The Divorce Tax
Legal Tax Angles:
How to Save Taxes Without Going to Jail
Whenever writers bring up the subject of divorce for any reason, they feel obligated to point out that one of every two marriages ends up in divorce. That’s not exactly correct, because the statistics only show that for every two new marriages there is one divorce. Meanwhile, there is a large “pool” of married folks who are not included in the statistic.
Nonetheless, there are a lot of broken marriages and in many cases, divorce is usually beneficial to the tax collector. Bear in mind that two single people with equal incomes will pay less taxes than a married couple with the same total income. One would think that a divorced couple would therefore pay less taxes after they are divorced. This is often not the case. It’s what I call the “Divorce Tax”. It’s the extra tax that results from an acrimonious divorce settlement and from lawyers who are more concerned about “winning” a contest than about beating the IRS.
In a divorce, there are substantial tax issues that affect each party depending on the terms of the agreement and the specific property that is distributed to each spouse. Let me give an example of a typical settlement with extremely bad tax results.
John has been unfaithful and Joan is furious to the point of being incoherent. John is feeling great guilt and remorse and isn’t resisting any demands by Joan’s lawyer. So, Joan gets half the assets consisting of cash, bonds, some recently purchased stocks and the home. Joan also gets a large child support payment (for fifteen years) with a smaller alimony amount. John agrees to pay for the college expenses of their two children. There was no agreement for them to share the dependent’s exemptions. John gets to keep his pension plan and the stock in his consulting business. He then has to move to an apartment.
In case you didn’t know, child support is not taxable to the recipient spouse and is not deductible by the paying spouse. Joan will get the dependent deductions and will qualify for the head-of-household filing status. John will have file as a single taxpayer.
If the the money used to pay for college is first paid to Joan, Joan would be able to use that money to get some tax breaks from a variety of tax incentives for college expenses. Even if John paid for the college expenses directly, few tax breaks would be available because the children are not his dependents.
The assets that Joan got in the settlement have a high tax basis (cost) and would not generate much taxable income when they are sold. . She also has the house which is a source of substantial tax deductions and can be sold for a tax free gain.
John has assets that will generate a lot of taxes when they are sold. He has few deductions, other than the alimony. The result is that John has most of the income and very few deductions. Joan has most of the tax deductions and very little taxable income, except for the alimony. The IRS is the big winner in this divorce. Joan, John and the children are the losers.
If the divorce would have been arranged differently, there would have been less taxes to pay and more money to share. That could have been accomplished with a different alimony and child support arrangement, with different arrangements for the dependents exemptions and with a different allocation of the assets. The ideal arrangement would provide most of the tax breaks to John to offset his high income. The loss to Joan could be easily made up with larger alimony payments or larger allocations of the assets. However, beating the divorce tax requires advance tax planning during the divorce; not afterwards.
Vern Jacobs
Copyright, 2003
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by Vern Jacobs
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