Tax Considerations in a Divorce

By Douglas M. Newton, CFA

Divorce most often involves dividing marital assets. Generally, splitting ownership of assets has no immediate federal or Pennsylvania tax consequences. Taxes are still an important issue however, because the ultimate owner of appreciated assets will eventually owe taxes when the assets are sold.

The party receiving the majority of the assets in cash may have a distinct advantage over the party receiving assets other than cash.

Particular care should be taken if your ex-spouse is to receive a share of retirement account money. Inappropriate disbursements or transfers will have ugly tax consequences. Another problem area is dividing stock options; they become taxable, according to the IRS, if "in the money" options are transferred to the other party.

Another major issue for separated or recently divorced individuals is whether to file joint or separate returns.

Marital standing at year- end determines filing status for the entire year. Married filing separate filers are usually treated very unfavorably under the tax code, so filing jointly with an agreement on splitting refunds, or paying additional taxes is a wise move. Either party may also be eligible for head of household filing status while still married. The greatest advantage of filing a separate return is that the IRS can only hold the party responsible for unpaid taxes liable. This can happen if one party failed to report income, overstated deductions, or skipped required tax payments. Relief for the "innocent spouse" does exist, but as with all tax issues, must be proven to IRS satisfaction.

There is a huge difference between alimony payments and child support.

Child support payments are tax free to the ex-spouse receiving them and nondeductible to the ex-spouse paying them. Alimony, in contrast, is includable in taxable income to the ex-spouse receiving it, while the payer gets the deduction. The tax trap to avoid is to structure the alimony so that it will not be considered child support or part of the marital settlement. There also may be an opportunity to favorably equalize tax brackets through the use of alimony. Which parent takes the children as dependents and takes the dependency exemption ($2,900 in 2001), child credit, (worth $600) a possible day care credit, and future educational tax credits should be carefully considered. This may also determine filing status between single and the more favorable head of household. In the absence of agreement, the dependency exemption goes to the parent with whom the children reside more than fifty percent of the time during the year. Like any major financial transaction, divorce has serious tax implications and proper planning is essential. All aspects of divorce taxation should be covered, including all the tax saving options available to the parties getting divorced. This is a service often ignored in a typical divorce.


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