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Tax Planning

Nichols, Sacks, Slank, Sendelbach & Buiteweg, P.C. are not tax attorneys and are not qualified to give definitive tax advice. We have included information from the Internal Revenue Service website but suggest you review any information here with a qualified tax preparer prior to relying on it.

Divorcing couples should consider the tax ramifications of:

Click on the terms above for more information.

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Filing Status and Exemptions

A divorced or divorcing couple’s filing status is determined as of the last day of a tax year, usually December 31.

  • A couple is no longer married for tax purposes when a final divorce decree or a legal separation is issued.
  • If you have custody of a child and are not remarried by the end of the year, you may qualify for Head-of-Household status even if the parent with custody is not claiming the dependency exemption for the child.

Personal Exemption. In 2008, the personal exemption is $3,500 for a parent and each child. A dependency exemption reduces taxable income by a specific dollar amount, which, multiplied by the parent’s tax rate, equals a tax savings. The tax savings depends on your tax bracket.

Dependent Exemptions. Available if a minor child resides with you more than half time or the primary parent has waived it to the non-primary parent. For adult dependent children, the test is whether you provide more than half of the support for the child. Check the IRS website at http://www.irs.gov/formspubs/ for details about dependent exemptions for college age dependents and other dependency issues.

For example, if the exempt amount is $3,500 and the tax bracket is 30%, tax savings are $950. But if the parent’s tax rate is 15%, the savings are $525. In this case, the exemption is worth nearly twice as much to the parent in the higher tax bracket.

If the tax rate is: You could save, for each exemption:
10% $350
15% $525
25% $875
28% $1,155*
33% $1,155*
35% *

However, high-income earners begin to see a phase out of this benefit above certain levels. To calculate a partial phase-out for a personal exemption, see IRS Pub. 501

The Economic Growth and Tax Relief Reconciliation Act of 2001 gradually eliminates the phase- out rule over five years, beginning in 2006, phasing out by one-third in 2006 and 2007, then by two-thirds in 2008 and 2009, and will be gone in 2010. It really is a way to have people pay higher taxes without saying so and is essentially a tax only on high wage earning parents, not all high incomes.

Spousal Support

Spousal support is treated very differently from child support with respect to taxation. Spousal support is treated as income to the receiving spouse, and deducted from the income of the paying spouse.

  • To qualify as spousal support the payments must meet the following five conditions:
  • The payment is a cash payment
  • The payment is received as a result of a “divorce or separation instrument”
  • The instrument does not specify that the payments are not for spousal support (for example, payments for a property settlement)
  • The payer and recipient are not members of the same household when the payments are made
  • There is no liability to make the payments for any period after the death of the recipient

These requirements apply whether the spouses enter a private settlement agreement that becomes an order of the court (contractual spousal support) or the court orders spousal support after a contested trial (statutory spousal support).

Viz a viz property settlement. There are sophisticated ways to transform what would otherwise be a property settlement into a tax deductible/includable form of spousal support. This can only be done by the agreement of the parties; the court cannot order it. Such agreements must be very carefully structured to avoid costly pitfalls. If you and your spouse reach such an agreement, your attorney may recommend consultation with an accountant who is familiar with these rules to help negotiate and draft a careful plan.

Dependent Child Tax Concerns

Dependent Exemption. Generally, the parent who has custody for the greater portion of the year may claim the child as a dependent, providing that both parents together provided more than 50% of the child’s support. Custody for purposes of claiming a dependency exemption is first determined by the divorce decree. If the divorce decree does not specify who should be the custodial parent, the parent who has the actual physical custody of the child for the greater portion of the year may claim a dependency exemption.

  • A custodial parent may relinquish the exemption by filing IRS Form 8332, Release of Claim for Child of Divorced or Separated Parents. This form must be filed with the claiming parent’s tax return. The exemption can be relinquished to a noncustodial parent for any number of years.
  • Form 8332 is not needed when the divorce decree states that the noncustodial parent has an unconditional right to claim exemption. Proper document must be attached to the claiming parent’s return.
  • The Child Care Credit may be claimed only by a custodial parent. The Child Tax Credit goes with the dependency exemption and is not available to the noncustodial parent even if the noncustodial parent can claim the dependency exemption. Only expenses actually paid by the custodial parent qualify for the credit.
  • Regardless which parent claims a dependency exemption, he/she may deduct medical expenses paid for the child.

Only the parent claiming the exemption can claim The Child Tax Credit. To qualify, the child must be under 17 at the end of the tax year. It is available to single or head of household taxpayers with income below $75,000. The maximum benefit is $1,000 per child. This too begins to phase out for higher income taxpayers. It usually does not result in a net refund (i.e. it can only reduce the tax to zero). However, for very low-income parents (no regular tax or when the Child Tax Credit exceeds the regular tax liability), the parent might qualify for a refundable Additional Child Tax Credit, essentially providing a tax refund. See http://www.irs.gov/newsroom/article/0,,id=106182,00.html.

Credit for Child and Dependent Care Expenses. If you paid someone to care for a child under age 13 so you could work or look for work, you may be able to reduce your tax by claiming the Child and Dependent Care Credit on your federal income tax return. To qualify, your child must be your dependent (See dependent exemptions, above). The credit is a percentage of the amount of work-related child and dependent care expenses you paid to a care provider. The credit can be up to 35 percent of your qualifying expenses, depending upon your income. For 2007, the taxpayer could use up to $3,000 of the expenses paid in a year for one qualifying individual, or $6,000 for two or more qualifying individuals.

