In the best of worlds, taxes can be complicated, provoke anxiety, and, of course, be costly. In a divorce situation taxes have the potential to become yet another battleground for the exhausted parties. Many of the financial decisions made by the parties – or made for them if they cannot agree – have serious, long-lasting tax consequences. Care and consideration must be given, as illustrated in the following examples:
It ain’t over till it’s over. Bette and Peter* are negotiating a particularly nasty separation that will span two calendar years. Peter is a banker and Bette is a stay-at-home mom. Peter wants to file as a couple – “married filing jointly” – so they will get a small refund. Because of the acrimony between them, Bette will not agree and thus they have to each file “married separately” returns – she will still not owe anything (no income) and Peter will owe a ton (the rates are much higher and the credits limited for “married filing separately”).
Logic dictates that for “the parties as a whole” married filing jointly is a more profitable choice, easier, cheaper. If it is a straightforward return (e.g. neither partner owns a business) and the parties trust the veracity of their reported figures, this is particularly true. Then again, if trust is gone it is hard to blame Bette, who from her own point of view has nothing to lose (well, time, lawyer’s fees, her husband’s assets that she may be relying on, any residue of good will…). There is also the thorny issue of allocating payments and refunds if the couple is filing a joint return and misuse of funds is already an issue in the divorce.
Should Bette continue to insist on a separate return despite the total higher tax cost, Peter’s counsel could advocate for “reimbursement” in the property settlement.
Know when to stop investigating. Sue runs a professional staffing agency. Her husband Larry is half-owner of the corporation but is not actively involved. The divorce was drawn out for five – Five! – years because Larry wanted to be bought out of the business. Fair enough Larry but as her tax preparer I know there is not much there. “Staff For You” has one core client, and no long-term contracts. There is little intrinsic value and virtually no hard-core assets. Essentially SFY provides employment for Sue, some tax breaks and liability protection. Larry may be entitled to alimony or child support based on Sue’s earnings, as well as his rightful share of personal property, but just because your spouse “owns a business” doesn’t necessarily mean there is a bucket of cash lurking there.
It ain’t over even after it’s over: Howard and Deirdre have two children, Al and Allie. They will stay with Deirdre during the week and with Howie on weekends. How should they determine who takes each “dependency exemption” after they are divorced?
Again, it helps if the parties can think longer term and not punitively. Howard’s income is substantially more than Deirdre’s – therefore, the dependency exemptions save him a higher percentage of his taxes than it would for her. In addition, he plans to fund the children’s’ education, and he cannot claim an education credit without the related dependency exemption.
Then again, Deirdre’s income has grown steadily each year and within a few years could be similar to Howard’s. Meanwhile, a spike in Howard’s income would make him less able to take advantage of that dependency exemption because of recent tax law changes. How should they structure the arrangement?
With two children and potential tax benefits for each parent, oftentimes the parties will specifically identify one dependent per parent in the divorce agreement – or, if one child they will agree to alternate the exemption annually.
Howard and Deirdre trust each other to be fair in these matters and they are remaining friends – this is a less hostile divorce than others. Given this, they do not want to write anything into stone — (especially since tax law is anything but). As the custodial parent, Deirdre has rights to both dependents, but she may waive either one or both in any year, and Howard would then be entitled to the benefit (s). They will “run the numbers” year by year and decide what approach is in their best interests. Yes, I have clients who see me separately and do this!
This is just a hint of the tax complexities inherent in the divorce process (we didn’t even mention child support, capital gains…) Every situation is different, but ultimately it is up to the parties what tack to take. Will you fight over every penny? Drag the proceedings out until you are both left bloodied, dissatisfied and no less angry? Switch lawyers until you find the perfect match for the lowest price, who is aggressive but effective, calls you back but doesn’t charge? Yes, you are right (you always are!), you are entitled and it’s not fair – but when all is said and done often it is best to get it done as quickly and painlessly as possible, even if you don’t get all you deserve.