Tax law does not interact with family law in a unified manner. It is a separate area of law, and is quite broad. There are federal and state tax codes, and numerous other regulations and procedures from regulatory agencies responsible for enforcing portions of these laws. The issue of how the tax law interacts with family law is difficult to summarize: the tax laws can interact in different cases in different ways. Ultimately, the best advice, if you have concerns about tax issues, is consult with a tax expert.
There are a number of areas in divorce and family law where tax issues come up regularly. If you’re going through a divorce, these are some of the issues you should keep in mind.
Taxes and Spousal Support
Spousal support contains several tax issues. First, spousal support is generally considered taxable income to the recipient spouse, and is deductible for the paying spouse. In contrast to most deductions, spousal support is considered a reduction to gross income, not an itemized deduction. This means spousal support deductions are not subject to some of the common limitations to personal deductions, and can have a greater-than-anticipated effect on reducing the payor spouse’s tax obligations for the year.
This isn’t always the case, though. Spouses can choose to designate spousal support as either non-taxable, non-deductible, or both. To do so, however, spouses must actually be receiving some sort of money payment. If, for example, spouses decide to do away with a monthly spousal support and have a one-time up-front, lump-sum payment, and satisfy the payment with a transfer of property, this is no longer considered spousal support, it is no longer taxable income, and it is no longer deductible on federal or state income taxes.
Additionally, voluntary spousal support is not deductible or taxable. For spousal support to be deductible or taxable, there must be a “divorce or separation instrument.” This means that there must be a written document, such as an order, a judgment, or an agreement between the spouses. An informal or verbal agreement is not enough.
There is no automatic right to spousal support after the date of separation: One spouse has to request it from the other, either directly as part of an agreement, or through the court, by filing a motion. This means a document that purports to contain a spousal support obligation but that is actually legally-unenforceable will not entitle anyone to a write-off or require anyone to report taxable income. It’s easier to simply obtain a legally binding divorce or separation instrument, such as an order or a stipulated agreement, so that you can be sure of the tax treatment of any support payments.
Spouses cannot live in the same house if they want to either claim support payments as deductible from their income, or report support payments as taxable income. Spouses must actually be living in different households in order to either deduct the support payments from income or include support payments as income. Note that this is not the same standard for “separation” required in a divorce case. In a divorce case, “separation” means that at least one spouse has the intent to separate from the other spouse or seek a divorce, and acts in a manner consistent with that intent.
Some support payments also may be recaptured and then must be reported as income by the paying spouse. In other words, the spouse paying spousal support may have to report some of the support payments as income. This usually occurs when support payments from the first three years of support are significantly different from the support payments in later years. If support for the first year is greater than $15,000 of the average of the support paid in the second and third years, then the paying spouse must declare the amount paid in excess of the amount as income in the third year. Similarly, if support in the second or third year is more than $15,000 greater than the other, then the paying spouse must declare the amount paid in excess of the amount as income in the third year.
An example using actual numbers can help demonstrate this. Assume that John and Jane separate, and John pays Jane $50,000 in support for the first year, $20,000 for the second year, and $4,500 for the third year. If John pays less than an average of $35,000 to Jane over years two and three, he has to declare the difference between $35,000 and what he actually paid as his own income, and he cannot take a deduction for the amounts he actually paid in spousal support. The average support John paid in the second and third years is $12,250 ($24,500 divided by 2). John must declare $22,750 ($35,000 minus $12,250) as income on his tax returns for the third year, and cannot reduce his gross income by that amount.
Taxes and Child Support
Child support is neither taxable as income, nor deductible from income. However, courts will sometimes order “family support,” which combines both child support and spousal support into one payment. Family support is deductible and taxable, provided that no part of it is allocated specifically as child support, and provided that the payments comply with the other requirements necessary for spousal support to qualify as deductible or taxable. If some part of the family support amount is allocated as child support, that portion is neither taxable as income, nor deductible from income.
Changing the status or the name of the payments themselves isn’t enough to avoid child support’s non-taxable, non-deductible status. Payments made or modified based on significant events in a child’s life will be considered too closely associated with child support to be non-taxable or non-deductible. For example, suppose the parties have a stipulated agreement for spousal support which includes terms reducing the monthly payments for spousal support by $500 for each child who becomes married, or reaches the age of 18 and is no longer in high school. A court would likely hold that spousal support on these terms is just disguised child support, and as such, it would not be taxable or deductible.
This doesn’t mean that support orders that contemplate a recipient’s need to support children is invalid. It just means that the ability to deduct those support payments from income might be affected.
Taxes and Dependents
Parents generally may claim their children as dependents for tax purposes. To qualify as a dependent, a parent must provide over half of a child’s “support” for the year. This includes things like food, clothing, medical expenses, and education costs. Only one parent can claim children as dependents at a time. If both parents claim the same child as a dependant, you may trigger a tax audit by the IRS or FTB.
Which parent is entitled to claim the child as a dependent is frequently negotiated in divorces. There are a range of possibilities the parents can agree to with respect to who gets to claim the child as a dependent. For example, the parents can agree that the custodial parent will claim the children as dependents. The parents can also agree that the support-paying parent can claim the children as dependents. The parents can also agree to claiming the children as dependents every other year, so that each parent gets the tax benefit in alternating years.
