Divorce is often a difficult process for the parties involved, but the pan may be abated by ensuring that any settlement executed by the parties will protect your tax interests without unnecessarily increasing your tax burden. When properly implemented, the following divorce tax tips may save both parties money in a dissolution matter.
TIP #1: Tax Deductible Attorney Fees
Divorce clients, who may be at a financially disadvantaged time in their lives, often pay their attorneys with funds that could be used for something more enjoyable than divorce litigation. Clients may be in a position to maximize the deductibility of attorney fees. There is, however, a two percent floor. For clients who remit payments on a timely basis, they can expect to save money on taxes by taking advantage of the two percent floor. According to the tax code, the costs of getting a divorce are personal and are not deductible (I.R.C. 262); however, some of the costs of divorce are deductible if the client itemizes deductions and the total miscellaneous deductions exceed two percent of the payor’s adjusted gross income. Examples of deductible fees include: fees for professional tax planning, fees incurred for obtaining taxable income, and fees for securing interest in qualified retirement plans.
The tax planning is required in order to maximize the advantage of deductibility. Other tax deductible costs, such as paying for tax return preparation, should be paid in the same calendar year as the attorney fees in order to receive the full benefit of this strategy. In the event the attorney fees are paid over more than one year, which is frequently the case with domestic relations matters, the deductible portions of the fees may require prorating over the years paid.
TIP #2: The Capitalization of Attorney Fees
Although attorney fees incurred in relation to the conservation of an interest in property are not deductible, clients may be able to include these costs in the capital basis of the property. While the client is not likely to realize an immediate tax gain, such capitalization can increase depreciation, if the property is a depreciable asset, or decrease the gain (or increase the loss) when the property is sold. In the event a number of assets are involved in the litigation, the fees must be specifically allocated among those assets, or the IRS may apply a prorated allocation of the costs. Remember, there must be a basis for deductibility in the legal services performed in the case. Organized billing records should be kept which delineate services on behalf of a particular asset.
TIP #3: Maintenance: When Is a Payment Tax Deductible?
Section 71 of the tax code defines alimony and maintenance payments, applies to any interspousal payments intended to be tax deductible whether they are labeled spousal support, section 71 cash periodic payments in lieu of maintenance, or family support. If a client would like to deduct the payments, the requirements of section 71 must be satisfied. Those requirements include:
1. The payments must be made in cash. Services or a transfer of property, other than cash, will not be considered alimony.
2. The payments must be made pursuant to a separation or divorce pleading. For example, there must be a decree of divorce or separate maintenance or written instrument incident to such decree, written separation agreement, or a decree requiring payments for spousal support or maintenance.
3. The payments must be made to or on behalf of the spouse. Under this provision, payments to third parties such as medical, dental, health insurance, rent mortgage, or tuition, may qualify. These payments cannot be voluntary and must meet all of the other requirements of section 71.
4. The payments cannot be designated as nontaxable and nondeductible per the divorce or separation instrument. The tax code provides that in the absence of language to the contrary, one can assume the intent was that the payments would be deductible to the payor. Whenever there is a situation of interspousal payments, it is always good practice to identify the intended tax result of the payments.
5. Under this section, the payor and payee spouses may not be members of the same household when the payments are made.
6. The payments must terminate upon the payee’s death. There can not exist the requirement that payments be made for any period following the death of the payee. Section 71 is silent as to treatment of payments when considering the death of the payor. In addition, there can be no liability to tender a payment, in cash or in the form of property, as a substitute for such payments after the death of the payee spouse. As a caveat, do not rely on state law providing for termination of payments upon death. The final settlement agreement should expressly provide that the payments terminate upon the payee’s death.
7. Do not disguise child support or property division payments as maintenance.
The above tax tips represent a sampling of those most divorcing couples find helpful in saving on tax obligations during the divorce process, and even thereafter. The second part of this two part series will address additional divorce tax tips which can be implemented as early as this year.
Read part two of this tax article.
Milandria King is a Senior Attorney in the Memphis, Tennessee office for Cordell & Cordell, P.C., admitted to practice law in the state of Tennessee. Additionally, Ms. King is admitted to practice before the Sixth Circuit Court of Appeals and before the United States District Court for the Western District of Tennessee. Her memberships include the American Bar Association, the Memphis Bar Association, the Tennessee Bar Association, as well as the Association for Women Attorneys.