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Tax Considerations in Divorce

Clarkston Legal April 5, 2016

Like death, taxes are a part of life; a certainty. When going through a divorce, there are significant tax considerations to take into account when negotiating a property and support settlement.

This post touches on several of the most common tax considerations involved in negotiating a divorce settlement: spousal support payments, retirement assets and property transfers.

Spousal Support. The primary consideration relative to spousal support is that the periodic payments are tax deductible to the payor and income to the payee. Even payments to third parties -to a mortgage lender for example- may qualify as an alimony payment and thus be tax deductible to the payor.

The relevant section of the Internal Revenue Code governing whether a specific type of payment qualified for the spousal support tax deduction is IRC 71. Depending on circumstances, a support payment that would otherwise qualify for a deduction as alimony may be elected not to be treated as such for tax purposes.

Typically, alimony is secured by a life insurance policy owned by the payee on the life of the payor. Also typical is that a spousal support obligation is not dischargable in bankruptcy.

For the payor of support, you pay, then you die. To qualify as alimony under the Code, the payment obligation must end with the life of the payor.

Retirement Assets. The two primary types of retirement assets divided in a divorce proceeding are deferred compensation plans [401(k) and IRA] and defined benefit plans, such as a pension.

When negotiating a divorce settlement, there are tax implications involved with how these assets are divided. For example, in a deferred compensation plan, the fund contains un-taxed dollars. In the divorce process, the alternate payee receiving a roll-over from a qualified plan can tap those dollars at any age, provided taxes get paid in the year of the disbursement. This provides a source of cash when the alternate payee needs it badly.

Pensions are different. When a pension is properly divided, the tax implications arise in that the alternate payee receives taxable income at the participant’s earliest possible retirement age, or whenever monthly payments begin.

Other more complicated tax issues arise when dividing non-qualified plans or other employment-related benefits such as stock options. These usually require the review of a tax professional prior to concluding the property negotiation.

Property Transfers. In general, transfers between spouses in a divorce proceeding do give rise to a taxable event; they are deemed as gifts between parties. When such transfers occur, there is an adjusted basis that is used to assess any gain or loss.

Transfers to third parties -as opposed to a spouse- can complicate tax considerations as they are treated as two separate transfers. Caution must be used when structuring such a property division.

There are also many types of specific property transfers that have complicated tax treatment meriting the review of a tax specialist. These transfers include:

  • recapture of depreciation and investment tax credits;

  • installment payments;

  • U.S. Savings Bonds;

  • S Corporation shares;

  • passive activity property;

  • life insurance policies; and

  • capital loss carry-forward.

To properly assess these types of property division, be sure your divorce lawyer utilizes a tax professional on the team.

If you are facing a divorce that involves any of the issues touched on in this post, consider scheduling a free consultation to assess your options.