Divorce Can be Taxing — Tips and Traps

In the best of worlds, taxes can be complicated, provoke anxiety, and, of course be costly.  In a divorce situation taxes have the potential to become yet another battleground for the exhausted parties. Many of the financial decisions made by the parties – or made for them if they cannot agree – have serious, long-lasting tax consequences. Care and consideration must be given, as illustrated in the following examples:

How to File: Bette and Pedro* are negotiating a particularly nasty separation that will span two calendar years. Pedro is a local banker (at “You Are Not A Loan) and Bette is a stay-at-home mom. Pedro wants to file as a couple – “married filing jointly” – so they will get a small refund. Because of the acrimony, Bette will not agree and thus they have to each file “married separately” returns  – she will still not owe anything (no income) and Peter will owe a ton (the rates are higher and the credits limited for separate status.) 

For “the parties as a whole” married filing jointly is generally a better financial choice, easier, cheaper.  If it is a straightforward return (e.g. neither partner owns a business) and the parties trust the veracity of their reported figures, this is particularly true. Then again, if trust is gone it is hard to blame Bette, who has nothing to lose (well --time, lawyer’s fees, any residue of good will.) There is also the thorny issue of allocating payments and refunds if the couple is filing a joint return and misuse of funds is already an issue in the divorce.

Being Realistic: Sue runs a professional staffing agency (“We Pay Less”) Her husband Larry is half-owner of the corporation but is not actively involved. The divorce was drawn out for five – Five! – years because Larry wanted to be bought out of the business.  Fair enough Larry but as her tax preparer I know there is not much there. We Pay Less” has one core client, and no long-term contracts. There is little intrinsic value and virtually no hard-core assets .Essentially WPL provides employment for Sue, some tax breaks and liability protection. Larry may be entitled to alimony or child support based on Sue’s earnings, but just because your spouse “owns a business” doesn’t necessarily mean there is a bucket of cash lurking there.

Common Good: Howard and Deirdre have two children, Homer and Marge.  They will stay with Deirdre during the week and with Howie on weekends. How should they determine who claims the “dependency exemptions” after they are divorced?

It helps if the parties can think longer term and not punitively. Howard’s income is substantially more than Deirdre’s – therefore, the dependency exemptions save him a higher percentage of his taxes than it would for her. In addition, he plans to fund the children’s’ education, and he cannot claim an education credit without the related dependency exemption.

Then again, Deirdre’s income has grown steadily each year and within a few years could be similar to Howard’s. How should they structure the arrangement? 

With two children and potential tax benefits for each parent, oftentimes the parties will specifically identify one dependent per parent in the divorce agreement – or, if one child they will agree to alternate the exemption annually.

Howard and Deirdre trust each other to be fair in these matters and they are remaining friends – this is a less hostile divorce than others.  Given this, they do not want to write anything into stone. As the custodial parent, Deirdre has rights to both dependents, but she may waive either one or both in any year, and Howard would be entitled to the benefit (s). They will “run the numbers” year by year and decide what approach is in their best interests. Yes, I have clients who see me separately and do this!

Ultimately it is up to the parties what tact to take. Will you fight over every penny? Drag the proceedings out until you are both left bloodied, dissatisfied and no less angry?  Switch lawyers until you find the perfect match for the lowest price, aggressive, effective, calls you back but doesn’t charge? Yes, you are right (you always are!), you are entitled and it’s not fair – but when all is said and done often it is best to get it done as quickly and painlessly as possible, even if you don’t get all you deserve.

* These are real names and real situations.  The names, details (and sometimes genders!) have been altered to protect privacy.

Rich Streitfeld is a CPA with Aaronson Lavoie Streitfeld Diaz and Co. in Cranston, R.I.  He works with individuals, businesses and nonprofits and is nicknamed "Zen Mensch Accountant"**. Rich can be reached at rich@alscpa.com or 401-223-0205.  He authors a blog “Peace Love and Business Planning – Prosperity for the Rest of Us.” –www.peaceloveandbusinessplanning.com.

** I can explain why. E-mail me.