Tax issues cannot be ignored. Often tax issues are not identified until it is too late to avoid the consequences, manage them, or structure around them. Tax is yet another area of sophistication that must be addressed in family law matters. Tax plays a role in many, if not most, family law cases. Family law involves income and assets that frequently have tax related issues.
Tax issues do not exclusively fall into these asset or income related categories but are grouped this way for illustrative purposes.
Tax rules and regulations must be strictly adhered to in order to avoid additional tax, penalties, and interest. The Internal Revenue Code (IRC) is somewhat like a minefield in enemy territory with the distinction being that the IRC provides a map detailing the exact location of the explosives. Unless you are familiar with the IRC and its traps you run the risk of unexpected and costly surprises.
Tax and the Valuation of Assets
Family law cases are consistent in holding that embedded capital gains tax relative to an asset is not deducted from the fair market value of the asset in a divorce. The deduction of the tax from the value of an asset in a divorce is limited to situations where the tax is immediate, specific and arising out of the divorce itself. If an asset is being awarded to a party in a divorce and that asset is not being sold pursuant to the divorce judgment there is no deduction from fair market value relative to the tax. Speculative future tax consequences are irrelevant to the valuation of assets in a trial. The one exception are taxes related to stock options and this exception relates to the fact that stock options have no intrinsic value unless and until they are exercised as opposed to other assets whose value is not dependent on a subsequent transaction. There is also an issue as to whether the family law court should tax impact earnings in the valuation of a business.
Even though a family law court will not deduct speculative potential taxes from the value of the asset, it is important to know the tax basis of all community property assets before they are divided in a divorce. To determine the potential tax, one must know the tax basis which is the cost of the asset plus any improvements made to the asset and less any depreciation taken since the asset's acquisition. Federal and state capital gains tax is applied to the difference between the adjusted tax basis and the net sales price. Sales costs and commissions are deducted from sales proceeds to arrive at the net sales price. Knowing the tax basis and the potential tax may impact the terms of a divorce settlement and the decision to retain or sell an asset.
Depreciation is designed to indicate what portion of an asset’s value has been consumed at a specific point in time. A business may deduct the amount of depreciation allowed by the IRC from its income which in turn lowers the taxes paid by the business. However, the reduction in tax is simply a deferral, not an elimination of the tax. If an asset is depreciated during its ownership, that depreciation must be recaptured upon sale of the asset which results in the business paying the tax that had been deferred in prior years.
Tax Free Transfer of Assets
The IRC allows for the non-recognition of gain or loss in the transfer of community property between parties to a divorce if the transfer is incident to the divorce itself and takes place within one year of the divorce. This provision also allows for non-recognition if the transaction occurs within six years of the divorce if the taxpayer can meet specific requirements set out in the code. The tax basis of an asset transferred in a non-taxable transfer remains unchanged.
Spousal support is taxable to the recipient party and tax deductible to the payor, if the terms of the spousal support are contained in a divorce court’s order or a written agreement signed by the parties effective before 1/1/19. If these conditions are not met, the support is not deductible and there are no exceptions. Specific events can convert some or all of what was legally deductible spousal support into non-deductible spousal support retroactively to the date of the order. The determination of the amount of the disallowed spousal support deduction is calculated in what is referred to as “re-computation.” Re-computation is performed in order to determine the amount of previous deductions that must be recaptured and claimed as income.
Child support is not taxable to the recipient and is not tax deductible to the payor. However, there are tax issues related to children in family law matters. Child dependency exemption, head of household filing status, and child care credit may be important issues in some divorces.
Family Residence Tax Basis Calculation
When dividing community property it is important to understand the tax consequences of a future potential sale of an asset. This information may impact decisions regarding the distribution or sale of asset.
A sale of the family residence will generate a capital gains tax if there is a taxable gain. This is an example of a tax basis calculation. Federal and state capital gains tax is applied to the taxable gain.
|6% Costs of Sale||< 192,000 >|
|Original Purchase Price||< 1,000,000 >|
|Improvements||< 500,000 >|
|IRS Home Sale Tax Exclusion
(Couple $500K/ Single $250K)
|< 500,000 >|
|Capital Gain Subject to Federal
and State Tax
Income Producing Property Tax Basis Calculation
The calculation of tax basis includes one additional component when the asset sold is an income producing property that has been depreciated. Depreciation must be recaptured. There is no IRS tax exclusion (like the home sale exclusion) for income producing property. This is an example of such a tax basis calculation.
|6% Costs of Sale||< 318,000 >|
|Original Purchase Price||< 2,000,000 >|
|Improvements||< 300,000 >|
|Add Back Previously Taken
|Capital Gain Subject to Federal
and State Tax