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Divorce and Separation (Portfolio 515)

Tax Management Portfolio, Divorce and Separation, No. 515-2nd, explains the primary income, gift and estate tax rules that normally apply in the context of divorce and separation. It points out potential pitfalls, suggests planning techniques and, in some cases, identifies issues which remain unresolved.

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Tax Management Portfolio, Divorce and Separation, No. 515-2nd, explains the primary income, gift and estate tax rules that normally apply in the context of divorce and separation. It points out potential pitfalls, suggests planning techniques and, in some cases, identifies issues which remain unresolved.

The analysis is written for both attorneys and accountants who specialize in the divorce area and for non-tax specialists who handle divorces and who must have a working knowledge of the tax laws in order to effectively represent their clients.


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AUTHORS

CINDY LYNN WOFFORD
Cindy Lynn Wofford is a principal in the law firm of Ravdin & Wofford. Ms. Wofford has practiced tax and estate planning for 20 years and domestic relations for 10 years. Prior to joining Ravdin & Wofford, Ms. Wofford was with the National Office of Chief Counsel, IRS, Tax Litigation Division, and in private practice with law firms in Dallas and Houston. A graduate of the University of Texas School of Law, Ms. Wofford received her master of laws degree in taxation from Southern Methodist University School of Law.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

II. Alimony

A. Introduction

B. Prior Law and Effective Dates

1. Prior Law

2. Effective Dates

C. Tax Treatment of Alimony

D. Statutory Requirements

1. General Rule

2. Payment Must Be in Cash

3. Payment Must Be Made Under Divorce or Separation Instrument

a. Divorce or Separation Instruments

b. Features of Qualified Divorce Instruments

(1) Decrees, Instruments Incident to Decrees

(a) Decrees

(b) Instruments Incident to Decree

(2) Written Separation Agreements

(3) Decrees of Support

c. Payments “Under” Qualified Divorce Instrument

d. Alimony Arrearages

4. Divorced or Legally Separated Spouses Must Reside in Separate Households

5. Payments to Third Party on Behalf of Payee

a. Payment of Housing Costs

b. Payment of Life Insurance Premiums

6. Payments Must Terminate at Death of Payee

7. Married Taxpayers May Not File Joint Returns

8. Qualified Divorce Instrument Must Not Designate Non-Alimony Treatment

E. What § 71(b) Does Not Require

F. Excess Alimony Recapture

1. Operation of the Excess Alimony Rules

a. Agreements Subject to Post-1986 Law

b. Calculation of Excess Alimony Payments

c. Exceptions to Front Loading Rule

2. Tax Planning

G. Tax Returns, Compliance and Tax Withholding

1. Tax Returns and Compliance

2. Withholding and Estimated Tax

III. Child Support

A. Introduction

B. Prior Law - The Lester Rule

C. Tax Treatment of Child Support

D. Statutory Requirements

1. General Rule

2. Payments Designated as Child Support

3. Reductions Related to Contingency Involving Child

a. Reductions on Happening of Contingency Specified in Divorce Instrument

b. Reductions Clearly Associated with Contingency Involving Child

c. Operation of Rules

(1) Fact Pattern 1

(2) Fact Pattern 2

4. What § 71 Does Not Require (Lester Lives)

IV. Property Transfers Between Spouses and Former Spouses - § 1041

A. Introduction

B. Prior Law - The Davis Rule

C. Effective Dates

D. Tax Treatment of Property Transfers Subject to § 1041

1. Gain or Loss on Transfer

2. Transferee's Basis in Transferred Asset

3. What Constitutes a “Transfer” of Property?

4. Losses

5. Transferee's Holding Period

6. Depreciation Recapture

7. Character of Property

8. Recordkeeping

E. Statutory Requirements

1. General Rule

2. Transfers Between Spouses

3. Transfers Between Former Spouses Incident to Divorce

a. Transfers Not More Than One Year After Divorce

b. Transfers Related to Cessation of Marriage

4. Transfers to Third Parties

F. Tax Planning

G. Transfers Outside the Scope of § 1041

1. Negative Basis Property

2. Installment Obligations

a. Interest Component of Installment Obligations Between Spouses

b. Transfers of Installment Obligations

3. Transfers to Nonresident Alien Spouse

4. Premarital Transfers

5. Assignment of Income Doctrine – In General

a. Assignment of Income and § 1041

b. Assignment of Income, Employee Benefits and § 1041

6. Individual Retirement Accounts and Individual Retirement Annuities

a. Overview

b. Tax Treatment of Distributions (Traditional IRAs)

