Getting Divorced? What You Need to Know About Your Unpaid Tax Liabilities.

Getting Divorced? What You Need to Know About Your Unpaid Tax Liabilities.

Getting divorced is unpleasant, even in the best of situations, and nothing can make it more unpleasant than when issues from the marriage continue to haunt the former couple after the marriage is ended. Unpaid taxes is just one of those issues. I am talking specifically about unpaid Federal and state income and the reason the problem persists past the end of the marriage is something called called joint and several liability.

What is Joint and Several Liability?

Joint and several liability is just a fancy way of saying both spouses are on the hook for the whole amount of any income tax liability, regardless of whose income it is. The IRS and state tax authorities can collect such taxes from one or both spouses in pretty much any manner they choose. Let me illustrate this with a simple example:

Tom and Sue are married. Tom works from home (he is self-employed) while Sue is employed at a bank and is paid a wage. Tom is less than diligent about paying his estimated taxes while Sue has her income taxes withheld from her paycheck. At tax time, the couple files a joint return which results in a balance due because Tom did not pay anything towards his taxes (to keep things simple lets just assume the taxes are due on just the Federal return).

Once the return is filed and the IRS is made aware of the unpaid taxes, the IRS has almost absolute discretion to collect from the couple in any manner it chooses. It can collect just from Tom or Sue or from them both. The IRS is not required to attempt first to collect from Tom, the person whose tax liability caused the shortfall. The IRS doesn’t even have to try to collect from the spouse who earns the most or who has more assets! There is absolutely no requirement that the IRS ever try to collect from Tom. Practically speaking, that means that the IRS could levy a bank account held in Sue’s name or garnish her paycheck without attempting to collect from Tom first. 

I think this example explains how joint and several liability operates. For that reason you can see why a couple should understand the concept of joint and several liability, especially if you are in the process of getting divorced. In all likelihood, under my example, the IRS will try to collect from both Tom and Sue equally but if Tom stops working and goes on unemployment then the burden will fall on Sue to pay the taxes due. Even if Tom and Sue later get divorced this joint and several liability will continue to exist until it is paid, compromised or the statute for collections pass. So what can the divorcing couple do to deal with a joint tax liability?

First, understand that the IRS is not bound by any agreements or the divorce judgment.

The hardest thing to explain to a divorcing couple is that the IRS is not bound by a state court divorce judgment or settlement agreement. The reason is that Federal law trumps state law – it’s as simple as that. As unfair as that may seem, that is the law. If the court assigns the repayment of a joint tax debt to a party (or the parties agree to divide the debts among them) then that is binding only on the couple but not the IRS. What ends up happening is that if the IRS collects unpaid taxes from a spouse who is not obligated to pay such liability then the non-liable spouse will need to go back to family court to try and collect the difference from the liable spouse. This result can be particularly galling when the liable spouse has no assets or earnings or who actively fights attempts to pay the other spouse under the divorce judgment or settlement agreement.

Second, consider married filing separate for any current year returns.

While this is not helpful when a joint return has been filed, it is important to understand that there is no requirement to file a joint tax return. If the other spouse is habitually behind in paying his or her taxes then you may want to consider filing a separate return to only be liable on your portion of taxes. Be careful though! While the IRS may not be able to collect your spouse’s tax liability from you (whether by garnishing your wages or seizing your assets) that doesn’t mean it cannot seize your spouse’s share of any joint assets. It is not unheard of for the IRS to foreclose on the marital home.

Before moving on I want to add that even if the joint return shows a refund that doesn’t protect you 100%. If the joint return is later audited and additional taxes are assessed then you will be on the hook, jointly and severally, for the additional amount due. So the lesson here is to be careful about signing a joint return if you suspect your spouse may be playing fast and loose with the tax rules.

Third, you may be able to sever joint liability through innocent spouse relief.

