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Paul Wapner
What CPAs need to know about divorce tax planning

Business valuation experts should be familiar with issues ranging from the taxation of alimony to the treatment of property distributions.

July 24, 2013
by Paul Wapner, CPA

CPAs who perform business valuations and provide other litigation support services for family law matters are often asked to consult on income tax planning issues. Income tax planning as it relates to divorce involves unique rules and opportunities, some of which are affected by local laws and practices. A CPA should be familiar with the taxation of alimony, application of innocent spouse relief, determination of filing status and exemptions, and treatment of property distributions. Below is a summary of these tax-related topics that may arise during the divorce process.

Alimony

As a general rule, alimony is deductible by the payer and included in the income of the recipient. Internal Revenue Code Sec. 71 defines the requirements for income tax treatment. Among other requirements, the payment must be made pursuant to a written divorce or separation agreement. Local jurisdictions may have unique definitions of alimony; therefore, the CPA should use caution in considering the tax treatment of alimony.

Alimony can generate post-tax savings for a divorced couple if the payer is in a higher income tax bracket than the recipient after the divorce. The payments can be structured to maximize the after-tax benefit to the recipient and minimize the after-tax cost to the payer. A CPA who assists with alimony planning should review the recapture rules, which prevent excessive “front-loading” of alimony payments to increase tax savings.

Innocent spouse relief

Individuals who file a joint tax return have joint and several liability for any tax due. The Code provides certain provisions that relieve innocent spouses of this liability. Sec. 6015 contains three scenarios allowing this relief. Sec. 66 provides relief from sharing of income, deductions, credits, and payments in community property states when certain conditions are met.

Filing status

Filing status is determined as of Dec. 31 for taxpayers who get divorced during the year. Taxpayers will still be considered married unless a) a final decree of divorce is issued by a family law court or b) a final decree constituting a legal separation under local laws is issued by a family law court. One of these conditions must be met by Dec. 31 for the current income tax year, or the taxpayer must file either married filing jointly or married filing separately. There is an exception to file as head of household if the taxpayer lived apart from his or her spouse for more than six months and paid for and maintained a home for a qualifying child.

Dependents and exemptions

A taxpayer must meet certain dependency tests to be eligible for an exemption. Sec. 152 provides an exception for children of divorced or separated parents, which allows a custodial parent to claim the dependency exemption even if the noncustodial parent provides more than half of the child’s support for the year. Also, a noncustodial parent can take the exemption if the custodial parent signs IRS Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, or a similar statement, and all other conditions are met.

A CPA might recommend that the parent with the highest income take the exemption, unless that parent’s income exceeds a phaseout threshold for the exemption (and related tax credit). Exemption phaseouts were reinstated for 2013. The divorce or separation agreement will often address which parent will be able to claim the dependency exemption.

Property distributions

The Code provides favorable treatment to divorcing spouses when it comes to distributing property. Under Sec. 1041, property transferred between divorcing spouses is generally treated as a gift. Cost basis and holding period carry over, and the transfer most often avoids treatment as a taxable event.

The Code allows for all taxpayers to exclude up to $250,000 of gain ($500,000 if married filing jointly) on the sale of their primary residence if they occupied the home for two out of the last five years. If a taxpayer maintains ownership of his or her primary residence with an ex-spouse, that taxpayer can include the ex-spouse’s ownership period as part of the two-year test. A taxpayer who receives a residence in its entirety as part of a divorce settlement can also use the ex-spouse’s ownership period as part of the two-year test.

These topics are encountered by all CPAs who provide income tax services, but they are more prevalent for practitioners who specialize in family law matters. Additional information is available using resources published by the AICPA. FVS Section members have access to the Quick Reference Guide to Divorce-Related Tax Matters and the practice aid A CPA’s Guide to Family Law Services. Both publications are available under the resources section of the FVS website at aicpa.org/fvs.

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Paul Wapner, CPA, is the AICPA’s program manager for Forensic and Valuation Services.