The French philosopher Rene Descartes said, “I think, therefore I am.” Since we are all creatures of our own thoughts, let’s engage in some thinking about income taxes which too often present problems resolved in darkness. In fact, when Descartes also said “Everything is self evident,” I doubt that he had in mind our modern obscure tax system.
TAX 101 – DON’T STAMPEDE TO DEFER TAX
During the 1970s and 1980s there was an epidemic of tax deferral fever. Many seemed to think that a dollar of tax postponed was akin to a dollar saved. In theory, tax deferrals make sense in limited circumstances:
1. As an arbitrage strategy to shift income to a year in which a lower tax bracket will apply. This tactic was more sensible during the era of the 70% top tax bracket.
2. As a deduction maximization strategy to average out bunched up income and thereby avoid phase out rules for various tax benefits (e.g., itemized deductions); or, to shift specific kinds of income to avoid the AMT. The AMT is not as common for Florida taxpayers as for those in high state income tax localities; and, itemized deductions now only partially phase out.
3. As a time value of money strategy to shift income that the tax payments delayed can be invested at well above average returns with little risk (often a pipe dream except for the owner of a successful growing small business); or for the executive receiving stock options.
4. As a pre-tax wealth accumulator in certain tax favored retirement accounts such as an Individual Retirement Account. With regard to IRAs, one can choose to defer current earned income with a regular IRA and also shelter investment earnings on the account; or, forego the earned income tax deferral with a Roth IRA that also shelters investment earnings but allows tax free qualified distributions. Which strategy makes sense depends upon ones’ particular circumstances.
5. As an estate planning tactic to take advantage of the step up in basis occurring upon the death of the owner of property which eliminates the built in gain.
In practice some of these strategies were distorted into senseless and counterproductive measures that actually worked against the sound financial interests of most. Thus:
1. High income professionals shifted income from high bracket years to high or higher bracket years accomplishing no rate arbitrage benefit and at times even increasing the tax burden. The postponed tax was often placed in low yielding passive investments or worse spent on lavish lifestyles.
2. Hard earned wages or savings were invested in very risky ventures that promised tax deferrals by questionable means. Instead, both the investment and tax benefit were lost and IRS charged harsh penalties and interest.
Think about strategies that deflect tax
There is a big difference between a tax deferred and a tax deflected. A deferral merely postpones the day of reckoning. A tax defection actually eliminates the tax altogether or lowers the tax from what it otherwise would have been. The special capital gains rate of 15% is an example of a tax shelter that deflects income tax and results in a real and permanent tax savings.
This year there is another reason to be cautious about tax deferrals. The U.S. economic horizon is not very pretty. Unprecedented budget deficits and continued unbalanced foreign trade mean that tax rates will not be lower in the future or even remain the same. Often, procrastination merely serves to make paying the tax painfully more expensive. Therefore, think carefully about what you are trying to accomplish before embarking on a tax deferral strategy such as a 1031 real estate exchange or postponing a bonus to 2010.
TAX RETURNS OF DIVORCING COUPLES
In almost every instance a joint return will produce a lower combined tax liability than will two married filing separate returns. Thus, in most cases, divorcing couples will agree to file jointly splitting the tax refund or agreeing who is to pay the balance due.
Form 8888 – Direct Deposit off Refund to More Than One Account
This form can be used where divorcing spouses desire to split a tax refund and want to make sure that each receives his or her due share.
Avoiding joint return liability
Sometimes, one spouse may fear a joint return because he or she does not trust the other spouse to accurately report all income or to refrain from taking frivolous positions in the return (perhaps due to past fraudulent returns having been filed). Since some courts in tax cases have found that a joint return was filed even when only one spouse signed the return or signed the other spouse’s name, a spouse not desiring to file jointly should file a separate return even if not technically required to file by the amount of separate income.
Whether one is married for tax purposes is determined on the last day of the year. Same sex marriages, legal in some states, are not recognized for federal tax purposes due to the Defense of Marriage Act (1996) which defines marriage as “between one man and one woman as husband and wife” and a spouse as “a person of the opposite sex who is a husband or a wife.”
Marital status determines tax rate schedule
Your marital status in turn determines which filing status you may choose and which tax rate schedule you must use to calculate your tax. Married couples filing separate returns may qualify for the filing status of Head of Household if they live apart and meet certain tests. If they do not qualify as a Head of Household they must use the filing status of married filing separately. In no case may married persons not legally separated (we don’t have legal separations in Florida) file as a single person. Married filing separately is the most disadvantaged filing status both because the tax rates are considerably higher and many tax benefits available to married or single persons are unavailable or severely limited.
Married Filing Separate Returns
When filing separate returns, married couples must report all income attributed to them and may take deductions for which statutory requirements are satisfied. Generally, income and deductions follow title. In these determinations, however, peculiarities and complexities abound and a few examples will illustrate just some:
1. Reporting income: The return preparer should think about whether the beneficial use of the funds or account match the tax reporting. Assume spouse A has signature authority and without the other spouse’s consent withdraws all of the funds from marital money market account (created with funds earned during the marriage) registered solely in the name of and under the Social Security number of Spouse B. Under Florida law the account is a marital asset that will be equitably distributed in the divorce proceeding. Spouse B, however, will receive a Form 1099 for $500 of interest income although Spouse A received the funds. While the spouses are each equitable owners of the account under Florida family law, Spouse B, being the sole legal title owner, must report all the income in his or her separate return. Were the account jointly owned, Spouse B could transfer ½ of the $500 interest to Spouse A by attributing ½ of the interest to the co-tenant on his or her return. Spouse B could ask the court to order Spouse A to reimburse the funds taken or award other assets to B. Issues of matching tax reporting with realities of ownership continue in the first tax returns filled following the divorce when assets may be awarded by the court to one spouse but income reported to the other spouse on tax reporting forms.