c. Transfers of IRAs Incident to Divorce

7. Qualified Retirement Plans, Government and Church Plans, QDROs and Other Pension Orders

a. Overview

(1) Private Plans

(2) Church and Governmental Plans

b. Tax Treatment of Distributions

(1) Qualified Plans

(2) Church and Governmental Plans

c. Statutory Requirements – QDROs

(1) General Rule

(2) Types of Orders

(3) Benefits Assigned

(4) Payment Terms

d. Survivor Benefits

e. Waiver or Divestment of Rights as Beneficiary of Qualified Plans

f. Duties of Administrator

8. Other Employee Benefits

a. Overview

b. Employee Welfare Benefit Plans

(1) Employer-Provided Group Life Insurance

(2) Other Welfare Plan Benefits

c. Employee Pension Plan Benefits

d. Archer MSAs

e. Nonqualified Retirement and Other Deferred Compensation Arrangements

(1) Overview

(2) Section 83

(3) Nonstatutory Stock Options

(4) Incentive Stock Options

(5) FSA 200005006

(6) Distributions from Nonqualified Employee Benefit Plans

(7) Tax Treatment of Transfers of Nonqualified Stock Options and Deferred Compensation Incident to Divorce-Rev. Rul. 2002-22

(8) Section 409A

V. Disposition of Marital Home

A. Introduction

B. Section 1041 Transfers Between Spouses and Former Spouses

C. Non-§ 1041 Transfers

1. Sale of Principal Residence and Other Real Property (Recognition of Gain)

2. Sale of Principal Residence (Deferral and Non-Recognition of Gain)

a. Prior Law – Former § 1034 (Residence Replacement Rule)

b. Prior Law - Former § 121 (Over Age 55 Exclusion)

c. Current Law - § 121 (Exclusion of Gain Rule)

(1) General Rule

(2) Effective Dates and Transition Rules

(3) Statutory Requirements

(a) Definition of Principal Residence; Property Used Partly for Business Purposes

(b) Ownership and Use Requirements; Special Rules for Married, Separated and Divorced Taxpayers

(c) Amount of the Exclusion

(d) Frequency of Exclusion of Gain

(e) Partial Exclusion of Gain on Certain Sales and Exchanges

(f) Election Out of § 121 Treatment

(g) Coordination with Former § 1034

VI. Deduction of Housing Costs

A. Introduction

B. Tax Treatment

C. Statutory Requirements

1. Mortgage Principal, Repair and Maintenance, and Homeowner's Insurance

2. Property Taxes

3. Qualified Residence Interest

a. Introduction

b. General Rules

c. Acquisition Indebtedness

d. Home Equity Indebtedness

e. Qualified Residence

(1) Overview

(2) Principal Residence

(3) Second Residence

(a) One Other Residence

(b) Use as a Residence

(c) Election as Second Residence

4. Marital Home Not Qualified Residence

5. Operation of Rules

VII. Dependency Exemption

A. Introduction

B. Tax Treatment of Dependency Exemptions

C. Statutory Requirements

1. General Rule

2. Married Child Filing Jointly

3. Citizenship or Residency Requirements

4. Income Limit Rule and Rules Applicable to Taxpayer's Children

a. Income Limit Rule

b. Child Under Age 19/24

(1) Under Age 19

(2) Student Under Age 24

5. Support Test

a. General Rule

b. Multiple Support Agreements

c. Allocation of Exemption Between Divorced and Separated Parents

(1) Overview

(2) Section 152(e) Requirements

(a) Pre-2005 Determination of Custodial Parent

(b) Post-2004 Determination of Custodial Parent

(c) Child in Custody of One or Both Parents Over Half of Year

(d) Divorced or Legally Separated

(e) Living Apart for Last Six Months of the Year

(3) Exceptions to General Rule

(a) Releasing Claim to Exemption

(b) Multiple Support Agreements

(c) Pre-1985 Agreements

(4) Examples

(5) Tax Planning

VIII. Filing Status

A. Introduction

B. Marital Status

1. Overview

2. Married

3. Deemed Unmarried

a. Legally Separated

b. “Abandoned Spouse” Rule

(1) Files Separate Return

(2) Maintains Home for Dependent Child

(3) Furnishes More than One-Half Cost of Maintaining Home

(4) Not Member of Same Household

C. Filing Categories

1. Head of Household

a. Statutory Requirements

b. Advantages of Filing as Head of Household

2. Married Filing Separate Return

3. Married Filing Joint Return

a. Introduction

b. Advantages of Filing Joint Return

c. Disadvantages of Filing Joint Return

(1) Precludes Deductions for Alimony

(2) Joint and Several Liability

d. Innocent Spouse, Separate Liability and Equitable Tax Relief

(1) Introduction

(2) Technical Corrections, Regulations, and Effective Dates

(3) Section 6015(b) (New Innocent Spouse Rules)

