In divorce court, it's you versus your spouse. That's bad. In tax court, it's you versus the United States Government. That's worse.

Marriage vows are not always everlasting, but the tax problems that may result from dissolving those vows can be. While the decision to end a marriage is given great thought, the tax consequences of that decision are often not considered. The parties involved think that they are fixing one mistake in their lives but they may end up creating other mistakes in the process. This paper will describe some of the potential tax pitfalls of the decision to separate and divorce.

Innocent Spouse Rule

A marriage is built upon trust. But when a marriage is ending, trust can lead to an unexpected tax liability. The majority of married taxpayers file their tax returns under the status of "married filing jointly," which is normally more favorable than filing separately. However, one of the most expensive mistakes a spouse can make is to sign a joint tax return without understanding and reviewing everything that his or her spouse reports on it. When spouses file a joint tax return, they both become responsible, individually and jointly, for any tax due on the return and for any subsequent tax, interest or penalty due on that return. This means that the Internal Revenue Service can collect the tax entirely from one spouse, even if all of the income was earned by the other spouse. Divorce does not relieve a spouse from liability on a joint return filed prior to the divorce. So although you may no longer have any involvement with your ex-spouse, you could end up paying his or her tax liability. This can keep the wounds of the divorce battleground fresh for years to come.

There is a small ray of hope for those taxpayers who find themselves in the position of paying an ex-spouse's tax bill, and that is the law known as the Innocent Spouse Rule. This rule is found in the Internal Revenue Code, Section 6013(e), and provides relief only if specific conditions are met. These conditions are as follows:

A joint return has been filed for the applicable tax year.

There is a substantial understatement, at least $500, of tax attributable to the gross income, deductions, credits or basis of the other spouse.

The spouse seeking the relief establishes that when he or she signed the return he or she did not know, and had no reason to know, that such a substantial understatement existed.

It would be inequitable, taking into account all of the facts and circumstances of the situation, to hold the spouse seeking relief liable for taxes due on the understatement.

If these conditions are met, then the spouse seeking relief under the rule may be relieved of liability for any tax, interest, and penalties attributable to the understatement. Notice that this relief is not automatic or guaranteed. Each case is examined individually to ascertain whether the spouse meets the conditions set out above and the burden is on the spouse seeking refuge under the Innocent Spouse Rule to prove that he or she is entitled to such relief.

In determining whether a spouse did not know, or had no reason to know, such a substantial understatement existed, the Tax Court has held in the past that the spouse must establish that he or she was unaware of the circumstances that gave rise to the error on the tax return. The more a spouse knows about a transaction, the more difficult it is to show that he or she had no knowledge of the understatement. Under the traditional approach, it then becomes a question of whether the spouse should have known about the tax consequences of the error. This burden is practically impossible to overcome. We have all heard the adage that ignorance of the law is no defense, which is particularly true in this context. For example, if a spouse knows that his or her spouse is involved in a tax shelter, he or she should make sure to ask questions and fully understand the tax implications of that shelter; a mere lack of understanding may not help in Court.

However, there may be some hope for those spouses who dislike being involved in the financial aspect of the marriage. A recent United States Court of Appeals decision held that a woman did not automatically lose out on innocent spouse relief simply because she knew her ex-husband had invested in a tax shelter that resulted in tax deductions, which were later disallowed by the IRS. The Court stated that the test should include the question of whether the spouse had the sophisticated financial insight to understand the tax shelter. Although it is too soon to tell, this new line of cases may be good news for taxpayers who know of the spouse's tax shelter but do not become involved in the details of the transaction.

The other subjective prong of the innocent spouse rule is whether it would be inequitable to hold a spouse liable for the other spouse's error, given all the facts and circumstances of the situation. In making such a determination, a factor to be considered is whether the spouse seeking relief significantly benefited, directly or indirectly, from the error.

Normal support is not considered a significant benefit. This means that the payment by your spouse of bills and costs normally expended by the family would not be a significant benefit to you. However, if a spouse receives property from the other spouse, even if that property is received years after the tax error occurs, that spouse will be considered to have received a significant benefit. For example, if a wife receives the joint tax refund as part of a divorce property settlement, she will be considered to have significantly benefited from the understatement, and thus she may be denied innocent spouse relief. Another example of a significant benefit would be if the spouse was able to enjoy a higher standard of living because of the tax error. Living a life of luxury should alert you to the fact that your spouse may be up to something and the tax court will hold you responsible for finding out what that something is.

Trying to maneuver the minefield of the Innocent Spouse Rule can prove daunting to even the most cautious of taxpayers. Sometimes the best-intentioned of us can get caught in the trap of proving that we should not be held liable for our ex-spouse's tax bill. Marriage is difficult enough without the added burden of worrying over your joint tax liability, but it may be advisable to substitute tact for trust and ask your spouse for the full details of any questionable transactions.

Rollover Of Capital Gains

One of the most common results of ending a marriage is that the marital home is put on the real estate market and sold to a third party. The sale of the marital home can produce some surprising results if both spouses are not aware of the tax complications within this area. Generally, Section 1034 of the Internal Revenue Code provides that a taxpayer who sells a home and buys a new residence within the requisite time period can roll over the gain realized on the sale into the new home. The requisite time period for most taxpayers is two years before or two years after the sale of their home.