2. Eligibility for deductions: Deductions are a matter of Legislative grace and one must therefore satisfy all of the statutory requirements for each deduction. Assume there is a $1 million mortgage used 6 years ago to acquire the marital home in which both divorcing spouses resided during the year 2009. Both are liable for the mortgage which is paid with marital funds from an account solely under Spouse B’s name. Each nonetheless can deduct ½ of the mortgage interest and escrowed real estate taxes on a separate return because:
a. Each is deemed to have paid 1/2 of the mortgage payments from marital funds. The Form 1098 will be issued to the joint obligors.
b. Each is fully obligated on the debt and for the real estate tax lien.
c. The debt was incurred to purchase a qualified residences as to each spouse, and,
d. The debt does not exceed $500,000 as to each spouse.
3. Assume the same facts as in example 2 above except that Spouse B rents an apartment and does not live in the marital home during 2009. Spouse B, however, voluntarily pays the mortgage including escrowed taxes from separate non-marital funds (e.g. post divorce petition wages). Spouse A cannot deduct any portion of the interest or taxes even if the home is titled in joint names because Spouse A did not pay any of the interest or taxes. Spouse B can deduct the interest as home mortgage interest because the home is a qualified residence as to Spouse B since married taxpayers filing separate returns are treated as one taxpayer for purposes of this test. Spouse B can also deduct 100% of the taxes paid because each co-ownership interest can be foreclosed against if 100% of the tax is not paid although there may be a claim of reimbursement against the co-tenant. The payments by Spouse B are not deemed alimony payments to Spouse A, however, because they are not made under a divorce decree or separation agreement. Things become even more tricky if, following the divorce judgment, the former spouses continue to own the home as tenants in common or the court awards the home to one spouse while the other spouse contuse to pay the mortgage, taxes and other home expenses.
4. Legal fees: Assume that a spouse pays legal fees from non-marital funds to defend against a claim for permanent alimony. The fees are not deductible in a separate return. Legal fees paid to obtain taxable alimony are deductible but fees paid to defend against a claim of alimony, taxable or not, are non-deductible. Legal fees for tax advice are generally deductible. Caveat: The fees for tax advice in a divorce must be determined from the lawyer’s contemporaneous bills. Divorce lawyers cannot usually attribute fees to tax advice because a divorce lawyer’s retainer agreement often states that the lawyer does not render tax advice. Legal fees to protect income producing property may also be deductible if the case involves an issue pertaining to the income from the property. Legal fees in the divorce that relate to acquiring assets may be added to the cost basis of the asset. The IRS has issued guidance on these determinations indicating that arbitrary after the fact allocations will not be respected. Tax counsel should identify these categories in each bill and assist the spouse in identifying fees of other billing non-tax lawyers that may be deductible. Fees of the forensic accountant must also be allocated in this fashion. Additional issues arise if the divorce court orders the spouse to pay from separate funds interim legal fees of the other spouse.
5. Temporary support: Assume that the divorce court orders: “The husband shall make monthly payments to the wife of $5,000 as and for temporary support beginning on February 1, 2009 and continuing until further order of this court.” Whether or not there are minor children, and whether or not the parties are living in the same home, the payments will be taxable to the wife and deductible to the husband because the payments meet the definition of alimony under the Internal Revenue Code. The order could have stated that the payments are to be non-taxable to the wife and non-deductible to the husband; or, absent such a statement the payment should have been calculated to include an amount for income taxes to be paid. These are but some of the issues that arise. Some others involve allocated estimated tax payments, switching from joint to separate returns and determining each spouse’s share of carryovers (net operating losses, charitable contributions, capital losses, foreign tax credits and unused passive activity losses). A tax preparer familiar with divorce issues should be employed; or, tax counsel should advise the existing preparer about these matters.
PROCESSING TIME FOR AMENDED RETURNS
IRS has announced that it expects the processing time for Form 1040X, Amended U.S. Income Tax Return, to take 12 to 16 weeks, not 8 to 12 weeks as usual. Taxpayer’s considering amended returns should think about the fact that an amended return is an admission of at least one the elements of the crime of filing a false return which was either committed or not committed when the original erroneous return was filed. The amended return is an admission that the original return was not true or correct. The only element remaining to be proven is willfulness or knowledge at the time that the return was not true or correct. Therefore, taxpayers should have tax counsel review the proposed filing to make certain that the facts surrounding the filing do not suggest that the original return was knowingly false and that the error was the result of mere neglect. Quiet filing of the amended return might not be the safest approach if the investigation indicates that there was no negligent error but an intentional falsity in the return. A CPA should not make these determinations.
A final word from our friend Descartes, “It is only prudent never to place complete confidence in that by which we have even once been deceived.” The tax code is a rogue capable of deceiving. Therefore, seek wise counsel when acting in reliance of it.