HOW DIVORCE AFFECTS YOUR TAXES WHEN SPOUSES DECIDE TO DIVORCE, THE FIRST QUESTION MANY FRIENDS AND RELATIVES ASK IS, "DO YOU HAVE A GOOD LAWYER?" THEY ALSO SHOULD INQUIRE, "DO YOU HAVE A GOOD ACCOUNTANT?"
(FORTUNE Magazine) – DIVORCE AIN'T pretty. There's anger. There's grief. And there's the need to move on. You can move to a new town, settle into a new business, surround yourself with a whole new group of friends. And just when you think you're about to come to closure on your past, in steps the Internal Revenue Service. While the code usually allows tax-free transfers between divorcing spouses, just one oversight can lead to a nasty surprise. When it strikes, our federal tax service is an equal-opportunity punisher: It doesn't matter if you're a high-level executive, a carpenter, or the sole supporter of an entire household. If it finds fault with your return, the IRS can (and will) hit you up for big bucks.
It's a kind of spontaneous combustion: Rub divorce decrees up against the tax code, and you get fire--an emotional, legal, and financial conflagration that not only will rekindle old disputes, but possibly consume your family assets.
Angst over the divorce/tax combination has all but become a specialty of Chicago tax lawyer Alan Segal. "I have people come to me all the time with incredible horror stories," he says.
Think of it: You've just spent five years trying to get past your ex-wife's affair and her new husband. Now the IRS wants to put the two of you back together, reunited in tax court for the next ten years. Or put the shoe on the other foot: Just when you think your domineering ex-husband is finally out of your hair, you find yourself sitting at neighboring tables in a courtroom with your lawyers--again. "How can this be happening?" you wonder, as you peer across at the person who once made your life a wreck (and is doing it all over again).
Listen to Sanford Ain, a divorce lawyer in Washington, D.C.: "No matter how much your [divorce] lawyer knows, if you have an accountant or financial planner whom you regularly rely on, it is extraordinarily shortsighted not to have these people review a proposed agreement. It does no good to have them review an agreement that has already been signed, unless you're a masochist and enjoy knowing what mistakes you've made."
The dramas that follow show just how varied are the ways a divorce can create tax misery--and how right Ain is.
THE CASE OF THE "INNOCENT SPOUSE" DEFENSE
Janet Bliss thought nothing of signing a joint return with her husband Harold in 1982. Their 20-year marriage had been sour for a long time--they were separated for ten of those years--yet she and her husband routinely filed together each April 15. Bliss says she kept track of the Scottsdale, Arizona, household funds, while her husband oversaw his business finances.
Bliss, with no college degree, was a stay-at-home mom during most of the marriage. But her life took a turn in 1983 when she and her husband divorced. Bliss wanted to finish school and move ahead. Then in 1988, five years after her divorce was final, that 1982 tax return resurfaced with a vengeance.
According to a tax-court opinion, a deficiency notice for close to $16,000 arrived from the IRS. The service questioned loans that her husband had taken from his law partnership on behalf of the family. Since the loans were never repaid, the IRS later deemed them taxable personal income. And Janet Bliss had to go toe to toe with the IRS.
The big shocker: She learned painfully that the IRS could pursue her for the total amount, even though her husband was the family breadwinner at the time the return was filed. Moreover, the IRS did not have to notify her of any collection attempts it might have taken against her ex-husband. Since he did not dispute that taxes were owed, Bliss's only chance for protection from being liable on the debt was to be declared an "innocent spouse" by the tax court.
Janet Bliss lost her seven-year struggle last year. When the litigation was completed, Bliss says she was jointly and severally liable for more than $70,000 in back taxes, interest, and penalties. The ruling was financially devastating. While Harold Bliss says he's making payments to the IRS, without innocent-spouse protection Janet Bliss still can be held liable for any unpaid portion of the outstanding tax.
Bliss, who had no professional work experience when the process began, now has a law degree. At age 54, she is starting again. "It was a living nightmare," she says. "Even today, when something comes from the IRS, I get a knot in my stomach. I cannot deal with it. I have to hand it off to my accountant." The only positive aspect of her ordeal was the good-heartedness of a law professor, who represented her throughout for no pay.
Lesson learned: Even if tax is due on a transaction that one spouse did not know about, the IRS can pursue either spouse who signed the joint return.