This all seems rather simple until you realize that Section 1034 applies to the sale of a taxpayer's principal residence. In a divorce situation, the marital home most often ceases to be the principal residence of one spouse. The typical scenario involves a husband and wife who make the decision to separate and therefore one spouse moves out of the house. This decision can result in the loss of the nonrecognition treatment of Section 1034 for that spouse's share of the gain. This would mean that the spouse who moved out of the home would have to recognize his or her share of the gain on the sale of the marital residence and would not be able to roll over any gain into a second home. This could result in a substantial tax liability to that spouse.

The determination of whether a home should be considered a taxpayer's principal residence is based on the facts and circumstances of each situation. In the past, the tax court has held that a taxpayer's home may cease to be his or her principal residence when the taxpayer lives in a different residence. The intent of the spouse who is moving may make a difference. It may be possible for some divorcing taxpayers to argue that the move was temporary and was brought about by the divorce; that they were intending to sell the home at the time that one person left the residence; or that the payment of at least one-half of the economic burden associated with the residence should allow the departing spouse to continue to classify the home as their principal residence. The problem, however, is that the taxpayer will not know if that argument is effective until it is challenged by the IRS. By then it may be too late.

The other part of the capital gain rollover puzzle relates again to the signing of joint returns. If, for example, a taxpayer signs a joint return with his or her spouse in the year that the marital residence is sold, he or she may be liable for the ex-spouse's capital gains should the ex-spouse fail to meet the rollover requirements. This was the result in a recent tax court case which held that a husband was liable for his ex-wife's share of capital gains because he had signed a joint return in the year they had sold their marital home. The wife then failed to purchase a replacement home within the requisite time period and when she did not pay the taxes due on her share of the capital gains, the IRS looked to the husband for payment.

The question of who should move out of the home during the breakup of a marriage is full of emotional turmoil. This question holds pain and surprise for most couples and the last thing they are usually thinking of is the tax implications of the decision. However, those implications can have a major effect down the road and the possible tax ramifications associated with a move should be considered by both spouses prior to either leaving the marital home.

Recapture Of Alimony

Alimony is normally deductible to the spouse who pays the alimony and it is included in the income of the spouse receiving the alimony. However, in some circumstances, a paying spouse may later be required to relinquish that deduction and include, as income, a portion of the alimony previously paid. This result can occur when the IRS believes that spouses are attempting to disguise property settlements as alimony payments in order to receive a more favorable tax treatment.

Under the recapture rule, a spouse who pays alimony will be required to recapture any excess alimony paid during the first three years after the parties separate. The three-year time period begins in the first year that the spouse makes alimony payments to the other spouse.

The recapture calculation is viewed by many as extremely complex. In general, if the amount of alimony paid in year three, plus $15,000, is less than the amount of alimony paid in year two, the excess will be recaptured. In addition, if a comparison of the first year's payment to the average of payments made in years two and three show that the average of years two and three, plus $15,000, is less than the amount paid in year one, the excess amount will again be recaptured. The spouse who paid the excess amount would then have to include that amount in his or her income and pay taxes on it, while the spouse receiving the excess amount would get to take a corresponding deduction.

This potential tax pitfall catches many divorcing couples off-guard and should definitely be discussed with both your divorce lawyer and your tax advisor.

Child Support

Payments made to a former spouse as child support are not deductible by the person making the payments, nor are they income to the person who receives the money. Clever spouses tempted to disguise the payments as alimony so that the payment will be deductible are almost certain to get caught. The problem is often discovered when the IRS matches up the payer and payee tax returns and finds a discrepancy between the amounts reported. The IRS is on the lookout for child support disguised as "alimony" and you must use caution not to fall into one of the traps set out in the tax code and regulations to catch this kind of illegitimate deduction. For instance, if alimony payments are terminated or reduced within six months before or after a child's 18th or 21st birthday, the IRS could disallow the deduction for all or part of the "alimony" payment.

Pension Division

In the division of marital property, one of the most frequently overlooked assets is a spouse's pension or retirement plan. However, this asset can be more valuable than all the others combined. A spouse involved in a divorce must understand the rules regarding the division of pension plans or his or her golden years may be spent working under those famous Golden Arches.

In order to effectively divide a qualified plan - including pension plans, profit-sharing plans, and 401(k) plans - a Qualified Domestic Relations Order (QDRO) must be entered by the Court. It is not sufficient for your separation agreement or divorce decree to state that you are entitled to a portion of your spouse's retirement. The administrator of the plan will not pay your share to you without a QDRO which is signed by a judge. A QDRO is not needed to divide a non-qualified plan such as an individual retirement account or an annuity.

The Qualified Domestic Relations Order provides a safeguard for the ex-spouse receiving a share of the pension in that it prevents the employee spouse from disposing of the other spouse's share. It also ensures that each spouse receiving a portion of the pension or retirement becomes responsible for his or her individual share of the income taxes due on that money.

Conclusion

One universal truth is that no matter how intelligent or accomplished a person normally is, when going through a divorce, he or she does not always function normally. Decision-making is often controlled more by emotion than by rational thought. However, the potential tax pitfalls associated with divorce are abundant and it is crucial for each spouse to analyze possible tax issues in making their decisions during this difficult time.