July 7, 2020 Update: The author Kelly Phillips Erb, is a Forbes Senior Contributor, Bloomberg Tax columnist, and PA, NJ, and U.S. Tax Court tax attorney. Kelly wrote this article for me nearly a decade ago, before COVID-19, the CARES Act, the 2018 Tax Reform, the Supreme Court Declared Same-Sex Marriage Legal, and when “Single Girl Guides” were popular. The principles in this article may, or may not apply to you, regardless of your or your spouse or domestic partner’s gender identity. LGBTQ, Non-binary, man, woman… you are all welcome. Please use this article as a starting point for further research, read Kelly’s articles, IRS Pub 504, and speak to tax pro. (Helpful links below.)
When it comes to a divorce, taxes are probably the last thing on your mind. But when you’re on your own, it’s more important than ever to be knowledgeable about financial issues that can affect your future. Below are seven things that you need to know:
1. Your filing status, for tax purposes, is determined as of the last day of the tax year (December 31). It doesn’t matter how long you were married during the year, or whether or not you continued to live together after the divorce. To figure out how to file, you only need to consider how you were classified on the last day of the year. Here are some helpful definitions:
Single – You can file as “single” if you were legally separated or divorced according to the laws of your state. If you live in a state like Pennsylvania, where there is no legal separation, your choices are only “married” or “divorced.”
Married Filing Jointly (MFJ) – You can file as MFJ if you were legally married as of the last day of the tax year, whether or not you were living together. However, you’ll need your spouse’s signature on the return, so you both have to be in agreement for this to work. In some instances, the financial benefit to your spouse may encourage him to consider this option.
Married Filing Separately (MFS) – You are more likely to get a higher tax bill filing MFS because you lose some of the benefits granted to MFJ filers, including certain deductions and credits. However, if you’re still legally married as of the last day of the tax year and your spouse refuses to sign a return as MFJ, this may be your only option.
Head of Household (HOH) – You can file as HOH if you are unmarried (single, legally separated or divorced) and provide a home and at least 50% of the care of at least one dependent. You may file as HOH even if you were not divorced, or legally separated at the end of the tax year if all of the following apply:
- you lived apart from your spouse for the last six months of the tax year, AND
- you file a separate tax return from your spouse, AND
- you paid over half the cost of keeping up your home for the tax year, AND
- your home was the main home of your child, stepchild, or foster child for more than half of the tax year, AND
- you can or could claim (under the rules for children of divorced or separated parents) your child as your dependent.
2. The IRS doesn’t care who spends more time with or money on the children. To avoid confusion and argument, you should agree, as part of your divorce and custody agreement, whether you or your ex-spouse will claim the children as dependents. In many cases, you both will agree to split the claim (e.g., you will claim the kids as dependents in odd years, and your ex-spouse will claim the kids in even years). The IRS will not be an active participant in any arguments about dependents; it has a “first come, first served” rule, which means that the first claim is generally allowed and subsequent claims are disallowed. Don’t end up in a race to file a return. Be sure to work it out beforehand.
3. Alimony may be taxable to you as income but child support is not. In most states, the amount of spousal support and child support will be determined by a formula. It’s important for you to understand that alimony may be taxable to you (and deductible to your ex-spouse) while child support will be tax neutral. Thus, it may be to your ex-spouse’s advantage to skew support in a settlement or other agreement so that more is classified as alimony. This, however, will not be beneficial to you. Consider alternate ideas that may be more tax beneficial. For example, you may want to ask for the family home as part of your settlement instead of a series of monthly payments. The home would not be taxable to you (the monthly payments would be), and if you were to refinance the home you could build equity and deduct the home mortgage interest.
4. If you know that you have to sell the home after your divorce, sell it quickly. I’m not suggesting that you have a “fire sale,” but if you do not anticipate remaining in the family home for more than a couple of years, sell it sooner rather than later. For purposes of capital gains, you may count the number of years that your ex-spouse owned the home with you to qualify for the gain exclusion (which will be $250,000 if you are single when you sell the home).
5. “Innocent Spouse” cases are your burden to prove. Many spouses assume that negative tax consequences during marriage can be explained away later with the “I had no idea” defense. This is not true. The IRS will apportion a tax liability accrued during a marriage according to a formula even if you are not married at the time that the IRS attempts to collect the liability. The burden of an Innocent Spouse protest is yours to prove – and it goes beyond simply saying “I didn’t know.” It can be expensive and difficult to win these kinds of arguments. To protect yourself before it becomes a problem, consider making it part of your settlement that your spouse confirms timely and proper filings of past tax returns. Also, consider having an accountant look over the returns. While this won’t hold water for the IRS, it can act as proof in tax court that you made an effort to reasonably resolve outstanding tax issues.
6. Divorce does not end a business relationship. If you had previously agreed to serve as an officer in a family-owned or closely held company, make sure that you that you resolve this matter prior to settling your divorce. Officers of a company can be responsible for tax liabilities (and other matters) and unless your name is officially removed from the records of the company you’re stuck with the consequences, divorced or not.
7. Retirement plans and business interests are generally taxable. Keep this in mind when you agree to accept retirement plan or business interest assets as part of a settlement. If you need $100,000 as part of your settlement agreement, remember that $100,000 in a retirement plan consists of pre-tax dollars and the real value of the retirement plan could be closer to $70,000 or $80,000. Similarly, business interest assets that have to be liquidated may carry significant capital gains.
Does all of this seem a little overwhelming? Relax – you’ve made it this far, right? Even if you don’t remember all of these details, keep in mind that you don’t want to rush into any settlement without having a qualified professional offer you some guidance. Don’t assume that you can’t afford an attorney or accountant – most are more affordable than you think. You also may qualify for reduced or free services; check with your local bar association for details.
Kelly Phillips Erb, a Senior Contributor at Forbes, writes about tax and tax policy, including tax-related security & technology issues. Kelly also has a regular column at Bloomberg Tax. Kelly is a managing shareholder at The Erb Law Firm, P.C., where she focuses on “tax law including domestic and international estate and tax planning; tax compliance and controversy matters such as tax delinquencies, offers in compromise, and audits.” She is licensed to practice in PA, NJ, and in the U.S. Tax Court. I am also permitted to practice law on a pro bono basis in NC through the Legal Aid of North Carolina. Kelly also is the Taxgirl.