The Internal Revenue Service defines how individuals file income tax returns based on their marital status as of December 31st. While still married, the individuals can file a Married Filing Joint Return or each individual can file a Married Filing Separate Return. Once divorced, the individuals will file separate returns as Single Individuals.
A divorce finalized in December versus January or vice versa could have a significant tax impact. While tax implications should not be the only consideration taken into account to determine the timing of the divorce, a tax projection could allow for a planning opportunity to save a significant amount of taxes.
Who gets to claim the children as a dependent is often an argument that may be simplified with some knowledge of their tax situation. It is not uncommon for one or both of the parents to blindly want the tax deduction for the personal exemption of the children without knowledge of what it really means to them in terms of dollars. The ability to claim the dependent as a personal exemption can be quantified so the divorcing parents can make informed discussions.
Along with the personal exemption, there are child tax credits and education tax credits tied to who claims the children. Each of these credits are phased-out based on income so it further reinforces the need to evaluate the options so as to fully utilize the benefits.
The IRS states that transfers between spouses incident to divorce are generally not taxable. As such, once an agreement on the division of assets is reached, the process of transferring the assets will generally not trigger any immediate income tax consequences.
While this seem pretty straight forward, it is important to note that not all assets are equal. In the division of assets, you may receive property that has a tax consequence in the future. An example of these types of assets would be retirement accounts, appreciated stock, stock options, etc. These tax consequences should be evaluated and considered when deciding on how assets are to be divided.
Child support is not taxable to the receiving spouse and it is not a deduction for the paying spouse. Maintenance (Alimony) generally is taxable to the receiving spouse and it is a deduction for the paying spouse.
As maintenance is a taxable event, there is a difference between gross maintenance paid and net available after tax. Without an understanding of these, unintended consequence could result. A cash flow analysis showing the effect of taxes on maintenance can be used to make sure everyone is on the same page.
Fluctuating maintenance or a defined termination of maintenance can potentially trigger scrutiny by the IRS. It is necessary to evaluate any potential maintenance recapture or an IRS reclassification of maintenance to child support. Both of these are used by the IRS to prevent the abuse of calling either a child support payment or a property division transfer as a maintenance payment to take advantage of the disparity of individual’s tax rates.