It may come as a surprise to you and your spouse that your decision when to move out of the marital home can have significant financial ramifications to one or both of you. You may even view this as an unkind divorce move that could unexpectedly saddle your spouse with a mountain of tax debt (more on that below). This all happens when one spouse decides to file MFS (married filing separately) and the other spouse has no choice but to do the same. Let me explain a bit further.
If you are forced to file as MFS, you will likely pay a much higher tax bill than you would if you filed as MFJ. Being forced into this situation has significant tax consequences. Truth be told if you drain your finances before you are finally divorced you are truly draining the marital estate which only leaves less for each of you. So, overall consciously or unconsciously it’s not a good move to make in a divorce proceeding.
There is a tiny piece of the tax law that could help you avoid being forced to file as MFS and experience this unexpected financial burden. You have to qualify for a tax filing status commonly referred to as “head of household” (HoH). Most people understand HoH is only reserved for people who are already divorced and is the primary person responsible to financially provide for the children. In this special situation, you may be eligible for the HoH status even though you are still married. How? The key is to be living apart form your spouse for at least 6 months during the latter half of the year. Why is this important? There are certain tests that have to be met to qualify for the HoH status. The IRS considers you unmarried on the last day of the year if you prove to meet all five tests below.
This is important to see if you qualify since the HoH status has a much lower effective tax rate as compared to the MFS tax filing classification. In fact, the difference in the tax burden can be staggering.
While still married, to qualify for the HoH tax filing status, you have to prove you meet the following tests. You:
- File your taxes separately from your spouse
- Paid more than half of the household expenses during the tax year
- Provide the principle home for a qualifying dependent
- Claim an exemption for your dependent
- Lived apart from your spouse for at least the last 6 months of the tax year
Each one of these can be sensitive tests. Yet, the last one usually goes unnoticed and can cause big tax headaches for you and your spouse. There are also special circumstances related to temporary absences you need to pay close attention to. Below are two examples that will cause you to be disqualified.
If your spouse moved out of the house on July 1st, the IRS will likely rule you did not live apart for the last 6 months of the year and you would fail the test above. There was one extra day that was included in the calculation that made you disqualified.
Your spouse could be temporarily absent due to a valid special circumstance. Examples include: illness, education, business vacation, military service, or detention in a juvenile facility. In addition to having a valid special circumstance, it must be reasonable to assume the absent spouse will return to the home after the temporary absence. You must continue to keep up the home during the absence.
Let’s consider your spouse went away on a business trip from June 29th through July 2nd. He or she moved out of the house on July 2nd, but was not physically present in your home on June 30. This would be considered a temporary absence due to a valid special circumstance. The IRS would deem that you did not live apart for the last 6 months of the year and you would fail the test above. Why? The period where your spouse was temporarily absent was included in the calculation that made you disqualified.
It is worth noting if you attempt to claim that you and your spouse lived apart for more than 6 months but knew this was not true then the IRS could subject you to a 75% penalty for the tax that was due on top of any interest and penalties that accrue on the outstanding tax liability. Furthermore, in more serious situations they claim they have the right to imprison you for up to 5 years for committing what would be deemed a fraudulent transaction.
You might say to yourself “what are the chances of that happening”? Well, they could be high. Why? Their computers look for taxpayers who file as MFS. They look for the other spouse to determine if she or he filed as MFS or HoH. If the other spouse filed as MFS then there are no problems per se as the IRS is getting their money. If the opposing spouse filed as HoH then the return gets flagged to make sure the taxpayer is meeting the battery of tests outlined above.
If the taxpayer fails one test, you can imagine what happens next. Letters, questions, requests for proof, etc. Basically, the IRS can engage a full assault on you in the form of an audit. Why would they do this? They want to make sure they get paid their money. So, they want to make sure people are abiding by the rules outlined above.
In summary, if your spouse wanted you to feel an unexpected financial crunch, your spouse could force you to file your taxes as married filing separately. How does this work?
Most people who are married file their taxes as married filing jointly. When people are considering getting a divorce or want to play less than kind in their divorce process they can subject their spouse to a much higher tax burden by filing MFS. If one spouse files as MFS you are forced to file as MFS too. You cannot file under the MFJ classification. Why? If you attempted to do so, you would need your spouse to sign the MFJ return. Since your spouse is interested to file as MFS your spouse will not sign the MFJ return which would make a potential MFJ return inadmissible and would not be accepted by the IRS. The e-file would likely be rejected.
It is worthy to note, there is virtually no literature available how to combat a forced MFS filing. The best option someone has are as follows:
- Offer in Compromise – File an offer in compromise (OIC) with the IRS substantiating your case. Technically an offer in compromise is focused on a dispute between you and the IRS, not between you and your spouse. Yet, given the IRS is imposing a much higher liability due to your circumstances you may have a chance if you demonstrate a well supported thinking process
- Early distribution in the settlement structure – Utilize the increase in tax liability which you were subject to pay within your settlement structure as an early distribution of your spouse’s share of the marital estate. This does require innate knowledge how to design your settlement structure but it is a definite option. It is worthy to note, you have to know how to negotiate and you are subject to other moving parts in your negotiation that may or may not go your way.If I were you, I would use both of these strategies to manage your financial exposure.
Both of these approaches require a skilled financial architect and negotiator to properly position your situation. This is not easy to do and comes with many challenges. Yet, the risks of paying the IRS are usually far greater than the costs of pursuing a lesser sentence per se. If a divorce spans more than one year then your exposure will likely be double (a 2 year divorce) or triple (a 3 year divorce) the exposure you would incur in your initial year filing as married filing separately. Under the traditional divorce process (a.k.a. as divorce 1.0) the average divorce lasts 1.25 to 3.5 years. Under divorce 2.0 the time can be potentially cut in half. This could reduce your exposure to filing as MFS in future years.
It is worthy to note the Innocent Spouse Relief or the Injured Spouse Relief is not an option in these situations. Why? These options require the couple to have filed a joint return. Since they are filing as MFS they are not filing a joint return which disqualifies a taxpayer from seeking Innocent Spouse or Injured Spouse relief from the IRS.
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.