The default rule is that the custodial parent is the one who is entitled to claim the child as a dependent. For tax purposes, the custodial parent isn’t quite the same thing as who the child spends the most time with. Instead, it’s the parent whose house the child sleeps at the majority of the time. If you and the other parent are interested in deviating from that rule, you may agree to do so. The custodial parent should sign a written declaration stating that they are shifting the deduction to the other parent. It’s also important to note that marital settlement agreements or judgments of dissolution are not sufficient, by themselves, to shift the deduction. The declaration the custodial parent signs must have the sole purpose of shifting the exemption to a noncustodial parent.
Child Care Credits
Parents with dependent children under the age of 13 usually can claim a credit for taxes paid on expenses for child care, when the child care was specifically to allow the parent to work. However, this changes when parents divorce or legally separate. For divorced parents, the custodial parent always claims the child care credit, if they qualify. It cannot be transferred, like the ability to claim the child as a dependent. Even if the noncustodial parent is claiming the children as a dependent, the noncustodial parent can’t take the child care credit. If the noncustodial parent is claiming the children as dependents, and the custodial parent has no expenses that qualify for the child care credit, then it simply can’t be claimed by either parent.
Taxes and Property Division
Generally, when property is sold or transferred, it may result in a capital gains tax on the gain in the value of the property. An example would be if someone purchased a house for $100,000, and years later sold it for $500,000. The person may have to pay a capital gains tax on the increase in value of $400,000. Divisions of community and quasi-community property, however, are not recognized tax events. They don’t generate gains or losses for either party, because there is no transfer or sale as recognized in the various tax codes. Transfers between spouses are generally exempt from capital gains taxes. This is true even if an otherwise inequitable division of property is offset by an equalizing payment. Therefore, in most cases, recently-divorced spouses will not have a large tax bill after their divorce resulting from the divorce property division.
Federal law typically applies a tax to transfers of property for less than full value, once a person has given away a certain amount in gifts. The threshold value changes from time to time and from circumstance to circumstance. It isn’t a concern in most marriages or divorces. While married, the gift tax applies to interspousal transfers of property above $5,490 per tax year. However, spouses have an unlimited gift tax deduction between themselves, which means that there is no tax on gifts between spouses, even when those gifts exceed $5,490 in a given year.
Transfers of property after separation, or as part of a dissolution proceeding, are usually not subject to the gift tax. Federal law prevents gift taxes from being applied to certain types of property transferred between spouses if the spouses entered into a written agreement relating to their marital and property rights, and if divorce occurs within a three year period starting the year before the agreement was entered into. The types of property transfers exempted from gift taxes are: (a) any property transferred in settlement of marital rights; and (b) and and any property transferred between spouses to provide a reasonable allowance for the support of children while the child is still in their minority. In other words, if the spouses have a written agreement relating to the divorce, and then are actually divorced within the next two years, gift taxes won’t apply to any property exchanged related to the divorce, or to provide support for a minor child. As you can probably imagine, that covers almost all possible property in a divorce, and almost all divorces.
Taxes and Attorney’s Fees
Fees and costs connected to family law cases are generally not deductible by either party. They are considered personal expenses. There are some rather broad exemptions, however. First, while legal expenses from a family law case that involves business interests generally are not deductible, when the origin of the claim is a “profit-seeking” one, those expenses can be deductible. This is a developing area of law, so predicting a specific outcome is difficult. Attorney’s fees in a case that originally existed as a pure business dispute, and just happened to have a family law matter included, might be deductible. In contrast, attorney’s fees in a case that is primarily a divorce or family law case, and just happens to include some financial disputes, will likely not be deductable.
Second, the spouses are allowed to claim a deduction on family law expenses when legal fees are generated related to producing or collecting income. That deduction applies on all legal fees that are over two percent of a spouse’s adjusted gross income. Income is a relatively broad term, and can include things like spousal support, or an interest in the other spouse’s retirement account.
Taxes and Retirement accounts
Retirement accounts are typically funded from pre-tax income, and generally remain untaxed so long as funds from retirements accounts are not withdrawn or distributed. However, in divorce cases, a spouse who receives an interest in the other spouse’s retirement account as part of the divorce process can receive a lump-sum payment without incurring penalties, regardless of the other spouse’s eligibility for the same. Spouses can also avoid immediate taxes on such a payment by immediately depositing the funds in an IRA.
Retirements are typically split by a document called a QDRO, or qualified domestic relations order. QDROs have exacting requirements, which must be completely fulfilled. While it’s possible, from a tax perspective, to receive a distribution from a retirement account without a QDRO being in effect before the distribution, any distribution of funds from one spouse’s retirement account to another spouse’s IRA must comply with QDRO requirements. If not, the distribution is immediately taxable.
It’s also important that a distribution transfer from a retirement account be directly deposited into an IRA. If a spouse were to physically receive a distribution, and then attempt to deposit the funds into an IRA, the distribution would be subject to a 20% withholding tax. Tax liability can also occur if the receiving spouse attempts to deposit the distribution into something other than an IRA. In contrast, when one spouse is transferring an interest in an IRA to the other spouse, the transfer is not taxable.
The current tax codes are dense, expansive, and unintuitive. They interact with family law cases in a number of different areas, and can radically impact the finances of parties after separation. If you’re involved in a divorce or family law case, and you or the other party have a large number of assets, consulting with an attorney and possibly a tax specialist is encouraged.