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Ups and downs

July 5, 2022

By Cheri G. David, CPA, CVA

Divorce can be like a stomach-turning roller-coaster ride. For me, it started in the Hanover Circuit Court, headed up to the Virginia Appellate Court and then all the way to the top — the Virginia Supreme Court — with an explosive win. And then, I came all the way back down the court chain again with a grand finale of more than $250,000 in legal bills (just for my side). David v. David 287 VA. 231 (2014) was most certainly not my favorite roller-coaster ride, but one that has shaped my perspective on what clients may be experiencing during separation and divorce. While most clients’ divorce journeys will not land them in front of the Supreme Court, it is important to recognize how we as CPAs can play significant roles in helping our clients and their families survive the ride.

THE INITIAL PHASE

Client contact

Amicable or not, the first very important stage of any divorce is a separation agreement. Hopefully your clients will, at minimum, consider this less litigious agreement, collaborative law or mediation first. However, sometimes emotionally charged divorcing couples will skip these steps completely and head straight to divorce court by way of filing a divorce complaint with full-blown litigation to follow. CPAs will often find that their clients only show them a separation agreement or divorce decree after it has been signed, agreed upon and approved by the judge. Moreover, these final agreements may or may not leave room for the CPA to provide the most tax advantageous scenario to the formerly happy, now not-so-happy, couple. In effect, the CPA is left with the daunting task of working through tax situations “after the fact.”

But CPAs can take a proactive role in assisting their clients before the agreements are drafted, signed and approved by helping them (and their lawyers) include very important elements in the final, legally binding documents.

Client representation

CPA firms that prepare joint tax returns for separated parties often find themselves in a precarious situation. Considering whether to retain both clients, one client or none after the separation should meet the state professional codes of conduct. To retain both clients, the separating spouses should be amicable and the firm must disclose to the clients that a conflict of interest could exist if the parties do not agree on their tax matters. Be sure to have two separate engagement letters, each containing a reference to the potential conflict of interest, if preparing both parties’ tax returns. Anything less will open your firm up to significant risks of malpractice, as well as distrust and the potential loss of both clients.

If the clients are anything less than amicable, immediately disengage from working with at least one of the parties or maybe both. From that point forward, it’s advisable that all future communications regarding agreements between the parties be made in writing and preferably ask the disembarking client if it is okay to communicate with their new CPA directly. Remember, divorce is a roller-coaster ride. One day everything is fine between the parties and the next it is not! Don’t jeopardize your firm’s professionalism by trying to keep both clients in this tentative type of situation.

THE SEPARATION PHASE

Understanding the separation agreement as well as referencing the guidance in U.S. Internal Revenue Service (IRS) Publication 504, Divorced or Separated Individuals, will help in the tax preparation and planning for the divorcing couples. Depending on the each of the party’s individual circumstances, the tax return may be very simple or somewhat complex. Collect the facts and be proactive. Ask a lot of questions, such as:

  1. What are the living arrangements?
  2. How are the children’s expenses paid?
  3. Who pays the household living expenses?
  4. Did either party move out?
  5. What are your plans for the marital residence (keep or sell)?
  6. What are your plans for handling the division of your assets?
  7. Have you retained or are you thinking about retaining a lawyer?

Early intervention in the drafting of the agreements is critical — the separation agreement is essentially the beginning framework for a final decree. Think of a separation agreement like a trial-run agreement as to how the couples are able to follow the terms of the agreement in their new paradigm, as co-parents or as independent living members of society. If the separation agreement is missing certain elements of tax law clarification, the parties will hopefully be afforded another opportunity to make modifications before the final court-ordered decree. Parties are often in a flurry of emotional trauma, and are not thinking about how dependents will be claimed or how the Affordable Care Act (ACA) will affect their taxes. A CPA who is able to work with attorneys and clients during this first phase can clear up potential tax-related pitfalls in those written agreements between the parties.

Filing status

Marital status is decided as of the last day of the year — Dec. 31. For those parting couples who can be somewhat agreeable, married filing jointly (MFJ) will likely yield the best tax result (though it is not a slam dunk filing status in all cases). For example, if the parties have split homes and there are children involved, a Head of Household (HOH) status should be considered. The HOH rules indicate that if, in the last six months of the year, the taxpayers maintained separate households with a qualifying child, HOH status may be available and will almost always yield the best tax advantage for both parties.

In high-conflict divorces, parties often will ask to file their returns separately. Sometimes, it really doesn’t matter that the tax result will be better under a MFJ status. These types of couples may not only despise the air the other party breathes, but the thought of having their name listed with their soon-to-be-ex is incomprehensible. In some cases, it’s absolutely necessary to prepare a married filing separate (MFS) return if there are past tax liabilities, debts or late tax filing issues to consider by either spouse.

Keep in mind that preparing MFS returns has some twists. The MFS filing status claimed must be the same for both parties’ returns. Additionally, the spouse who files first gets to pick whether they want to itemize or claim a standard deduction. The spouse who files last is stuck with having to file in the same fashion, including using the same itemized or standard deduction as the first spouse. Let your client know the MFS filing ramifications before filing season, and that mix-and-matching in the MFS returns will earn them unwanted IRS attention.

Living under the same roof

More than ever before, divorcing couples are living together while their divorces are pending —and even sometimes during high-conflict litigation. Be extra careful when couples are in this situation. Support agreements may indicate spousal support, child support and other directives. However, if the couple is still living together, the normal exemptions, deductions, child tax credits, dependent care credit and income allocation rules are modified and may not apply. For example, the dependent care credit is not available for MFS returns.

Who gets to claim the kids?