(a) Overview and Tax Treatment

(b) Statutory Requirements

(i) General Rule

(ii) Understatement of Tax on Joint Return

(iii) Erroneous Item of One Spouse

(iv) Knowledge of the Understatement

(A) “Knowledge” Under Regulations

(B) “Knowledge” Under Prior Case Law

(C) Duty to Investigate

(v) Unfair to Hold Spouse Liable

(vi) Proportionate Innocent Spouse Relief

(vii) Electing Innocent Spouse Relief

(4) Separate Tax Liability for Divorced and Separated Taxpayers

(a) Overview and Tax Treatment

(b) Statutory Requirements

(i) General Rule

(ii) Divorced, Legally Separated, or Living Apart

(A) Divorced or Legally Separated

(B) Maintaining Separate Households

(iii) Exceptions to Separate Liability Treatment

(A) Actual Knowledge of Item Giving Rise to Deficiency

(B) Fraudulent Scheme

(C) Transfers of Property to Avoid Tax (“Disqualified Assets”)

(iv) Allocation of Deficiency Between Spouses

(A) General Rule and Burden of Proof

(B) Separate Allocation Rules

(C) Allocation of Items Giving Rise to Deficiency

(D) Other Examples

(v) Electing Separate Liability

(5) Equitable Relief

(a) Overview and Tax Treatment

(b) Rev. Proc. 2003-61

(i) Threshold Requirements for Equitable Relief

(ii) “Ordinarily” Qualifying Circumstances (A Safe Harbor)

