Ten Tax Tips From The Teacher….As A Student

In August, 2000, I looked forward to the opportunity to participate in a program for family lawyers on the special tax issues in our practice. Fortunately, I joined a wonderful panel of lawyers and an accountant. As I prepared for the course, I realized how many subtleties in tax law I had previously overlooked. After study, preparation, and teaching for a day, I share with you a portion of what I learned. If you want to benefit from the day-long course, it is titled Tax Consequences in Divorce: Avoiding the Pitfalls, PBI No. 2000-2585. I was on the teaching team which presented on Tuesday, August 22 in Harrisburg. The book and video can be ordered from PBI, at 800-932-4637.

1. Can an alimony agreement be memorialized in writing without the signature of the parties? I was aware that the writing requirement can be met by a court order. When there is a private agreement, however, I was surprised to learn that the Internal Revenue Service has found that the attorneys for the parties may bind the client by confirming, in writing, the clients' agreement to the alimony arrangements. The agreement must be mutual, so there must be documented evidence of offer and acceptance. I was not aware before that an exchange of letters between the attorneys would be sufficient, and the clients would be bound.
2. Must every alimony order specify that payments terminate on the death of the recipient? The Internal Revenue Service has found that if the individual state law provides or requires that payments terminate at the death of the recipient, payments otherwise meeting the IRS alimony requirements will be found to have met the requirements of termination at death. Many of our local counties do not provide in the form Order for spousal support, alimony pendente lite or alimony that payments terminate at death. Most tax advisors in Pennsylvania will say that the Pennsylvania law requires payments terminate at death. New proposed Rule amendments will reinforce this. The clients are probably protected. It is still best to reference termination at death of the payee in the document, but it is probably not fatal if you don't.
3. If you go to court for spousal support, can it be deductible alimony if the parties live under the same roof? I always assumed that it was always required that the parties be living separate and apart at the time of the alimony payments. Yet there is an exception in the tax law that if there is no divorce decree, and spousal support or alimony pendente lite is ordered by the Court, the "Distance" requirement does not apply. If you simply have a support agreement, the exception does not apply, and therefore, those support payments are not deductible while the parties are under the same roof.
4. If the divorcing parties need the cold hard cash, and one has a Qualified Retirement account, what's the best way to minimize taxes at liquidation? I actually knew this, but the question still comes up repeatedly. If, pursuant to the divorce decree, a QDRO issues designating the non-participant spouse as alternate payee, the recipient spouse enjoys special tax benefits if the money is then cashed out. It is critical that the withdrawal of funds be done by the recipient alternate payee. If someone gets retirement funds pursuant to a divorce decree or QDRO, the alternate payee, who promptly withdraws the money, will only be subject to ordinary income taxes and therefore avoid the 10% penalty. There is special annuity treatment available as well. Usually the recipient is also at a lower tax bracket, so although there is some tax impact, it is not as severe as the original owner liquidating the account.
5. Who gets the mortgage deduction when a payor agrees to pay the joint mortgage obligation pursuant to a spousal support, alimony pendente lite or alimony order or agreement? If the payor is the joint obligor on the mortgage, the IRS has found that the payment of the mortgage is one-half the payor's payment of his/her obligation, but the other half payment is the obligation of the beneficiary spouse or ex-spouse. For the person paying, half the payment will be his/her mortgage payment for which there may be a portion deductible as mortgage interest. The other half payment, which is the payment of the spouse or ex-spouse's half obligation is deductible as alimony for paying the other person's obligation. Unfortunately, the beneficiary spouse cannot show that he/she paid her/his share of the joint mortgage. Therefore the beneficiary spouse cannot take the mortgage interest deduction for that half. With careful planning, the parties could do a better job of maximizing the deductions. The payor may want to make the alimony payment to the recipient's bank account, and the recipient can direct the bank to automatically pay the recipient's mortgage. That makes the recipient obligated to claim the alimony income, but eligible to deduct the full mortgage interest deduction.
6. What are the consequences of the payor spouse paying the dependent spouse's bills? Are those deductible as alimony? Most often, lawyers do not wrestle with the tax consequences of one party paying the other one's bills. At the end of the tax year, the person who has paid and wants to file a separate return is going to turn to the attorney and accountant for advice. It is best to plan ahead. If the payment of bills is not identified as alimony, spousal support or alimony pendente lite, there is no presumption in the law that it will terminate at the spouse's death. If the payor is obligor on the bills, probably the payments not solely for the benefits of the other spouse. It is definitely possible to structure those payments as alimony which could be beneficial to one or both parties. It is important to address all the alimony requirements.
7. When can payment of the spouse's or ex-spouse's counsel fees be deductible? Keep in mind that the statute provides that there can be an obligation imposed on a spouse or former spouse to pay the counsel fees of the other. This would never qualify as alimony, as the payor only get an alimony deduction for paying the other party's obligation. You can structure a deal where the ex-spouse agrees to pay the counsel fees, providing additional financial security for the attorneys. But if the ex-spouse pays the counsel fees, he or she may want the tax deduction. Since a payment of counsel fees does not presumptively terminate at the death of the recipient spouse, you must identify the payment as an alimony payment. You might also want to structure the payment so that counsel fees are paid as alimony, but the benefiting person can designate a portion of the counsel fees as tax deductible legal advice in connection with the divorce, alimony and tax structuring.
8. Doesn't everybody know there is no "legal separation" in Pennsylvania to allow non-divorced spouses to file as a "single" tax payer? Too many attorneys and accountants do not realize that Pennsylvania does not qualify as a state where there is a decree of legal separation giving rise to the possibility of filing as a single person in a year in which the divorce decree has not yet issued. You still must look at the marital status on the last day of the year to determine if the parties are married or single. That is one that I did know, but it still is a point of clarification year after year.
9. Is Head of Household status available to a spouse who is a custodian of children in a separate household, but pre-divorce? Yes, but there are several requirements. Head of Household status does not require the filer to be single, but it does require that the married parties have been separated for more than six months of the year. Someone who separates after June 30, cannot qualify for Head of Household that year. Plus the Internal Revenue Code requires that the person declaring Head of Household status must show that he or she pays more than half of the living expenses for one's self and the specified dependent. Head of Household status also requires that there be a qualified dependent residing in the household for more than six months of the year. It will be rare for both parents to qualify as Head of Household unless there are two (or more) children and each has primary custody of one child for more than six months of the year.
10. Are there dire tax consequences to the ability to avoid capital gains from the sale of a primary residence if one owner is ousted by a Protection from Abuse Order or agreement to separate? Each owner can exclude from taxable gross income up to $250,000 of gain from the sale of property owned and used as one's personal residence for two of the past five years. If one party is out by a divorce or separation instrument, the benefit of this deferral is not lost by that party if the property is sold after three years. A divorce decree or PFA Order qualify as a divorce or separation instrument. If one party is out by a PFA Order or Separation Agreement, the other party's residency is tacked on for the benefit of the dispossessed spouse.

Please understand that these tips are not intended to be a comprehensive survey of divorce tax. These are just the items I found fascinating and supplemented my knowledge of divorce tax. The list will surely grow.