There used to be an old saying: “He who files first gets to claim the kids.” Although to some degree that remains true, if both parties claim the same kids, the IRS will eventually review both parties’ returns and send letters to your clients asking who has the right to claim the children. Several examples are itemized in IRS Publication 504. However, it simply boils down to this: Whichever parent provides more than half the support is entitled to the deduction. If both parents provide equal support, then the exemption goes to the parent with the higher Adjusted Gross Income. If the non-custodial parent provides more than half the support, then the custodial parent needs to release the exemption by completing IRS Form 8332, Release of Claim to Exemption for Child by Custody Parent, and file it with the return. Have a directive as to who will be signing the Form 8332 and for which years included in the parties’ agreements and decree. The IRS can disallow the deduction to the non-custodial parent without this form attached to the return — regardless of what the court order states about exemptions.

There are a few exceptions when neither parent can claim the children. This mostly happens if the child is being supported by another provider, grandparent, foster care or family member. Sometimes the parents are receiving significant aide from public sources, such as Social Security or government aid. Thorough client inquiry and communications will help in the accurate tax preparation and proper dependency exemptions reporting.

Alimony or spousal support

Transfers of marital property between spouses as a result of divorce or separation are generally not taxable. However, payments required by a legally binding separation agreement or decree to spouses for maintenance can be considered alimony. Unlike alimony, which is taxable income to the receiving spouse and a deduction to the paying spouse, child support is not alimony and not taxable or deductible. Parties can also agree in their agreement or decree that support or certain payments (i.e. auto expense, insurance, utilities) will not be designated as alimony. If the parties wish to exclude support payments from their tax return, a legal binding document (separation agreement or decree) must be filed and attached to their returns to qualify for the exclusion.

Parting spouses — even if living in the same home in separate bedrooms and with a legal separation agreement or decree — cannot claim support payments as alimony unless one of the spouses leaves no later than one month after the date of the payment. In other words, it’s not enough to just have an agreement that includes a party’s requirement to pay expenses for the other spouse. The couples must live in separate residences to claim this tax deductible obligation.

Be careful of alimony recapture rules. It’s often difficult for couples to fathom writing checks to their soon-to-be ex. While the courts, bound by state laws, may require mandatory payments under certain circumstances, a crafty lawyer may draft spousal support agreements that include a reduction of those payments when the kids turn 18. Even though this fact may not be identifiable in the agreement, the mere dropping of payments in the future should raise caution flags for potential recapture. Specifically, if the alimony/spousal support decreases by more than $15,000 or decreases significantly in years two and three from the first, the parties likely may have to recapture that alimony.

Affordable Care Act Provisions

The ACA is now adding additional layers of complication for divorcing couples. The ACA provisions consider that households with incomes from 100 percent to 400 percent of the poverty level are eligible for the advanced premium tax credits (PTC) for payment toward their health insurance premiums. This means there are incentives to how couples divide children dependency exemptions and allocate income. If a higher-income spouse makes alimony payments to the lower-income spouse, then essentially there is a shift of income to the lower-income spouse. In some states, like Virginia, a minimum household income in 2016 of $11,880 is required to be eligible for the PTC. Therefore, in some circumstances alimony and/or spousal support that meet a minimum income threshold for ACA purposes may increase the couple’s chances to save significant tax dollars, combined with correctly reporting the PTC between the returns.

The PTC is essentially a subsidy tied to the taxpayer and their dependents. The parent who claims the child gets claim the credit if within the eligible income limits. The parent who doesn’t claim the child but receives the subsidy (PTC), may have to pay a portion or the entire subsidy back. This subsidy is reconciled between the parties’ returns and hopefully it is referenced in the parties’ legally binding agreements. If the unhappily divorcing couple does not communicate with one another about who is claiming the dependent exemptions and who will be carrying the health insurance policy, but one or the other holds the policy, the parties may be out of luck in being able to claim the credit — or worse, they may have to pay it back. This is due to another mismatch between the party’s returns, one claiming the dependency exemptions and the other receiving the PTC subsidy. Further guidance of the PTC and the interplay between divorcing couples’ tax return filing statuses, as well as dependency exemptions, can be found in IRS Instructions for Form 8962, Premium Tax Credit.

THE FINAL DECREE

For divorcing couples, a final divorce decree is the pathway to the future. Divorce decrees come in all shapes and sizes. Hopefully, the clients have worked with their CPAs during the process and the final decree clearly identifies directives based upon the couple’s mutual agreements or the finality by a highly litigated court decision. The decree should include concise and specific directives of how the marital and separate assets are divided or sold, how IRAs are to be transferred, who makes which payments and for how long, child support, alimony and various other support requirements.

Divorcing couples are often battle-worn by the time they get to the final decree stage. They will find themselves in a “just get through it” attitude. It’s okay to assert your knowledge and help them from “just” signing off on a legally binding document that does not include necessary tax planning objectives. Fundamentally, once a court order of final decree is entered, it can take a tremendous amount of time and financial resources to have it changed later.

A NEW CHAPTER

A CPA is often the most trusted and neutral advisor between divorcing couples. Whether you helped your client navigate through the process of preparing taxes or provided them with just an empathetic ear, a proactive approach can save your client much agony and dispute through the divorce process. CPAs are in a unique position to supply sound advice in the early stages from the separation agreement all the way through to the final decree.

While it sounds contrarian, divorcing couples who can work together are far better off — not just as it relates to their tax savings, but for their kids and their future economic statuses as well. CPAs who add value by helping their clients stomach the rollercoaster ride will land sincere loyalty and a long-trusting relationship for years to follow.

 

Cheri G. David, CPA, CVA, has nearly 20 years of experience in the area of tax, financial and small business consulting. She is an owner and managing partner at Clarkson David, CPA. Cheri also is a partner at Valuation One, LLC, a firm specializing in expert witness testimony and divorce litigation matters. She is a member of the Disclosures Editorial Task Force.