Tax season can be stressful under ordinary circumstances. When spouses are separated or going through a divorce, preparing a tax return can become considerably more complicated.
The spouses may need to determine whether they will file jointly or separately, who may claim the children, how a refund or tax liability will be divided, and what records each person needs. Decisions made in the divorce can also produce tax consequences that may not become apparent until years later.
A collaborative divorce can give spouses an organized setting in which to identify these issues before someone files a return or signs a settlement agreement.
Marital Status at the End of the Year Matters
For federal income-tax purposes, filing status generally depends on whether the spouses are considered married or unmarried on the final day of the tax year. The IRS generally considers spouses married until they receive a final decree of divorce or separate maintenance.
Consequently, spouses who are still married on December 31 may have the option of filing jointly or separately. Someone whose divorce was finalized before the end of the year ordinarily files as single unless that person qualifies for another status, such as head of household.
The IRS provides additional information about filing taxes after a divorce or separation. Because filing status can affect tax rates, deductions, credits, and eligibility requirements, spouses should avoid assuming that one option is automatically better.
Should the Spouses File Jointly or Separately?
A joint return may produce a better overall tax result in some cases. However, filing jointly can also create joint responsibility for the accuracy of the return and the taxes owed.
Before agreeing to file jointly, both spouses should have access to the relevant income records, deductions, business information, and prior returns. Transparency is especially important when one spouse operates a business, receives irregular compensation, or traditionally handled the family’s finances.
The collaborative team may ask a tax professional to calculate the likely results of filing jointly and separately. If the spouses decide to file jointly, their written agreement can address:
- Who will prepare the return;
- When each spouse must provide tax documents;
- Whether both spouses may communicate with the preparer;
- How any refund will be divided;
- How any amount owed will be paid;
- Who will respond if the return is audited; and
- How interest, penalties, or later adjustments will be allocated.
An agreement between spouses may allocate responsibility between them, but it does not necessarily prevent a taxing authority from pursuing someone who signed a joint return. Each spouse should understand that distinction before signing.
Who Will Claim the Children?
Parents sometimes believe they can simply alternate the children as dependents from year to year. The actual tax rules are more complicated.
The ability to claim a child can affect the child tax credit and other tax benefits. However, the rules governing dependency claims, head-of-household status, and childcare-related benefits are not necessarily interchangeable. A provision giving one parent the right to claim a child may not transfer every tax benefit associated with that child.
The IRS explains some of these distinctions in Publication 504 for divorced or separated individuals. In appropriate circumstances, a custodial parent may also need to execute IRS Form 8332 to release a claim to a child.
A collaborative parenting agreement can address which parent may claim each child, whether the parents will alternate years, what conditions must be satisfied, and when any required tax form must be provided. A qualified tax professional should review the proposed language before the agreement is finalized.
The Family Home Can Carry a Hidden Tax Consequence
A house cannot be evaluated solely by looking at its current market value and mortgage balance. Its tax basis and potential capital gain can also matter.
If one spouse retains the residence and later sells it, that spouse may face a tax consequence that was not obvious when the divorce agreement was signed. Records showing the original purchase price, capital improvements, prior use of the property, and selling expenses may become important.
The IRS discusses these considerations in Publication 523, Selling Your Home. Spouses should investigate the potential tax consequences before deciding whether to sell the home, transfer it to one spouse, or continue owning it together temporarily.
Equal Values May Not Produce Equal Results
Two assets with the same stated value are not always economically equal.
For example, cash generally does not carry the same future tax consequences as a traditional retirement account. Likewise, appreciated investments may carry built-in capital gains, while another asset of equal market value may have little or no taxable gain.
Property transferred between spouses as part of a divorce may retain its existing tax basis. The spouse receiving the property could therefore receive both the asset and its unrealized tax obligation. The IRS provides more information about basis in Publication 551.
This is one reason a financial neutral can be helpful in a collaborative divorce. The neutral can help organize information and illustrate the potential after-tax effect of different settlement options. This may be particularly valuable in a high-asset collaborative divorce.
Past Returns and Current Payments Should Be Reviewed
Tax planning should not be limited to the return currently coming due. The spouses may also need to review:
- Previously filed joint returns;
- Unfiled or amended returns;
- Tax liens, payment plans, or outstanding liabilities;
- Estimated tax payments already made;
- Business and payroll tax obligations;
- Refunds applied to an earlier debt;
- Tax-loss carryforwards; and
- Changes needed to payroll withholding.
The IRS Tax Withholding Estimator may help individuals determine whether their withholding should be adjusted after a change in marital status or household finances.
Clients should begin gathering these materials early. An existing article explains what documents to provide to a collaborative divorce lawyer.
Address Tax Questions Before Signing the Settlement
A divorce lawyer can identify provisions that may have tax implications, but lawyers do not replace qualified tax professionals. Depending on the complexity of the case, the spouses may need assistance from a certified public accountant, tax attorney, financial neutral, or other appropriate professional.
The collaborative process allows these questions to be examined before the divorce is finalized. That can be far more productive than discovering an unexpected tax bill after the settlement has already been signed.
Every divorce and tax situation is different. Individuals should obtain legal and tax advice based on their particular circumstances.
If you are considering resolving your divorce outside of court, Stange Law Firm, PC can help. You can contact our collaborative divorce lawyers online or call 855-805-0595 to schedule a confidential consultation.
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