For the "innocent spouse" defense to work, the spouse must prove, in part, that he or she did not know--and had no reason to know--of a substantial understatement of income. But experts argue that this tax code provision is a farce. "The innocent-spouse rules are so difficult that it takes the Virgin Mary to qualify," says Philip Jacobowitz, a divorce attorney in Oakhurst, New Jersey.
It's unrealistic to assume that spouses won't sign joint returns during their marriage. But once the divorce is final, most spouses are powerless to ward off the IRS for prior marital taxes.
As a precaution, Jacobowitz recommends setting up a trust fund or escrow account as part of the divorce settlement that a spouse can hold as collateral in the event of a tax problem arising from the marriage.
THE CASE OF THE EXPLODING ANNUITY
At age 61, Gloria Blatt thought of retirement and of writing a book. Then, after 41 years of marriage, her life took an unexpected turn when she and her husband divorced. Her retirement plans were shelved when, in addition to a divorce decree, she received a deficiency notice from the IRS for $96,787.
When Blatt signed the divorce agreement in 1987, she thought she and her husband had neatly tied up all legal strings. She never could have imagined the bureaucratic nightmare that would consume her for the next seven years.
As laid out in a tax-court opinion, it all began innocently enough: Blatt, an education professor at Oakland University in Rochester, Michigan, maintained a tax-sheltered annuity as a retirement benefit. Her husband also contributed to a tax-sheltered annuity during his career at another university. As part of the settlement, Blatt's husband agreed to transfer $194,000 from his annuity into hers.
A qualified domestic relations order (QDRO) was drafted and entered so that the funds could be properly transferred between the parties. (QDROs are required by federal law to roll over most types of retirement benefits from one spouse to another in a divorce.)
Since transfers made between spouses as part of a divorce settlement are generally tax-free, Blatt was stunned when she received that $96,787 notice. While she knew she eventually would have to pay taxes on the funds upon withdrawal, getting hit with the tax right after she had taken on the costs of a divorce and a new life was a backbreaker: Paying the deficiency would wipe out a chunk of principal that generated tax-deferred income.
Blatt hired a tax lawyer and battled the IRS. She argued that the transfer was a tax-free rollover, properly completed by a QDRO. The tax court disagreed. In its opinion, it found that if the funds had been rolled over into an IRA or a separate retirement annuity, the transfer would have been non-taxable. However, since the money was transferred to Blatt's existing annuity, the rollover was taxable in the year of the divorce.
It was a minute detail--a boiler-plate technicality, really--but it was about to cost Blatt dearly. When the ruling came in 1993, taxes, interest, and penalties had swollen to nearly $200,000. The suit put Blatt's life on hold. "I didn't dare retire. Part of it was that I love my job, but I also had no idea what was going to come from that situation," she says. Blatt appealed, and the annuity-fund manager filed a friend-of-the-court brief on her behalf. Shortly thereafter, Blatt and the IRS settled the case with no taxes due on the annuity transfer. But her legal fees still topped $25,000.
Lesson learned: When retirement plan assets are transferred between divorcing spouses, an attorney drafts a QDRO, which is entered by a judge. Prepare the document with a high degree of caution and expertise: It must comply with federal law and the rules that a company sets for its retirement plans. Says Anthony Daniele, a Manhattan divorce attorney: "There are so many hidden traps for the unwary spouse. When it comes to any significant transfer such as a pension, it may pay to find a lawyer with a retirement plan background to take a second look before signing anything."
THE CASE OF THE HARMLESS HURT
When Yolanda Bello and her husband of 17 years divorced almost four years ago, the proceedings were quick and painless. That was the good news. The bad news: a letter from the IRS telling her to pay $158,551.
Bello was surprised, to say the least, because she believed her divorce agreement protected her from the IRS. When she and her husband divorced, each party agreed to be responsible for certain potential taxes stemming from the marriage. What she didn't realize is that the "hold harmless" provisions they agreed to really don't matter at all to the IRS. While she and her husband dispute who owes what (if anything), the IRS just wants to be paid. In fact, Yolanda Bello learned the service was well within its rights to ignore the divorce papers and pursue her for all marital taxes. A freelance artist who designs porcelain dolls, she was a sitting duck.
Last summer the IRS seized an $8,000 royalty check from Bello to satisfy joint tax obligations. "I didn't know how much more they would take, but at that moment, I had no way of paying my mortgage," she says.
