In Divorce, Who Carries the Largest Tax Burden?

By Sari M. Friedman, Legal Counsel
Fathers' Rights Association (NYS & Long Island)

There are so many pressing issues in divorce, who thinks about tax issues? Well, you had better think about it now especially if you are the paying non-custodial parent.

The IRS determines who is entitled to the dependency exemption and, if there are no other provisions, they will award it to the custodial parent. Unfair? Maybe. But you can do something about it.

Case Precedence

There is case precedent for asking the Court, in a divorce action, to award the dependency exemption to the payer, even if he/she is the non-custodial parent. Burns v. Burns 84 NY 2d 369( Court of Appeals), and Litwack v. Litwack 237AD 2nd 580 (2nd dept.97) each awarded the dependency exemption to the non-custodial parent who was the payer.

Parties Can Agree on Who Will Get Exemption

Can parties agree in advance on who will get the exemption regardless of the IRS rule? Yes, they can. Required simply is a stipulation on who gets the exemption that would be included in the separation agreement or stipulation of settlement resolving the divorce action.

There is an IRS form to be executed by the custodial parent that will waive the exemption either for a specific year, for a specific number of years, or for all future years. This form, is then attached to the non-custodial parent's tax return. If, at a future date, the custodial parent refuses to execute the form, the non-custodial parent can seek enforcement by the Court.

Additional Tax considerations

Although child support is tax free to the recipient (and non-deductible to the payer unless there has been advance agreement to the contrary, in writing) spousal support, or maintenance as it is usually called, is tax deductible by the payer and must be declared as taxable income by the recipient, absent any agreement to the contrary.

How does this affect divorce negotiations and settlements? It is within the law to maximize maintenance payments and minimize child support payments, as long as the parties state they are deviating from the child support guidelines. This is something you might want to consider if the payer is in a much higher tax bracket than the support recipient To do this, you must add a clause to your agreement that should there be a future request for increased child support, the maintenance agreement will be null and void. The reason is obvious. If the Court modifies the child support because it is seemingly too low, it could create an unintended inequitable support arrangement, which the payer should not have to continue to pay since it was never intended.

Taxes on Property Distribution

Transfers of property between spouses are non-taxable. Similarly, a transfer of property subject to a divorce or separation agreement or decree, is non-taxable. However, when the transfer is made, the recipient keeps the same cost basis amount as the party who transferred the property. That makes face value of an asset deceiving.

Why, for example, is a $100,000 bank account worth more than $100,000 stock that was originally purchased for $1,000? Because the latter is subject to capital gains tax on $99,000 when it is sold, a factor that significantly reduces its value. The same thing hold true for retirement funds, which are pre-tax assets and will be tax affected when cashed. Therefore, when trading assets in a divorce settlement, one must consider the tax consequences of the asset by examining the asset's true value.

Conclusion

Be sure to consult with your divorce lawyer about the tax ramifications before making any of these agreements. The choices you make at the time of agreement can make a big difference later on.