Taxes & Equitable Division
Transfers of Property
The Domestic Relations Tax Reform Act of 1984 changed the prior rule of law concerning transfers of property between spouses upon divorce so that divorce-related transfers after July 18, 1984, are treated as gifts which result in neither gain nor loss to either party and have no tax consequences.
According to the Act, if a transfer of property between spouses or former spouses is incident to a divorce, neither gain nor loss will be recognized for income tax purposes. I.R.A. §§ 1041(a)(1) and 1041(a)(2). However, for transfers between spouses to not result in a gain to one spouse or a loss to another for tax purposes, the transfer must be "incident to divorce" or it must be "related to the cessation of the marriage." A transfer is "incident to divorce" if it occurs within one year after the date of dissolution of the marriage. A transfer is "related to the cessation of the marriage" if it is according to a divorce or separation agreement and it occurs no later than six years after the date of dissolution of the marriage. See I.R.A. §1041(a) and Temp. Reg. §1.1041-1T(b). In essence, this means that the parties to a divorce action have a specific window of time to complete transfers related to the divorce before such transfers will be treated as taxable gains or as losses on the parties' income tax returns. According to the Act, the transferred asset will only be treated as a gain to the transferee once or if the property is ultimately sold. Temp. Reg. §1.1041-1T(d).
Sometimes, a large portion of the assets owned by married couples consists of the right to payments from pension plans. In many states, like Georgia, these assets are subject to division during a divorce.
A significant advantage of saving for retirement through a pension plan is that employees' and employers' contributions for plans such as 401(k) 's are not taxed as income until distributed by the plan. This distribution usually occurs after retirement, at lower tax rates. However, according to the Internal Revenue Code provisions, the assignment of pension benefits or 401(k) disbursements, including transfers to a spouse during a divorce, may result in the loss of such tax benefits.
To avoid these adverse tax consequences, the spouse who participates in the retirement plan (participant spouse) must obtain a Qualified Domestic Relations Order, commonly referred to as a QDRO. A QDRO is an order that a Court must enter before becoming effective. Additionally, the QDRO must also be approved by the administrator of each retirement plan affected.
A QDRO creates or recognizes a recipient spouse's (referred to as an "alternate payee") right to receive all, or a portion of, the retirement plan benefits. According to federal law concerning the division of tax-deferred retirement plans, an alternate payee may only be a spouse, former spouse, child, or other plan participant's dependents. A validly created and approved QDRO allows the recipient spouse to be treated, for federal income tax purposes, as a plan participant. The QDRO may also enable the alternate payee to take a lump sum withdrawal or begin receiving payments at the earliest time allowed for retirement, regardless of when the participant spouse retires. In sum, the entry of a QDRO enables the division of a tax-deferred retirement plan without the recipient spouse or the participant spouse experiencing any adverse tax consequences.
However, suppose a court orders the division of an interest in a tax-deferred retirement plan during a divorce and the plan participant simply pays the amount from the pension plan without obtaining a QDRO. In that case, the participant may become liable for an early withdrawal penalty (depending on age and method of withdrawal), plus income and capital gains taxes on the amounts distributed to the former spouse. See our article entitled: "Retirement Assets" to further discuss the divisibility of retirement assets upon divorce.
Deductibility of Legal Fees
According to provisions of the Internal Revenue Code, specific divorce-related legal fees may be tax-deductible. This will likely come as a pleasant surprise to those recently divorced or those currently going through the divorce process. Unfortunately, in most situations, attorney's fees incurred obtaining a divorce are considered personal expenditures and not tax-deductible. I.R.C § 262 (1986). However, there are a few instances in which a spouse may deduct his or her legal fees related to divorce.
According to the Internal Revenue Code, an individual may deduct ordinary and necessary expenses paid during the taxable year:
- For the production or collection of income;
- For the management, conservation, or maintenance of property held for the production of income; or
- In connection with the determination, collection, or refund of any tax.
I.R.C. § 212 (1986). With this being said, careful record-keeping on the part of you and your attorney during the divorce process may enable you to obtain this tax advantage.
Please note that the Tax Reform Act of 1986 has limited the extent to which attorney's fees related to the divorce may be deducted. Under the Act, any such deduction for attorney's fees (combined with other itemized deductions) is only permitted to the extent that it exceeds 2% of the taxpayer's adjusted gross income. I.R.C. § 67 (1986).
Innocent Spouse Rule
In addition to the defenses that one spouse may use to avoid liability for an inaccurate joint tax return that was discussed in our article entitled "Taxes and Equitable Distribution: Joint or Separate Returns?", there is an exception to the rule of joint liability for spouses who file joint tax returns known as the "Innocent Spouse Doctrine" or "Innocent Spouse Rule." This rule was introduced in 1971.
Initially, to qualify as an innocent spouse, a taxpayer was required to prove that he or she did not know about the inaccuracies on the return and that he or she did not benefit from the underpayment of taxes. In 1984, this law was revised to be more liberal than the pre-1984 "no benefit" test. The 1984 law relieved an innocent spouse of liability if, after taking all the facts and circumstances into consideration, it would be inequitable to hold the innocent spouse liable. I.R.C. § 6013(e)(1)(c). The Internal Revenue Code was revised once again in 1998 to afford "innocent spouses" even broader protection. Under the revised law, former spouses may elect to limit their liability arising from a joint return filed during their marriage to the liability that would have been attributable to them individually had the couple filed separately. The revised law also allows relief when the understatement is attributable to an erroneous item of the other spouse. I.R.C. § 6015.
Even though the above-discussed protections are available according to the Internal Revenue Code, it is important to discuss tax liability issues with your divorce attorney. Your attorney may suggest including additional provisions in your divorce settlement agreement that offer you extra protection from unanticipated tax problems that may arise post-divorce. Among other things, provisions such as these should require both spouses to advise the I.R.S. of all new addresses and require each spouse to direct the I.R.S. to notify both spouses any time an investigation is commenced concerning liabilities arising from the couple's joint returns filed while the parties were married.