Five Tax Tips For The Divorced

By Cheryl A. Morse

After years of tax practice, I've concluded that the first "custody" decision in any pending divorce should be: who gets to keep the tax preparer?

In most cases, it's a bad idea for both parties to use the same tax professional. Yet the tax issues involved in divorce, particularly when there are children involved, are complicated enough to require professional help. And the sad fact is that many divorce lawyers are not well versed in the latest tax laws. This is understandable, considering that Congress made 235 changes to the tax code last year.

The Internal Revenue Service and the U.S. Tax Court are in the business of enforcing the tax law, not family court decisions. So the fact that you have an order from your local family court entitling you to do something--say to claim dependents--does not make it so from a tax perspective. Here are some points to consider.

1. Tax "custody" is different.

These days, family courts often award "joint" custody of a child--joint legal custody and sometimes joint physical custody too. In the tax world there is no such thing. Custody, meaning the $3,650 dependent exemption for a child and the $1,000 child tax credit belongs to the parent in whose home the child spends more nights.

What often happens in the real world is that parents with joint custody haven't resolved who gets tax custody and so both claim the child. The parent who files his or her 1040 first gets the exemption/credit. When the second to file claims the child, his or her refund is held up. Both then receive an IRS notice saying a dependent was claimed twice, and requiring each to submit proof of entitlement to the dependent. So mark your calendars the nights your children stay with you so you will have "contemporaneous records" to prove your claim for tax custody. (Days may be used for parents who work nights.)

2. Tax custody can be assigned--but only for some purposes.

It is possible for the parent without physical custody to claim the $3,650 dependent exemption, but the custodial parent must sign a Form 8332 allowing the non-custodial parent to do this. Moreover, if someone claims a child by reason of a signed 8332, that does not make him/her entitled to all the deductions and credits a parent with true physical custody would receive. Certain deductions go to the parent who claims the child and others go to the custodial parent whether or not he/she claims the child. For example, the child tax credit always goes to the person who claims the child, as does the up-to-$2,500 American Opportunity Credit for college. But the earned income tax credit, worth up to $5,657, and the dependent care credit, worth up to $2,100, can only be claimed by the custodial parent. Warning: A noncustodial parent is not entitled to divert pretax salary into a dependent care account at work, and if he or she does so, the amount must be added back into income. (For more on the dependent care accounts and credits, click here.)

3. The value of a tax break is variable.

The most common tug-of-war regarding taxes in a divorce is over who will be allowed to claim the children. Yet most of those fighting would be hard pressed to tell you the financial value of an exemption they are so emotionally invested in "winning." Moreover, an exemption's value to each spouse might be strikingly different. It is not enough to compare tax brackets and say that a $3,650 exemption is worth $365 to a parent in the 10% tax bracket and $1,022 to a parent in the 28% bracket. There are credits and deductions attached to that exemption, and phase-outs of these various breaks, that must be considered in order to make an informed decision about such a contentious issue.

Here's an example of the calculations required: George earns $165,000. Ann earns $16,500 and has physical custody of their two children, Ginger, 21, a college junior, and Penny, 12, who is in an after-school program. If George claimed the two children, the children's exemptions would be worth a total of $1,735 in tax savings to him. He could also receive a child care credit of $600, if he were the custodial parent. But he earns too much to qualify for the $1,000 child credit for Penny or the $2,500 college credit for Ginger.

Ann, with a zero income tax liability, would get no value from the dependency or nonrefundable child care credit. But she would be entitled to a $3,026 earned income credit, a $1,000 refundable child tax credit, and a $1,000 refundable college credit--a value of $5,026 compared with George's $2,335. There can be many variations to this formula based upon whether each person claims one child or two, the age of that child, whether the divorce is final and the parents' current living situation. The point here is that someone needs to run the tax numbers to make an informed decision during the divorce process.

4. Alimony, child support and retirement accounts.

There is often confusion about these three items and whether they count as income. Alimony is taxable income to the person receiving it and deductible by the one paying it. Child support is neither taxable nor tax deductible. Workplace retirement accounts, such as 401(k)s, transferred to a spouse as part of a court-ordered settlement (and with a qualified domestic relations order) are not taxable, so long as the money is rolled into a retirement account for the ex. But if the money is then taken out of the retirement account for living expenses, it is taxable, and is subject to a 10% penalty if the spouse withdrawing the money is not yet 59 1/2. If, however, the money from the retirement account isn't initially rolled over, it is subject to ordinary income tax but not a penalty. By contrast, individual retirement accounts can't be transferred tax or penalty free as part of a divorce.

5. The first year is tricky.

Your living arrangements during the first year determine your filing status. If you and your spouse begin living apart after June 30, your only options will be to file jointly with your soon-to-be ex or to use the "married filing separately" status, which carries a standard deduction of $5,700 (or less, if your spouse itemizes and you cannot). If you separated before July 1, an additional, more beneficial "head of household" status with a standard deduction of $8,350 is available if you had custody of a dependent child, and paid more than half the cost of providing the home for him or her. This can be complicated if there is more than one adult in the household, as in the case of multigenerational families. I often have to explain to my clients that we cannot have two heads in a household without creating a two-headed tax monster the IRS won't allow.

A word of caution here: Think long and hard about filing a joint return with your soon-to-be ex. Even if your decree says your ex-spouse will pay all taxes for the year, if they cannot or do not pay, you are stuck with the bill. It is called joint and severable liability. In other words the entire bill is owed by both of you, and the taxing authorities will collect from whomever they can.

Cheryl Morse has been an enrolled agent specializing in individual and small-business taxes for more than 25 years and is a tax manager with Emerging Business Partners in eastern Mass. She is a national instructor for the National Association of Tax Professionals, an instructor for the University of Massachusetts Tax School and area chair of the IRS Taxpayer Advocacy Panel.