These dollar limits must be reduced by the amount of any dependent care benefits provided by an employer that are excluded from income, such as an employer “cafeteria plan” that includes pre-tax set asides for health care or child care. See http://www.irs.gov/newsroom/article/0,,id=106189,00.html.

For those with “cafeteria plans” at work or qualified fringe benefit plans with childcare options, up to $5,000 of income can be received tax free for childcare expenses. At the highest tax brackets, this can result in a tax savings of $1,955. You cannot use this benefitand take the Credit for Child and Dependent Care.

The Hope Credit and the Lifetime Learning Credit. Two tax credits can help you offset the costs of higher education by reducing your income tax: the Hope credit and the lifetime learning credit, also referred to as education credits.

These credits may be taken on the tax return of the person claiming the student as a dependent exemption, whether the expenses were paid by the student or by one or both parents. The benefits are phased out at $47,000 to $57,000 of income for a single taxpayer or $94,000 to $114,000 for married joint filers. You cannot claim a Hope credit if your Modified Adjusted Gross Income (MAGI) is $57,000 or more ($114,000 or more if you file a joint return).

The Hope Credit is good for a credit against your taxes of up to $1,568 (indexed annually for cost of living changes) for the first two years of post-high school education. The Lifetime Learning Credit is worth up to $2,000 per return for costs beyond the first two years. The credits are not available if expenses are paid with tax fee money such as public assistance or tax-free educational savings.

  • For higher income households, it may make sense for the student to take him or herself as a dependent since there may be no benefit to the parent and the use of the credit might wipe out any tax liability from even a part time or summer job of the student.
  • Be careful to know if health care benefits for adult children are dependent on the tax filing status. If coverage is only available when the child is a dependent on the employed parent’s tax return, the cost of a loss of this benefit will outweigh the tax savings of the child taking their own exemption.

For more information, refer to Form 8863 (PDF), Education Credit (Hope and Lifetime Learning Credits), Publication 970, Tax Benefits for Education, or Tax Topic 605, Education Credits. http://www.irs.gov/publications/p970.

Earned Income Credit. The Earned Income Tax Credit (EITC), sometimes called the Earned Income Credit (EIC), is a refundable federal income tax credit for low-income working individuals and families. Congress originally approved the tax credit legislation in 1975 in part to offset the burden of social security taxes and to provide an incentive to work. When the EITC exceeds the amount of taxes owed, it results in a tax refund to those who claim and qualify for the credit.

The rules are complex. You must have earned income, which does not include spousal or child support. A qualifying child need not be your dependent. If you have low income from any source and there is a qualifying child living with you, it may be worth asking a tax advisor or CPA to look at whether there could be a “win-win” for both parents where one parent may make use of the EITC and the other of the dependency exemption and Child Tax Credit, especially where the low wage earning parent cannot make full beneficial use of all three. So much for “simplified” tax forms! In 2008, MAGI for the credit is about $35,000.

Certain U.S. Savings Bonds can be used to pay for college expenses and exclude from taxable income. However, this benefit is only available to the person claiming the dependent exemption.

Negotiating Dependent Exemptions

  • First prepare an estimate of the anticipated tax savings and potential child tax credits, dependent care expense credits, and educational tax credits for each parent.
  • Second the parent with the greater dollar benefit in terms of overall tax savings should claim the exemption, and take credits consistent with the exemption. Remember that other credits are not tied to the exemption and may be left with the custodial parent.
  • Third, get advice from a competent tax preparer or accountant where more than one credit or deduction is in play.
  • Finally, split the value of the credit(s) and or exemption(s) between the parents equally or in some equitable fashion. The parent who could have claimed the exemption should not end up paying more tax or receiving a lower refund because of the assignment. If the tax brackets of the parents are different enough, the benefiting parent and the paying parent will both be better off.

Retirement Benefits

A Qualified Domestic Relations Order (QDRO) is a court order that assigns the benefits of a qualified retirement plan to a nonemployee alternate payee. A plan administrator is required to determine if an order meets QDRO requirements within a reasonable period of time after the receipt of the order and must notify the spouses and any alternate payee of that determination.

Among the tax consequences of QDRO payments are:

  • Payments are taxed to the spouse or former spouse when received unless rolled over to an IRA.
  • A pro-rated share of the original participant cost is used to figure the taxable amount of the payments.
  • Lump-sum distributions to a beneficiary may be eligible for special averaging or capital gain treatment if the original participant would have been eligible for that treatment.
  • The 10% early distribution penalty does not apply.
  • When an IRA is transferred between spouses, the receiving spouse is treated as the owner of such an account upon date of the transfer.
  • Spousal support constitutes earned income for purpose of computing the IRA contribution limit.

Tax Carryovers

  • Capital loss carryovers are allocated based on each spouse’s separate capital losses. Gains and losses on jointly owned or community property are generally divided equally between the spouses.
  • A joint charitable contribution carryover is divided between the spouses with the same ratio of what separate carryovers would have been if the couple had filed the return married-separately.
  • A joint net operating loss is divided between the spouses based on their separately computed income.
  • There is no published authority on how to allocate alternative minimum tax (AMT) carry-forward credits.
  • Suspended passive activity loss is added to the underlying property’s basis and is entirely allocated to the spouse who owns the property.

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