Bello did whatever she could to get by. She sold personal belongings to keep her Glen Ellyn, Illinois, home afloat. She retained a new lawyer to halt the flow of money into IRS coffers. "I'm now at a point where I know I won't come home and find yellow tape around my house because the government is going to take it," she says. Bello has consulted three tax lawyers in three years, and she says she has spent more than $100,000 in legal fees, taxes, and penalties. Her battle with the IRS is far from over.
Lesson learned: In a divorce settlement, it's common for spouses to establish who should be responsible for potential taxes and who should be held "harmless." But these agreements do not bind the IRS.
A CASE OF PAIN IN CAPITAL GAIN
One of the eternal verities of divorce is that the subtraction of the parts leaves a lot less than the original whole. In other words, post-separation, there's often just not enough money for husband and wife to live in separate residences. While sneaker bills for the children remain a constant, there are now two mortgages, two electric bills, two telephone bills.
And that's just the start of the one-into-two-can't-go divorce blues. Divesting resources means that capital gains taxes can drain what little is left. If divorcing spouses are aware of (and plan for) capital gains consequences while negotiating their settlement, writing that check to the government may be less traumatic. But just as no one goes into a marriage anticipating a divorce, no matter how well you plan, the capital gains consequences of your divorce can be both startling and unpredictable.
William and Judy Murphy realized a capital gain of nearly $186,000 when they sold their $475,000 Illinois home in 1988. According to a tax-court opinion, they filed a return that year and, as many couples do when they sell a home, deferred recognition of their gain, perhaps intending to buy a new home within the two-year replacement period allowed by the IRS.
Whoops: The couple separated the next year. William Murphy then spent $200,000 to purchase his new home in Phoenix, and realized only a nominal gain ($37,500) on his share of the proceeds.
In 1991, three years after the sale of their house, the couple divorced. Just before their divorce became final, William Murphy amended their 1988 joint tax return to reflect the purchase of his home. Since Judy had not yet purchased a new residence, she still had to deal with a capital gain on her share of the original $186,000.
The tax court held that William Murphy was jointly and severally liable for the capital gains tax on the unspent amount, since the couple had filed a joint return when they sold the house. More than three years after the divorce, Murphy's potential IRS tab for his wife's share of the gain would be an estimated $26,000, plus interest and penalties.
Lesson learned: William Murphy's tax lawyer, James Roach of Scottsdale, Arizona, recommends that all spouses--even those in seemingly solid marriages--file separately during the year they sell a house. In effect, each spouse becomes liable for only half of the gain, instead of jointly and severally liable for the total gain. It may be impractical and cost more money, but Roach thinks the approach offers valuable protection.
Divorcing couples can also include a provision in their settlement addressing how to divide the gain, but the IRS isn't bound by the agreement.
THE CASE OF THE CASH COW GONE SOUR
There is not just pain in divorce; there is irony as well. Imagine a family, in the throes of a divorce, further threatening its financial well-being by going to divorce court and testifying about income that hasn't been reported honestly to the IRS.
Meet Tom and Sue (a hypothetical couple). For years they've run a plumbing business out of their garage, Tom doing the plumbing and Sue handling the books. They earn about $80,000 a year--a great deal of it cash--but report only $20,000. This is how they've always run the family finances. In fact, it's how their neighbors the electricians run their family business, and the same way the folks who own the diner down the street go about their work.
It's a way of life--until the marriage goes sour. When it's time to agree to a child and spousal support order, Tom pulls out the old joint tax returns, which show the family income was only $20,000 a year.
Sue's mad. Sure, she wants a fair deal, but she also wants a little revenge (and some more child support). She attempts to prove in court that the family income was substantially higher, but they never reported all the cash.
The result: While no longer wedded in matrimonial bliss, Tom and Sue are reunited in financial hell, joined at the pocketbook as the subjects of an IRS investigation that could even lead to criminal charges of tax fraud
Lesson learned: Settle who gets what from a cash-intensive family business privately, with the assistance of a lawyer, whenever you can, says Edward Slott, an accountant at E. Slott & Co. in Rockville Centre, New York. If there's a tax skeleton hiding in your closet, divorce court is not the place to bring it to light. At least one state requires judges to notify the IRS of cases where testimony indicates a gross underreporting of income. Divorce records also are where many IRS investigations begin.
REPORTER ASSOCIATE Edward A. Robinson