If you are going through a divorce and filing as married filing jointly or married filing separately, be wary how the tax liabilities are allocated in your divorce. Why?
If one of your goals in your divorce is to keep as much wealth in your pocket as you can, you need to be careful how this calculation is performed. Read on to learn more.
Method 1 – Tax compliance method
This method focuses on identifying and therefore allocating the tax liability solely based on whose social security number is written on a specific tax form. For instance, if you receive an early retirement distribution but reported on a 1099-R and your social security number is listed on that form, then through the tax compliance method you will be assigned 100% of the taxable income associated to the early retirement distribution. You may be asking yourself the question whether that is fair or not, and rightfully so. It all depends how the funds were used. If you withdrew the funds and went for a vacation around the world and your spouse did not benefit from those funds then it is likely fair that you receive 100% of the taxable income. Yet, if you used those funds where your spouse benefited as well (e.g. paid down marital obligations), then the tax compliance method is likely not a good way to allocate the funds. You have to be careful how these calculations are performed as you may find yourself assuming a higher level of tax obligation than you expected. Paying a higher level of tax obligations translates into future wealth at risk.
The tax software can print out what is referred to as a taxpayer vs. spouse analysis. Inside the software the tax practitioner tags each piece of information with a “T” (taxpayer) and an “S” (spouse). The software does the assignment to each party and calculates the tax liability accordingly for each party. If you have a very simple situation, this method may be a good method to use as there is limited strategic planning required in this process.
Method 2 – Days allocation method
This method focuses on evaluating how much each spouse benefited from the income, expenses and payments made to the government. There are more details than this, but in a nutshell those are the larger items. The days allocation method does exactly what it sounds like. You determine the number of days each spouse enjoyed the income and related expenses associated to the marital estate. You allocate income, expenses, tax credits and payments accordingly. Be careful as these items may not be allocated evenly. It all depends on the situation. The longer the period of time the spouses lived together during the tax year the bigger the impact this method has on the allocation of the tax liability. Be cautious about the withholdings among other factors that go into this calculation. This method is useful if you have a lot of uniformity across your tax profile and the numbers can be allocated with relative ease and are applicable for relatively simple situations. Note: This method may be combined with another method where appropriate to create a hybrid approach.
Method 3 – Specific identification method
This method focuses on specifically identifying each tax item and related tax attribute that should be associated to each taxpayer. This is not only about tax compliance. This is about enjoyment and benefits along with obligations and risk assumption. This method is most beneficial when there is more complexity in the situation. It is important to get behind the numbers and figure out the story of what is going on. Once you understand the story you can determine how each tax attribute is allocated to each party.
Method 4 – Wealth optimization method
This method focuses on figuring out how to optimize the wealth position for each party. It involves a bit of the methods outlined above yet strives to assign the appropriate tax attributes to each party where the most benefit will be derived, yet under an agreed upon plan if possible. When the evidence is created the negotiating position can be better managed to drive towards the desired outcomes.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
If You Have a Question
If you have a question, feel free to contact me at [email protected] or 617-680-5222. The call is free. I will spend 30–60 minutes with you. I will provide you an honest assessment as to where I think you are positioned in your divorce process or answer any questions you have. I may provide you some guidance, insight or advice that you can take with you as you wish. There is no obligation to move forward. The phone call is designed to ease your fears, provide you some options to pursue and a potential road to run on that can lead you down a path to achieve a successful outcome.
About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
- continuously strive to provide a return on our services
- build balanced financial solutions grounded in evidence
- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
- provide mental clarity to make decisions
- reduce the total process time from start to close
- minimize the stress and unpleasant memories that can last a lifetime
As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.