All hope is not lost if you have a joint tax debt. The IRS has a process called innocent spouse relief which provides a means of severing a couple’s joint and several liability for taxes. This relief is available often where there is some inequity in holding you liable for the whole tax liability – usually where there is some bad behavior on the part of the other spouse. If you qualify, innocent spouse relief will de-couple your tax liability (in whole or in part) from your spouse or ex-spouse. Innocent spouse relief comes in three “flavors” as it were:

General Relief – relief is available where there is a tax understatement that results from an “erroneous item” solely attributable to your spouse (erroneous items are things such as unreported income or claiming non-deductible/fictitious expenses). Beyond the requirement of the erroneous item solely attributable to your spouse or ex-spouse, you must also show that: one, had no actual or constructive (meaning that someone in your shoes should have known) knowledge of the erroneous items; and two, it would be inequitable to hold you responsible for the understatement, considering all of the facts and circumstances.

Separate Liability – relief can be granted up to your share of the tax liability (based on what your liability would have been if you had filed separately). Separate liability relief will not be granted if: one, the IRS can show that assets were transferred between you and your ex-spouse as part of a fraudulent scheme; or two, you signed the joint tax return with actual knowledge of the item giving rise to the tax understatement, unless the return was signed under duress.

Equitable Relief – this is a catch-all if you do not qualify for relief under innocent spouse or separate liability relief. To qualify for equitable relief, you must show that under the facts and circumstances of your situation that it would be inequitable to hold you liable. In this case, the IRS will consider a series of factors that point to whether or not relief should be granted. Factors that indicate relief should be granted are: taxpayer would suffer an economic hardship if relief is not granted, taxpayer was abused by the spouse, the other spouse has a legal obligation, such as in a divorce decree, to pay the tax liability, and the liability is solely attributable to the other spouse. Factors that indicate that relief should not be granted are: the taxpayer had reason to know or knew of the tax liability, the taxpayer benefited significantly (beyond normal support) from the understatement, and the taxpayer has not made a good faith effort to comply with the tax laws during the year the tax liability arose and thereafter.

Finally, you do have options even if you are jointly and severally liable and there is no way to obtain innocent spouse relief.

Even if you cannot obtain relief or avoid joint liability you can still work with the IRS to reduce or remove the unpaid tax liability. Installment agreements, offers-in-compromise, currently not collectible status and penalty abatement are all tools to obtain relief from your tax liabilities and you may be able to use these tools to handle your tax debts.

In summary, be aware of the rules regarding joint and several liability as it may have an impact on your divorce. I hope you found this information useful and if you have any questions about what I have written feel free to call or email me.

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Getting Divorced? Here are Some Tax Traps to Avoid.

Divorce is tough. No doubt about it. So avoiding more bad news is probably a good idea. While I can’t make divorce any easier here are some tips on avoiding tax troubles in your divorce:

1. Filing a joint return in your final year of marriage.

The instinct that often prevails during divorce is to file as married filing jointly one last time. The reason is that most separating couples want to take advantage of the lower tax liability and the availability of certain credits one last time. There is a downside, however. Filing a joint return makes you liable, jointly and severally, with your soon-to-be ex-spouse. That means the IRS can come after you for the full amount of the tax liability shown on the return or if additional taxes are assessed after a later audit.

By filing a joint return, the IRS now has the right to collect all of the tax debt from both of you, even if the source of the liability was your ex-spouse. For example, you have a regular job but your husband is self-employed and he took deductions he shouldn’t have. The IRS later audits the return and assesses additional taxes. Now you are on the hook for those additional taxes. What’s worse is that even if the divorce judgment allocates a tax debt between you and your ex-spouse the IRS does not need to honor it because Federal law trumps state law. The better course of action may be to file married filing separately in certain cases. The takeaway here is don’t just assume that filing jointly is the way to go merely because it means you have to pay less taxes overall. Speak with your accountant first.

2. Alimony recapture.

The IRS has a quirky rule regarding alimony. If you are required to pay alimony to your ex-spouse and your payments decrease within the first three years following your divorce than you might run into some tax trouble. Normally, alimony payments are taxable to the recipient and deductible by the payer but where the alimony recapture rules apply than the payer may have to report some portion of those alimony payments as income in the third year.

