Divorce and Taxes: Taxes Issues and Mistakes

The first financial mistake to avoid regarding divorce and taxes is failing to consider the tax impact of each asset. For instance, receiving IRAs is not the same as receiving cash, especially if you will need to withdraw funds from the IRA to cover your expenses. If you hope to keep the family home, or a vacation property, you must know the tax basis of the property, the rules related to capital gains taxes to be imposed on a subsequent sale of the property, and what, if anything, could be done to lower these taxes.

You must also consider the rules regarding eligibility and phase-out of dependency exemptions to ensure maximum available benefit.

Alimony, which is now “maintenance” under New York law, must comply with certain rules to be tax-deductible to the payor, and avoid any subsequent recapture disallowance.

Working with financial experts if necessary, your attorney must calculate your after-tax cash flow of the award or settlement offer so you’ll understand what you are really getting.

For more information about how taxes could impact your divorce settlement, speak to one of our experienced family law attorneys, or see IRS Publication 504: Divorced or Separated Individuals.

Filing Joint Tax Returns Before or During Divorce

Many married taxpayers file joint tax returns because of the financial advantages this filing status allows them. However, when married taxpayers file jointly, both taxpayers are jointly, as well as individually, responsible for the taxes and any interest or penalty due on the joint return, even if they later divorce. For example, if a stay-at-home spouse filed joint tax returns during the marriage while the moneyed spouse under-reported his or her income or made fraudulent claims, both parties may be liable for all the taxes, interest, and penalties in connection with those joint returns. This is true even if a divorce decree or judgment states that one of the spouses will be responsible for any amounts due on the previously filed income tax returns. Further, one spouse may be held responsible for all of the taxes, interest, and penalties, even if all of the income was earned by the other spouse.

Therefore, filing a joint return during the marriage or after separation presents spouses with risks that they must consider and protect themselves against. The Internal Revenue Code offers possible remedies for spouses who find themselves in the position of defending an improper or erroneous tax return, which is referred to as “innocent spouse relief.” By requesting innocent spouse relief, a joint taxpayer could be relieved of the responsibility for paying tax, interest, and penalties if their spouse has improperly reported or omitted items on their joint tax return.

Generally, the tax, interest, and penalties which qualify for relief may only be collected from the spouse or former spouse for misreporting. To qualify for innocent spouse relief, a taxpayer must meet certain, fairly strict requirements under the Internal Revenue Code. If they do meet said requirements, they could qualify for the status without being held responsible to the government to pay the taxes, penalties, and interest.

The Importance of Tax-Affecting Earnings in Divorce

Tax-affecting the earnings of pass-through entities can have a profound effect upon valuation of the entities. As you can imagine, taxes play an important role in valuing a business for any purpose, including divorce, because taxes can reduce the value by as much as forty percent (40%).

To understand the role of divorce and taxes in a business valuation, one needs to step back and review the technical part of valuation. Most valuations have three moving parts: (1) A future cash flow stream; (2) expected future growth of those cash flows; and (3) a required rate of return to attract an investor to the risks associated with the future cash flows and growth.

A sound valuation must match apples with apples, so to speak: When applying the required rate of return to the cash flows, whether in the form of a multiplier or discount rate, or capitalization rate, both the cash flows and the risk factor must treat taxes the same way, otherwise the entity may not be valued properly.

On a more granular level, valuation analysts build up a required rate of return, and they do so by including, among other factors, the yields that an investor would receive when investing in a publicly-traded stock. That yield is generally net of taxes, as we say, “tax impacted” – and thus it can only be applied to tax-affected cash flow streams.

So, even if a pass-through entity does not pay entity-level taxes, the normalization process burdens those cash flows with a hypothetical tax expense so that the tax-impacted risk factor – a “multiplier”, “discount rate”, “or capitalization rate” – is “apples-to-apples.”

At Nolletti Law Group, our high-asset, or high-net-worth clients trust our team of qualified tax lawyers and forensic accountants to provide that degree of tax and valuation expertise required in the divorce process. Our culture of excellence demands an extraordinary work product and legendary client service to business owners and other high-net-worth individuals in marriage dissolutions.