as a result of the investment. However, there are several issues to consider; specifically the "hobby loss" and "passive loss" rules.

Hobby Loss Provisions: To deduct expenses that exceed income, the taxpayer must demonstrate that they are engaged in horse-related activity with the intention of producing a profit. Initially, the burden of proof falls upon the taxpayer. However, if a profit can be shown in two of seven consecutive years beginning with the first loss year, the burden shifts to the IRS to disprove the "general presumption of profit intent."

The IRS cites these factors in determining whether an activity is a hobby or business as follows:

1. THE MANNER IN WHICH THE TAXPAYER CARRIES ON THE ACTIVITY: Sound business practices, a business plan and modifying methods of carrying on the operation when it has been unsuccesful support the existance of a business.

2. THE EXPERTISE OF THE TAXPAYER OR HIS ADVISORS: The taxpayer's industry expertise or an effort to learn how to successfully manage in the equine industry will support a business objective.

3. THE TIME AND EFFORT EXPENDED BY THE TAXPAYER IN CARRYING ON THE ACTIVITY: This factor considers the time devoted to the horse activity, either in planning, supervising or in performing labor. If substantial time is not devoted by the taxpayer but he employs qualified people, the lack of time he spends will not necessarily indicate a hobby.

4. EXPECTATION THAT THE ASSETS WILL INCREASE IN VALUE

6. THE TAXPAYER'S HISTORY OF INCOME OR LOSSES IN THIS ACTIVITY

7. THE AMOUNT OF OCCASIONAL PROFITS, IF ANY, WHICH ARE EARNED: The costs of maintaining horses in training are generally greater than the amount of purse monies available. This is tolerable to owners because most have a desire to be a part of the sport and because of the potential for profit.

8. THE FINANCIAL STATUS OF THE TAXPAYER: A lack of substantial income from other sources is favorable in determining that your horse operation is a business. Conversely, a large income from other sources may work against you.

9. ELEMENTS OF PERSONAL PLEASURE OR RECREATION: Personal motives for recreation or pleasure are contrary to assertion of the activity as a business. This does not mean the taxpayer can't enjoy the activity, but motives must include an objective of making profit.

The IRS does not add up the number of positive and negative factors and base its decision on a mathematical result. To the contrary, the courts appear to have placed greater emphasis on some of the factors than they have on others.


"Passive Loss": Under the "passive loss" provision, to offset losses incurred as a result of equine business against other ordinary income, an owner must be able to prove that they materially participate in the activity. A taxpayer materially participates in an activity if he or she works on a regular, continuous and substantial basis in equine operations.

A taxpayer is required to identify the amount of his or her participation in a trade or business activity for each year. The type and quantity of time documented determines whether an activity should be treated by the taxpayer as passive or non-passive. A taxpayer can have a significant financial interest in a business, and yet not materially participate.

Material participation is a year by year determination. Consequently, it is conceivable that a taxpayer could be passive in one year and materially participating in the subsequent year. If an activity is considered passive, its losses can only be deducted to the extent of passive income.

Note that the ultimate sale of the investment will trigger the deductibility of all past losses disallowed.

Therefore, even if you own your race horse as part of a group and the venture is intended to be profitable, operated in a business-like manner and has sufficient expertise and resources: each taxpayer must consider their own unique position when determining the tax treatment of their investment.