The rules for alimony recapture are a bit complicated to explain in a blog post but watch out for the following situations which may indicate you have an alimony recapture problem: (1) there is a change in your divorce judgment, reducing payments; (2) you fail to make your alimony payments timely; (3) there is a reduction in either your ability to pay the alimony or in your ex-spouse’s need for alimony payments. If you find yourself in one of these situations you may want to talk with your accountant to determine if you may have to pay some unexpected taxes to Uncle Sam.

3. Dividing an individual retirement account.

Many marital estates contain a retirement plan that has to be divided, usually in the form of individual retirement accounts or IRAs. Unlike 401ks or a military pensions, IRAs do not require a special order from the court (called a qualified domestic relations order or QDRO) for the IRA to divided between the parties. This ease of transfer is, of course, a trap for the unwary. While no court order is required to divide your IRA it does not mean that you can simply write a check to your ex-spouse from your IRA and the matter is done. No, nothing is quite that easy in life or taxes. The IRS has specific guidance on how the IRA is to be divided.

To accomplish the transfer, the IRA must be divided among the divorcing couple under a divorce or separation instrument, which means the IRA should be divided in the divorce judgment or through a written agreement between the parties. Once that is done then the IRA must be transferred by a direct trustee-to-trustee transfer. If you take the money out of the account and transfer it then transfer is treated as a taxable distribution. Which means that the recipient spouse must set up his or her own IRA and provide instructions to the IRA trustee to make a proper transfer. If 100% of the IRA is going to be transferred than the owner merely needs to have the name changed.

Failure to follow these procedures may mean you may be facing additional income taxes and an early withdrawal penalties (10%) on the amount transferred.

4. Not considering the tax consequences of a property division.

Property divided in a divorce does not trigger a taxable event and so property can be freely transferred between divorcing spouses. Again, while this all sounds good, this is a trap for the unwary. Just because you can transfer property among divorcing spouses tax free does not mean that it is without tax consequences.

Consider the following. A couple has two jointly assets to divide: stocks worth $100,000 (with a tax basis of $50,000) and $100,000 in cash. The husband wants the stocks while the wife wants the cash. After the divorce is finalized, the husband changes his mind about keeping the stock and sells the whole lot for $100,000. Come tax time the husband gets a surprise when he has to pay taxes on the gain from the sale of the stock ($100,000 less $50,000 basis equals a gain of $50,000). So while his wife got $100,000 in cash, he will only receive whatever is left over after paying taxes (which is certainly less than $100,000). Laughing all the way to the bank, the ex-wife owes no taxes on her $100,000 in cash because cash has a basis equal to its face value ($100,000) while other property may have a basis that is less than fair market value, especially where you purchase appreciating property like stocks and collectibles. Changing hands does not increase the basis to fair market value because it was a tax free transfer.

Now let’s say the couple gets cute and decides to have the wife “sell” her interest in the stock to her husband in exchange for cash. Sadly, that will not work either as transfers, to include sales, are not taxable between spouses for a period of time after the divorce (while this presumption doesn’t go on forever, it goes for a number of years after divorce). So pay attention to the potential tax consequences of dividing up your marital property, there may be hidden taxes due!

5. Marital status.

Finally, the issue of marital status comes up quite frequently. Many divorcing couples believe that if they are separated (but not divorced) at the end of the tax year than they can choose the tax status that provides the most benefit, usually head of household. The reason for this is obvious: married filing separately has restrictions on the credits that can be taken, such as the child care credit, education credits and earned income credit. All of which can have a big impact on your taxes.

Your tax status is determined by your married status as of December 31. If you are still married at year-end than you cannot file single and there are restrictions on filing head of household. For the most part, you must file married filing joint or married filing separate. To be able to claim head of household the taxpayer must meet the strict requirements of the statute. Again, if you are not divorced at year end, speak with your accountant to determine what filing status’ are available to you.