Income Tax Considerations in Divorce
by Jerri L. Hammer and Janet E. Stigent-Burns
General Filing Considerations for Community Property Spouses
Governing Rules. Federal tax law respects the characterization of property and income under relevant state law. As such, the Texas Family Code is a necessary tool in the characterizing process. Federal tax law also acknowledges that marital agreements can serve to modify characterization. The validity of such agreements may serve to affect the tax reporting of transactions by the parties.
Below are some general rules regarding tax effects of divorce. There are many more, and care must be taken in analyzing the tax implications of divorce.
Modification of Community Property Law Application. The IRS has indicated that if certain conditions are met, the general rules for reporting one-half of all community property activity will not apply if:
- The spouses lived apart for the entire year;
- The spouses do not file a joint income tax return;
- Either or both spouses have earned income for the year that is community income; and
- The spouses did not transfer, directly or indirectly, earned income during the year. This does not include child support payments.
The results of this modification are that each spouse reports all of their earned income. Furthermore, each spouse would report one-half of other community income, such as interest, dividends, etc.
Effect of Partition Arrangements on Tax Returns. In both pre-marital and post-marital agreements, earnings can be partitioned to a spouse. This would have the effect of recharacterizing the income so that it does not follow the normal community property reporting rules. Although a martial agreement may be in place, this does not prevent the spouses from filing a joint return. If the partition agreement contains provisions regarding allocation of the tax burden, this provision should be provided to the tax preparer so that proper allocation can be made.
Tax Ramifications of Typical Marital Assets
Marital Residence. Internal Revenue Code section 121 allows for taxpayers to exclude up to $250,000 of gain from the sale of a residence (or up to $500,000 for joint filers) if certain requirements are met. Generally a taxpayer must meet an ownership and use test:
- The taxpayer must have owned the residence for at least 2 years; and
- The taxpayer has lived in the home as their primary residence for at least 2 years out of the last 5 years.
If the anticipated gain from the sale of the residence is expected to exceed $250,000, care should be taken in considering whether the house is awarded to one spouse or jointly for the selling process.
Retirement Funds—Early Distributions. Generally there is a 10 percent penalty for early withdrawal of retirement funds before the age of 59½. However, there is a specific exception for distributions from qualified plans if required by a divorce decree or separation agreement.
Property Held Within Entities
Partnerships. Because partnerships are “a pass-through entity” distributions may or may not be taxable events. In a divorce context, it may be possible to distribute partnership assets with no tax effect and thereby assist in the division of the marital estate. Assets distributed from partnerships will generally have a carryover tax basis to the partner receiving the distribution.
S Corporations. S Corporations are also “pass-through entities” with transactions characterized similar to partnerships. However, distributions of property from S Corporations can produce very different results. In most situations, distributions of appreciated property will be treated as if the S Corporation sold the asset for fair market value thereby causing gain to be recognized.
Net operating losses are created when individual or business expenses exceed income. Generally net operating losses were allowed to be carried back 2 years and forward 20 years.
If individuals or businesses have net operating losses that have not been carried back to obtain a tax refund, then this asset should be considered in the overall division of marital assets. Additional tax attributes include capital loss carryover, passive loss carryover, at risk loss carryover, charitable contribution carryover, investment interest carryover, and AMT credit carryover.
Planning Considerations for Allocation of Tax Attributes
The Family Code allows partitioning of income (including retroactive allocations) in the year of divorce. This can provide for optimum tax planning and the ability to recharacterize income to be reported only by one spouse. In addition, it may eliminate the exchange of tax information for the year of divorce. The “value” of tax attributes can be considered in the overall division of the marital estate. Lastly, if various tax attributes can be traced to separate assets or funds, they may be allocated entirely to one spouse.