Whenever money is being transferred there is a possibility of taxes. Perhaps there is no bigger transfer than the transfer of assets and income during divorce. Therefore, taxes and divorce must be considered together when negotiating and finalizing a dissolution of marriage.
Tax Implications of Transferring Property In Divorce
Any transfer of property pursuant to a settlement of a divorce is not considered either a gift or income for tax purposes. 26 U.S.C. Sec. 1041(a)(2). That transfer has to happen within three years of the divorce however to remain untaxable. 26 U.S.C. Sec. 2516.
This means it is usually in the parties’ interests to transfer property in lieu of some other taxable transfer like alimony or maintenance (see below).
Taxes Owed After Divorce
If either or both of the members of the divorcing couple owe taxes, that tax debt is a marital debt and is therefore divisible in the divorce.
A good divorce lawyer will recognize that tax debt is not like other debts. For most debts, It can be irrelevant as to who is responsible for what debt in a divorce if the parties don’t have significant non-house or 401k assets. Either party can just file for bankruptcy and discharge the debt. Tax debt cannot be discharged in a bankruptcy so it definitely has to be allocated to one of the parties. Therefore, it has to be paid back.
Tax debt, however, can be negotiated through settling with the IRS via an Offer-In-Compromise. The final tax debt owed can be paid after negotiation by as little as 10% of the previous debt depending on the circumstances. If one party believes they can adequately negotiate this debt, they may try to take responsibility for it in exchange for more assets or less of another liability.
More frequently, tax debt is accrued over years of both parties having filed joint tax returns and therefore, both parties must be required in their Marital Settlement Agreement to cooperate with reducing the outstanding tax debt through a joint Offer-In-Compromise.
Tax Refunds And Divorce
Sometimes, after filing taxes the government will owe you money. If so, that money is marital and thus divisible in an Illinois divorce.
“[T]he Federal income tax refund, based upon income earned during the time the parties were married, is marital property subject to division…The refund represented a return by the Federal government of marital property to the parties. The fact that the refund was not received until after the marriage was dissolved does not change or detract from its characterization as marital property. The respective interests of the parties in the refund could have been divided according to the agreement of the parties, or can be determined by the court in the absence of agreement of the parties.” In Re Marriage of Ormiston, 523 N.E.2d 148 (Ill. App. Ct. 1988)
Filing Previous Tax Returns Together In Divorce
If you have been married for the entire year, January 1 through December 31, you have the right to file either jointly or separately with your spouse.
It is almost always more tax effective for the parties as a whole to file jointly because the lower top marginal rate is less for two people if they have different incomes.
The fairest way to divide marital tax debt in a divorce is to do so proportionally. Proportional division of marital tax debt can have your Martial Settlement Agreement include language such as this:
“if the parties file joint income tax returns each party shall pay his or her proportionate share of all income taxes. The proportionate share of each party shall be an amount bearing the same ration to the total joint tax liability for the period covered by the return that (1) the amount of income tax for which each party would have been liable, if the party had filed a separate return for the period reporting the items of income, deduction, gain, loss, credit, etc bears to (2) the total of the amount for which both parties would have been liable if both had filed separate returns during that period.”
In summary the equation ends up being (single filer # 1’s tax obligation) / (total of the two single filer’s tax obligation) X (joint filers tax obligation)
For example, if Spouse 1 owed $ 50,000 if she filed separately and Spouse 2 owed $ 30,000 if he filed separately but if they filed together they would owe $ 70,000. Then Spouse 1 would owe (($50,000/$80,000) X $ 70,000) = $ 43,750. The other Spouse would owe the balance, $ 26,500. Both amounts owed would be less than filing separately but would reflect their proportional separate obligations.
Alimony and Taxes
Before January 2019, the person who received the alimony had to declare that alimony as income on their taxes. Meanwhile, the person that paid alimony could declare that alimony to as deductible against their income.
The IRS noticed that a lot more payors were deducting alimony than alimony receivers were declaring alimony as income. In an effort to rectify this anomaly, the deductibility of alimony as income for tax purposes was reversed.
Now, for all divorces or separation agreements entered after January 1, 2019 the tax payor must pay the taxes on the alimony. This can make alimony extremely expensive for the tax payor under certain jurisdictions like Illinois that mandate a guidelines alimony payment of 33% of the payor’s income less 25% of the receiver’s income. For an alimony receiver who does not work, the alimony payor could be paying over 40% of his or her income for alimony after taxes.
Because of this massive additional tax burden, a good divorce lawyer may wish to negotiate maintaining the status quo in the final Marital Settlement Agreement with language such as this:
“Alimony Payments. At any time or times that alimony is payable under this Agreement and such alimony is not deductible to the payor under the Internal Revenue Code and not includible in the payee’s gross income under the Internal Revenue Code, then such alimony payments shall be reduced by the average tax rate of the Parties, as determined using the average marginal tax rate of both parties fo the year immediately preceding the year of payment.” Florida Bar Tax Section CLE, May 23, 2018
Divorces that were entered before January 2019 shall have the alimony taxable to the receiver and deductible to the payor no matter how many modifications of maintenance are made. Again, language can be included in an order for modification that makes the payments effectively tax neutral.
Child Support and Taxes
“The court shall compute the basic child support obligation by taking the following steps:(A) determine each parent’s monthly net income” 750 ILCS 5/505(A)(1.5)
““[N]et income” means gross income minus either the standardized tax amount” 750 ILCS 5050(a)(3)(B)
Getting to the net income amount is based on the above formula NOT whatever an accountant put on a tax return.
“[I]n determining appropriate child support, we are not bound by the technicalities of federal income tax law.” In re Marriage of Ackerley, 333 Ill. App. 3d 382, 392 (Ill. App. Ct. 2002)
Taxes and 401ks and other tax-deferred retirement accounts
If you withdraw money from your retirement account before the age of 59 ½ you will have to pay a tax penalty.
When 401ks or other tax-deferred retirement accounts are divided in a divorce the money is not withdrawn. The 401k is instead divided via a Qualified Domestic Relations Order (QDRO) so as to create two 401k accounts, one in each party’s name. The amount of money in each QDRO divided 401k will be determined by the Marital Settlement Agreements’ details.
The two 401ks will therefore still exist as tax-deferred retirement accounts with no tax penalty due to divorce unless either party withdraws from their respective 401k before they turn 59 ½, respectively.
If you’d like to learn more about the tax implications of your divorce, contact my Chicago, Illinois law office today to speak with an experienced Chicago divorce lawyer.