This week my very smart colleague Jen Green is back with Part 2 in her series of important tax issues that need to be considered when dividing marital property during a divorce.
4. Principal Residence
The marital residence is one of the largest marital assets. In general, the tax code provides that a single taxpayer can exclude up to $250,000 of gain from the sale of a principal residence, provided he or she has lived there for two out of the last five years .
5. Business Interests
The existence of business interests as marital assets may create tax consequences when dividing those interests pursuant to a divorce agreement. Tax planning for transferring business interests depends on the type of entity involved, and specific care must be taken to ensure that certain tax attributes are not lost or that inadvertent tax liabilities are not somehow triggered. For example, interests in S corporations can result in suspended losses (losses that are carried into future years) instead of being able to be deducted in the year that they are incurred. When those interests are transferred pursuant to a divorce, those suspended losses may be forfeited altogether.
The transferability of stock in a corporation could also be impacted by the existence of a stockholder agreement. This means that if the stock is transferred and the terms of the agreement are not followed to the letter, there could be adverse tax consequences upon the transfer of the former spouse’s stock to the other spouse.
Similarly, in situations involving ownership interests in partnerships, the transfer of an interest could create a termination of the partnership, or create other unintended tax consequences to the partnership and the other partners.
6. Assignment of Income Doctrine
A former spouse, even pursuant to a divorce decree, cannot assign his or her income to the other spouse and avoid paying taxes on that income. Income is ordinarily taxed to the person who earns it. For example, Husband may think that he is being clever and assigns his income to Wife pursuant to the divorce. Husband will be in for quite a surprise when he learns that he, and not Wife, is still responsible for including the entire amount of that income on his tax return, despite the fact that he never received a penny of that income. Husband, however, could agree to assign a portion of his income as alimony to Wife. In that case, Husband would still report his full amount of wages as taxable income but would be able to deduct the portion that he paid over to his wife as alimony.
Conclusion: Tax consequences have a major impact in the division of marital assets in a divorce. If tax issues are not considered from the outset, one or both of the spouses may receive less than what he or she bargained for during the divorce settlement. If tax consequences are not taken into account, the result of the distribution may lead to unintended results. Therefore, each spouse should be aware of the applicable tax issues when dividing up their marital assets.