A life event with tax consequences, such as marriage, divorce, separation or the death of a spouse is not easy. Regardless if the occasion is stressful or fantastic, the last thing most people think about are the tax ramifications. Taxpayers are frequently blindsided when their filing status changes due to one or more of these life events taking place. However, tax consequences are real and need to be considered to avoid unpleasant surprises. The following are some of the major tax complications for each situation.
#1 Life Event with Tax Consequences: Divorce
Once a couple is legally divorced, tax issues become clearer. This is because each former spouse will file based upon their own income. Also the terms of the divorce are spelled out relating to spousal support, custody of children and division of property.
Filing Status
An individual’s marital status on the last day of the year is used to determine filing status for the year. So, if a couple is divorced during the year, they can no longer file together on a joint return for that year or future years. They must, unless remarried, either file as single or head of household (HH). To file as HH, an unmarried individual must have paid over half the cost of maintaining a household for a dependent child or dependent relative who also lived in the home for more than half the year. An exception is that a dependent parent does not need to live in the child’s home for the child to qualify for HH status. If both ex-spouses meet the requirements, then both can file as head of household.
Children
Normally, the divorce agreement will specify which parent is the custodial parent. Tax law specifies that the custodial parent is the one entitled to claim the child’s dependency and associated tax benefits. With the exception being if the custodial parent releases the dependency to the other parent in writing. The IRS provides Form 8332 for this purpose. The release can be made for one year or multiple years. The release can also be revoked. If a release is revoked, the revocation is effective in the tax year after the year the revocation is made.
Family courts often award joint custody to the parents. The IRS’s tie-breaker rule will be used if the parents can’t agree on who claims the child as a dependent. The tie-breaker rule specifies the parent with the most custody is entitled to claim the child as a dependent. (Custody is measured by the number of nights spent in each parent’s home.) The parent claiming the dependency is also eligible to take advantage of other tax benefits, such as childcare and higher education tuition credits.
Alimony
See alimony under “separated”.
#2 Life Event with Tax Consequences (and the most complicated): Getting Separated
Separating from a spouse is probably the most complicated life event and is certainly stressful for the family involved. For taxes, a separated couple can file jointly, because they are still married, or file separately.
Filing Status
If the couple has lived apart from each other for the last 6 months of the year, either or both of them can file as head of household (HH). This is provided that the spouse(s) claiming HH status paid over half the cost of maintaining a household for a dependent child, stepchild or foster child. A spouse not qualifying for HH status must file as a married person filing separately if the couple chooses not to file a joint return. The married filing separate status is subject to a host of restrictions to keep married couples from filing separately to take unintended advantage of the tax laws.
In most cases, a joint return results in less tax than two returns filed as married separate. However, when married taxpayers file joint returns, both spouses are responsible for the tax on that return. This is referred to as joint and several liability.
What this means is that one spouse may be held liable for all of the tax due on a return, even if the other spouse earned all of the income on that return. This holds true even if the couple later divorces. So when deciding whether to file a joint return or separate returns, taxpayers who are separated should consider the risk of potential future tax liability on any joint returns they file.
Children
Who claims the children can be a contentious issue between separated spouses. If they cannot agree, the one with custody for the greater part of the year is entitled to claim the child as a dependent along with all of the associated tax benefits. When determining who had custody for the greater part of the year, the IRS goes by the number of nights the child spent at each parent’s home and ignores the actual hours spent there in a day.
Alimony
Alimony is the term for payments made by one spouse to the other spouse to be used for income support. Under tax law prior to tax reform, the recipient of the alimony includes it as income. The payer deducts alimony as an above-the-line expense, on their respective separate returns. The tax reform rule is that alimony is non-taxable to the recipient if it is received from divorce agreements entered into after December 31, 2018, or pre-existing agreements that are modified after that date to treat alimony as non-taxable. Therefore, post-2018 agreement alimony cannot be treated by the recipient as earned income for purposes of an IRA contribution and can’t be deducted by the payer.
A payment for the support of children is not alimony. To be treated as alimony by separated spouses, the payments must be designated and required in a written separation agreement. Voluntary payments do not count as alimony.
Community Property
Nine U.S. states – Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin – are community property states. Generally, community income must be split 50–50 between spouses according to their resident state’s community property law. This often complicates the allocation of income between spouses, and they generally cannot file based upon just their own income.
#3 Life Event with Tax Consequences: Recently Married
When a couple marries, their incomes and deductions are combined, and they must file as married individuals.
Filing Status
If a couple is married on the last day of the year, they have choices. They may either file a joint return combining their incomes, deductions and credits or file as married separate. Generally, filing jointly will provide the best overall tax outcome. But there may be extenuating circumstances requiring them to file as married separate. As mentioned earlier, married filing separate status is riddled with restrictions to keep married couples from taking undue advantage of the tax laws by filing separate returns. Best look before you leap.
Combining Income
The tax laws include numerous provisions to restrict or limit tax benefits to higher-income taxpayers. The couple’s combined incomes may be so much that they’ll encounter the higher income restrictions, with unpleasant tax results.
Affordable Care Act
If one or both spouses acquired their health insurance through a government marketplace and were receiving a premium supplement, their combined incomes may exceed the eligibility level to qualify for the supplement, which may have to be repaid.
And finally, often the most emotionally devastating life event with tax consequences: the death of a spouse.
When one spouse of a married couple passes away, a joint return is still allowed for the year of the spouse’s death. Furthermore, the widow or widower continues to use the joint tax rates for up to two additional years, provided the surviving spouse hasn’t remarried and has a dependent child living at home. This provides some relief for the survivor. As they would otherwise be straddled with an unexpected tax increase while also facing the potential loss of income. Examples of this loss income include the deceased spouse’s pension and/or Social Security benefits.
If any of these situations are relevant to you or a family member, please call for additional details that may also apply with respect to your specific set of circumstances.
False Employee Retention Credit Claims Can Mean Big Problems Later
