Avoid Unnecessary Tax on Divorce Payments

When a couple is going through a divorce, taxes are probably not foremost in their minds. But without proper planning and advice, some people find divorce to be an even more taxing experience. Two cases illustrate some of the pitfalls:

1. Paying an ex-spouse a share of the business. As part of a divorce decree, the husband was ordered to pay his wife for her stake in a family-owned corporation. The payments, which included an interest charge, were supposed to be spread over a period of ten years. But instead of making the payments out of his own pocket, the husband directed the corporation to pay his ex-wife.

The IRS said the money paid by the corporation constituted taxable dividends to the husband. Why? There was no valid business reason for having the corporation pay his ex-wife directly (IRS Field Service Advice 200203061). As for the ex-wife, only the interest portion of the payments represented taxable income to her.

2. Making alimony payments the wrong way. Alimony payments are deductible by the person paying them and taxable income to the recipient. And, as one ex-husband found out, there are strict rules about what qualifies as alimony under the tax law.

In the case, the taxpayer's payments were not found to be made on account of a divorce decree or written separation agreement. (John Alleva, 2002-1 USTC 50,188; U.S. District Court, East. Dist. N.Y.)

The taxpayer claimed he had an oral agreement with his former wife. Unfortunately, in order to deduct payments as alimony, they must be required in writing as part of the divorce decree. They must also be made in cash, by check or money order.

In the same case, the taxpayer claimed that payments made on joint credit card debts constituted alimony. However, one of the requirements for alimony is that the payments must cease if the recipient ex-spouse dies. But with the credit card debts, if the taxpayer's former wife died, he still would have been obligated to make payments.

Two more tax traps

Retirement savings. One of the most important issues that needs to be addressed is the division of your qualified retirement accounts, such as 401(k) plans and Keoghs.

Specifically, you need to make sure your divorce papers include a "qualified domestic relations order" (QDRO). This establishes a legal right to a portion of a retirement plan and ensures that your ex-spouse is responsible for paying the income taxes on any distributions that he or she receives. Without a QDRO, you could wind up paying the tax bill.

Higher education costs. Another unexpected problem can surface when a divorced couple has children heading to college. If one spouse has custody and claims the kids as dependents on his or her tax return, the other spouse can't claim the Hope Scholarship or Lifetime Learning credits even if he or she pays all the college bills. Reason: In order to take advantage of the education tax credits, you must be able to claim your children as dependents on your tax return.

To avoid winding up in this kind of trouble, consult with your tax adviser about QDROs, alimony, education tax breaks and other possible tax traps.

DEPENDENCY EXEMPTION

Which parent is entitled to the dependency exemption for a child when a couple gets divorced or separates? Without an agreement, it is the parent who has physical custody. However, “joint custody” arrangements where children split their time between the divorcing parents are becoming more commonplace and clouding the issue.

Case in point: A divorce settlement granted joint custody of a couple’s young son. The child resided with the father from Monday morning to Thursday evening and the mother from Thursday evening through Monday morning. The time with the child was split evenly between the parents during the year in question. However, the child spent a couple weeks exclusively with the mother in the summer when she took him to visit the boy's ailing grandmother.

Since the mother had greater physical custody of the boy and maintained his principal place of residence, the Tax Court ruled that she is entitled to the dependency exemption. (Dail, TC Memo 2003-211)