Tax Traps That Can Arise During Divorce

Let’s be a fly on the wall and look over attorney Alice’s shoulder during her first conference with Mary. Mary is divorcing George and the first words out of her mouth are:

“I’m worried. George has never given me any information about his company so I have been filing my own returns. I don’t think he has been filing.”

It turns out that Mary has taken her W-2 to a tax preparer and filed married filing separately reporting her wages. She has a common problem, which is compounded by the failure of tax preparers to identify the problem. Tax law looks to state law to determine property rights. Absent a premarital agreement, community property and income is split between the two spouses. Under California law, until the date of separation, Mary should be reporting one-half her wages and one-half George’s income.

What to do? First determine whether George has been filing. In all likelihood he hasn’t because he would have taken advantage of the savings from filing jointly if he had. Since community property is liable for the debts of either spouse, George’s tax debt is a lien on their community property. Ideally, you can bring George into compliance and pay the tax. This rarely happens.

To bring George into compliance, he must file overdue returns. The criminal statute for nonfilers is six years. The IRS is usually satisfied if George files his last six years of tax returns. Generally, the statute of limitations to amend a return is three years. There is no statute that requires Mary to amend a return filed in good faith. However, if the IRS turns up the problem from a matching program, the penalties will be higher than if she amends voluntarily. Mary will want to amend as a joint filing if George’s income is less than Mary’s income.

If Mary cannot get George’s tax information, there are ameliorative provisions allowing Mary to estimate George’s income. George can get a transcript of his account at IRS customer service at 185 Lennon Lane in Walnut Creek if he is unsure as to liabilities or how much he earned. Mary cannot get George’s records, but I should think a judge could help in this regard.

“I’ve got George over a barrel. He’s been forging my name to our returns.”

This does not bode well for Mary because if she claims she did not sign the return, she is admitting to not filing a return. The IRS does not show compassion for someone who has not been signing returns and the courts generally find that there is implied authority for George to file the joint return. She will have to keep quiet or plan to file returns reporting one-half the community income.

It is also generally a good idea to avoid involving the IRS in domestic disputes because of the likelihood that the strategy will backfire and Mary will end up in trouble with the IRS or George will have no money to pay alimony. The IRS checks the accuser as well as the accused.

“George and I owe a lot of tax because he never paid his share. I’m an innocent spouse.”

If there are balances owing, the IRS will seek to recover from the spouse who is the easiest collection target. The innocent spouse protection is rather limited. If George and Mary are audited, George is found to have omitted income or taken a deduction erroneously and Mary was not aware of the erroneous item at time of signing the return, Mary can assert the defense against the adjustment as long as she did not benefit from the underreporting of income. It only applies where there has been an audit and George and Mary owe tax. Another provision allows Mary to elect to be responsible for only that amount of an audit adjustment that is due to her income and deductions. There is also relief if Mary signs the return with a balance owing upon the assurance that George will pay the balance and then George fails to pay. Alice will have to make sure that the indemnity provisions in the marital settlement agreement don’t nullify the effects of these provisions.

“George is supporting me hoping we will get back together.”

Good for Mary, bad for George. If George files a separate return, he will not be able to deduct these payments unless there is a Court Order or separation agreement specifying that this is alimony.

“George has offered to give me the house.”

Mary will want to weigh the tax consequences. Mary’s basis in the house will be the amount that she and George paid for it plus any improvements. When she sells the house, she will report all the gain. If the house is foreclosed upon or disposed of in a short sale, Mary will report any gain or loss. If George and Mary both signed the mortgage, the indebtedness is usually a personal liability and each spouse will report one-half the cancellation of indebtedness income. If Mary is insolvent and George is not, she will be able to exclude the income and he will not.

“George has offered to let me live in the house until the children are out of school.”

George will want to make sure that he can use his $250,000 exclusion from gain at time of sale. This requires a court order that the out spouse cannot inhabit the house.

“George is buying me out of the business (and other business transactions).”

George owns a business. Buying out Mary’s interest is fraught with tax issues and tax counsel should be retained at the start of the negotiations. The same can be said for dividing stock options.

“I am thinking about giving the dependency exemption for our son to George in return for more alimony, but I want to file as a head of household.”

Mary can file head of household if she and George are separated for the entire year, the son is living with her for more than half the year and she is paying over half his support, even if George is taking the dependency exemption.

“George and I are expecting a refund this year.”

This is a huge administrative problem. The best solution is often to file separately claiming each spouse’s respective rights in withholding and estimated payments. Otherwise, address the refund in the marital separation agreement as part of the community property for purposes of division.

Oh, the tangled webs we weave.