At every stage of a divorce case, particularly when writing a marital settlement agreement, there is an opportunity to deal effectively with tax consequences and avoid tax traps. In my book, Frumkes & Vertz on Divorce Taxation, we provide sample tax clauses that can be included in a marital settlement agreement. These clauses will help to anticipate and control tax ramifications to avoid unintended consequences in routine and complex divorce cases.
- Deciding whether to file jointly
When married people are separated, they have an option to file their income tax returns separately or jointly. Joint filing offers the lowest tax rates, and allows them to pool their deductions, but may expose a spouse to audit risk and penalties if the other spouse takes deductions that are disallowed or fails to report income. In a marital settlement agreement, divorcing spouses may decide whether to file their final returns as married couple jointly or not.
- Allocating the risk of joint and several tax liability
When divorcing spouses file joint tax returns, each of them is legally liable for the entire tax liability, regardless of who earned the taxable income. So, in a marital settlement agreement, they might want an indemnification clause that will allocate the risk. The indemnification clause does not tie the hands of the IRS, but it opens the door for a divorce court to fashion remedies if an innocent spouse is held liable by the IRS.
- Splitting up the refund or tax liability
The Tax Code contains default rules that apply to some situations, but leaves loopholes that can be closed with an effective marital settlement agreement. When divorcing spouses settle their financial affairs, they should not forget to decide on how to split up a tax refund from a joint return or who will pay any tax due.
- Choosing which parent will claim the children
When parents get divorced, they might want to decide which parent will get the most benefit from tax deductions associated with children, such as the dependency exemption. This may also tie into the filing status, such as head of household, which has more favorable tax brackets. A marital settlement agreement can determine which parent will claim the children.
- Designating payments as deductible (or non-deductible) alimony
Most divorcing spouses know that alimony can be tax-deductible. But there are some situations where it is more advantageous to have a non-deductible alimony payment, especially if it is front-loaded or tied to a child-related event. In a marital settlement agreement, parents can designate alimony as tax-deductible or non-deductible.
- Avoiding alimony front-loading penalties
Alimony that terminates or reduces sharply in the first two years can be a tax trap for the unwary. This trap can be triggered unintentionally. For instance, if an alimony payor is excused from the alimony obligation due to disability in the first two post-separation years, the recapture tax penalty might apply. A marital settlement agreement should contain a clause that anticipates this contingency and authorizes the divorce court to fashion an appropriate remedy.
The provision of a marital settlement agreement intended to allocate tax liability was upheld by the U.S. Tax Court in Estate of Goldman v. Comm’r., 112 T.C. 317 (1999). There, a taxpayer and spouse entered into a marital settlement agreement providing for 10 years of monthly payments of $20,000 per month (a princely sum for 1984). The agreement contained a clause designating the monthly payments as transfers of property under I.R.C. § 1041, and also a waiver of the spouse’s right to receive alimony. So, the payor took alimony deductions for the first few years.
Fortunately, the marital settlement agreement also contained an indemnification clause. So, when the Tax Court rules that the agreement designated the payments as non-deductible, the spouse was not liable for additional taxes, interest, penalties or legal fees.
Tax consequences are pervasive in family law, so it is critical to consider tax clauses when drafting a marital settlement agreement. These clauses and many others are covered in Appendix 14 of my book.
For family law help in Western Pennsylvania, call Brian Vertz. For more than 25 years, he has crafted effective marital settlement agreements for business owners, entrepreneurs, pro athletes, executives and professionals. In Pittsburgh and Western Pennsylvania, call Brian at 412-471-9000.