Identifying the Tax Consequences of Divorce Part 3
6. My spouse was awarded some of my vested stock options in our divorce. Who pays taxes on what and when?
The transfer of an interest in vested stock options incident to a divorce is not a taxable event. However, income is reported when the former spouse exercises the stock options. The specific issue of what taxes must be paid upon the exercising of an option is discussed later in further detail along with other capital gains and appreciated assets concerns.
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
7. What about retirement accounts? What?s the best way to transfer funds from them incident to divorce?
Retirement accounts are an important to know exception to the tax-free transfer rule established in Section 1041 of the Internal Revenue Code. The best way to handle the transfer of funds from retirement accounts incident to divorce is to use a Qualified Domestic Relations Order (QDRO). This vehicle allows the distribution of the marital asset without damaging the integrity of the plan or the creation of a taxable event. A QDRO is a useful tool to designate a portion of a qualified retirement plan, and the associated taxes, to the other spouse. Benefits are taxed when distributions are made, not when the QDRO is established.
Failing to use a QDRO can result in the following situation: Spouse A receives a distribution from their portion of Spouse B?s retirement account, but since there?s no QDRO in place Spouse B is assessed for taxes on the distribution while Spouse A receives the income tax free.
QDRO?s are not required for the transfer of Individual Retirement Accounts (IRA?s). The transfer of an IRA pursuant to a divorce or separation agreement is not a taxable event (26 U.S.C.A.? 408(d)(6)). If such a transfer is anticipated, it is imperative that language requiring such a transfer be included in the divorce agreement. Failing to have such language in the divorce agreement, or the premature transferring of an IRA, can result in the transferring party being assessed taxes as though they received a disbursement (including a 10% penalty for anyone under 59).
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
8. I no longer live with my spouse/family but my name is still on the mortgage on their house. Who gets to claim the mortgage interest and the real estate taxes??
When a couples? ?family home? (for IRS purposes) is jointly owned and the mortgage interest and real estate taxes are paid from a joint account there is a presumption that these payments are attributed to each party on a 50/50 basis. If the mortgage is paid by one spouse to help the other, it is sometimes called an ?equalization payment?, and under IRS 1041 there are no tax consequences.
It gets more complicated when a home is jointly owned and these payments are paid directly by the non-occupant spouse. Half of the mortgage interest and real estate taxes is deductible to the paying spouse as an itemized deduction and the remainder qualifies as spousal maintenance (IRS alimony). The occupying spouse must report these amounts as income but is able to deduct the interest and taxes as an itemized deduction.
If the home is owned only by the occupying spouse but the non-occupying spouse is still obligated on the mortgage, the non-occupying spouse can only deduct the mortgage interest if a minor child of the marriage resides in the home. The non-occupying spouse cannot deduct any of the real estate taxes, since he or she has no ownership in the property.
Alternatively, if the non-occupying spouse solely owns the house and pays the mortgage interest and real estate taxes then those amounts can be deducted in their entirety as an itemized deduction. The occupying spouse would not have to report these amounts as spousal maintenance (IRS alimony).
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
9. Innocent Spouse Relief
Many individuals intentionally cheat on their taxes, and many more make mistakes in their interpretations of the tax code or the production of their returns. In the event that one spouse engages in improper behavior resulting in nonpayment or underpayment of taxes on joint tax returns, the other spouse may qualify for relief as an ?innocent spouse?.
There are three major types of innocent spouse relief, one of which is specific to
divorcing couples:
1.? Innocent Spouse Relief (IRC ?6015(b):? This traditional innocent spouse relief is available to all joint filers where one spouse had no actual knowledge and no reason to know of a tax deficiency. A request for relief must be filed within two years of the first collection activity taken by the IRS.
2.? Separation of liability relief (IRC ?6015(c): This relief is available only to those who are divorced or separated for at least 12 months before applying for relief.? The return must have been jointly filed, and the spouse must have had no knowledge of the incorrect item(s) on the tax return. The burden of proving actual knowledge is placed on the IRS.? This form of relief is typically easier to obtain and allocates liability for the tax deficiency among the spouses based on who was responsible for the nonpayment or underpayment.
3.? Equitable relief (IRC ?6015(f): This type of relief is available to spouses who do not qualify under ?6015(b) or ?6015(c). Equitable relief is afforded to filers who are able to prove that it would be unfair to hold them responsible for the nonpayment or underpayment of the taxes.
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How to Make an ?Innocent Spouse? Claim
Those seeking innocent spouse relief can begin the process by filing form 8857 with the IRS. When this form is submitted individuals must submit evidence proving their right to relief.? A divorce is one important piece of evidence that can be used when filing form 8857. Further, while those who are ending a marriage are specifically entitled to relief under IRC ?6015(c), divorcing clients are not restricted to using only this provision of the Internal Revenue code to escape an unfair tax obligation.
The following factors are considered when determining the availability of relief:
- Knowledge,
- Economic hardship,
- Benefit,
- Compliance with tax laws,
- Tax liability attributed to non-requesting spouse,
- Marital status, and
- Spousal abuse
The innocent spouse rule is not only an important rule for protecting spouses from the malfeasances of one another, it also is important to subsequent spouses. Consider this scenario:
Spouses A and B were married for 15 years. Spouse A operated a small business which
spouse B assisted with. Spouse A, primarily in charge of the business, handled all of the
bookkeeping and regularly cheated on the business?s and the couple?s taxes. Spouses A? and B divorced after 15 years, and shortly thereafter spouse B remarried a third party, Spouse C. Soon after B?s marriage to C, the IRS audited and prosecuted Spouses A and B for 15 years of unpaid and fraudulently reported taxes. Spouse B was unable to prove that he/she had been an innocent spouse, and now the community assets of Spouses B and C are able to be seized by the IRS.
Recent Developments
On July 25, 2011 the IRS issued Notice? 2011-70, which made a significant change to the requirements for those seeking innocent spouse relief under (IRC Section 6015(f). In Notice 2011-70, the change made by the IRS is simple: they extended the eligibility period for those seeking equitable relief, lifting the previously enforced two-year limit. Under the new rules established, the IRS will consider equitable relief for:
? Collection of tax debt as long as the collection period on the debt still remains open.????? IRC ?6502 establishes a general 10-year statute of limitations for collection on tax debt, so the deadline is extended for the duration of this 10-year period.
? A refund of tax debt as long as the statute of limitations on credits or refunds has not?? yet expired. IRC ?6511 establishes a general statute of limitations for collecting refunds of the later of three year from the time the return was filed or two years from the time the tax was paid.
It is, however, important to note that these changes provide broader relief only to spouses seeking equitable relief and not to those seeking traditional innocent spouse relief or separation of liability relief
I am not a tax professional and this information is not intended as tax advice. Refer your clients to an independent tax professional in any situation where a client requires tax advice.
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