(iii) Other Relevant Factors

(A) Relevant Factors

(B) Factors Weighing in Favor of Relief if Present

(iv) Effective Date

(6) Making an Election for Relief Under § 6015

(a) Overview and Tax Treatment

(b) Form 8857

(c) Period for Making Election

(d) Collection Activities

(7) Due Process for Nonrequesting Spouse

(8) Court Review

(a) Overview and General Rule

(b) Timing of Filing Petition

(c) Contents of Petition

(d) Nonrequesting Spouse's Right to Participate

(e) Suspension of Collection Activities

(f) Refunds

e. Changing Filing Status on Amended Returns

(1) Separate Returns to Joint Return

(2) Joint Return to Separate Returns

f. Signing Joint Returns

(1) Requirements

(2) One Spouse Fails to Sign

(3) Disavowing Signature

D. Allocation of Tax Refunds

1. Introduction

2. Statutory Provisions

3. Allocation Formula

IX. Credits Relating to Dependents

A. Dependent Care Credit

1. Introduction

2. Tax Treatment

3. Statutory Requirements

a. General Rule

b. Maintaining a Household

c. Qualifying Individual

(1) Under Age 13 or Incapable of Self-Care

(2) Allocation of Credit Between Divorced and Certain Separated Parents

d. Applicable Percentage

e. Employment-Related Expenses and Statutory Caps

(1) Household Expenses

(2) Expenses for Care of Qualifying Individual

(3) Cap on Allowable Employment-Related Expenses

(a) Dollar Limitation

(b) Earned Income Limitation

f. Filing Requirements

B. Child Tax Credit

1. Introduction

2. Tax Treatment

3. Statutory Requirements

a. General Rule

b. Qualifying Child

c. Limitations on Amount of Credit

(1) Based on Adjusted Gross Income

(2) Based on Amount of Tax

d. Refundability of Credit

4. Allocation of Credit Between Divorced and Separated Parents

C. Educational Credits: Hope Scholarship and Lifetime Learning Credits

1. Summary of the Scope and Operation of the Educational Credits

2. Allocation Between Divorced and Certain Separated Parents

X. Gift and Estate Tax Consequences of Divorce-Related Transfers

Introductory Material

A. Gift Tax

1. Introduction

2. Statutory Exceptions

a. Annual Exclusion

b. Direct Payment of Tuition and Medical Expenses

c. Unlimited Gift Tax Marital Deduction

d. Payments and Transfers Made Under Written Settlement Agreements

(1) Written Agreement

(2) Agreement Made Within Designated Period

(3) Final Decree of Divorce

(4) Only Payments for Specified Obligations

(5) Payments Required by Agreement

(6) Transfers to Trusts

3. Judicially-Recognized Exceptions to Gift Tax

a. Introduction

b. Presently Enforceable Claims to Property

c. Support Obligations

d. Payments and Transfers Made Pursuant to Court Adjudication

4. Chapter 14 Special Valuation Rules

a. Introduction

b. Statutory Requirements and Tax Treatment

(1) Retained Interest or Power

(2) Member of the Family

(3) Qualified Interest

(4) Unexpected § 2702 Transfers

5. Gift Tax Returns

B. Estate Tax

1. Introduction

2. Inclusion in Tax Base

a. Completed Gifts

b. Incomplete Gifts

c. Adequate Consideration in Money or Money's Worth

(1) Release of Marital Rights

(2) Release of Support Rights

(3) Court-Ordered Transfers

3. Deductibility of Payments and Obligations

a. General Rule

b. Obligations Founded on Decree or Judgment

c. Obligations Founded Upon Promise or Agreement

C. Fiduciary Income Tax Accounting for Alimony and Child Support

D. Features of Divorce Settlement Trust

XI. Treatment of Community Income

A. Introduction

B. Statutory Requirements

1. Spouses Living Apart

a. General Rule

b. Prerequisites for Allocating Community Income in Accordance with § 879

(1) Spouses Must Live Apart

(2) No Transfers of Community Earned Income Between Spouses

c. Section 879(a)

2. Spouse Unaware of Receipt of Community Income

3. Community Income “Innocent Spouse” Rule

XII. Tax Treatment of Counsel Fees

A. Introduction

B. Tax Treatment

C. Statutory Requirements

1. Section 212(1)

2. Section 212(3)

3. Ordinary and Necessary

4. Substantiation of Deductible Expenses


WORKING PAPERS

Working Papers

Table of Worksheets

Other Relevant Forms

Worksheet 1 Conference Committee Report to Accompany H.R. 4170, Tax Reform Act of 1984 [H.R. Rep. No. 861, 98th Cong., 2d Sess. (June 23, 1984)] (excerpt).

Worksheet 2 General Explanation of the Tax Reform Act of 1984 [Staff of the Joint Committee on Taxation (December 31, 1984)] (excerpt).

Worksheet 3 Conference Committee Report to Accompany H.R. 3838, Tax Reform Act of 1986 [H.R. Rep. No. 841, 99th Cong., 2d Sess. (September 18, 1986)] (excerpt).

Worksheet 4 Explanation of the Technical Corrections to the Tax Reform Act of 1984 and Other Recent Tax Legislation (Title XVIII of the Tax Reform Act of 1986) [Staff of the Joint Committee on Taxation (May 13, 1987)] (excerpt).

Worksheet 5 [Reserved]

Worksheet 6 [Reserved]

Worksheet 7 IRS Pub. 504, Divorced or Separated Individuals

Worksheet 8 Flowcharts on Innocent Spouse Relief IRS Pub. 971, Innocent Spouse Relief

Worksheet 9 Rev. Rul. 72-545, 1979-2 C.B. 179

Worksheet 10 FSA 200005006 (Transfer of Compensatory Stock Options Incident to Divorce (§ 1041))

Worksheet 10A Rev. Rul. 2002-22, 2002-19 I.R.B. 849 (Transfer of Nonqualified Stock Options and Deferred Compensation Incident to Divorce (§ 1041))

Worksheet 10B Rev. Proc. 2003-19, 2003-5 I.R.B. 371 (Administrative Appeal Rights of a Spouse or Former Spouse When a Taxpayer Seeks Relief Under § 6015)

Worksheet 11 Sample Tax Allocation Provisions

Worksheet 12 Sample Alimony Provisions

Worksheet 13 Sample Provisions for Allocating Housing Costs Deductions and Dependency Exemption

Worksheet 14 Sample Qualified Domestic Relations Orders

Worksheet 15 Exemption and Phase-Out Amounts

Worksheet 16 Johnston v. Johnston, 465 A.2d 436 (Md. 1983).

Worksheet 17 Form 8857 - Request for Innocent Spouse Relief

Worksheet 18 Erisa Conversion Chart

Bibliography

OFFICIAL

Statutes:

Treasury Regulations:

Legislative History:

Treasury Rulings:

Cases:

UNOFFICIAL

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