TAX ASPECTS OF DIVORCE

In the cover article of the Summer 2017 issue of the National Association of Tax Professionals’ quarterly TAXPRO JOURNAL I discuss in detail “The Tax Aspects of Divorce”.

 

The article includes the following statements –

 

“The U.S. Tax Code trumps the divorce agreement when it comes to who is able to claim a child as a dependent on the tax return.”

 

And –

 

“A local judge cannot overturn federal tax law.”

 

A reader sent me the following email in response to the article -

 

“The Tax Aspects of Divorce was very informative.  I do have a question, however.  In NATP’s Taxpro Journal it’s Page 13, first column, first paragraph.  The US Tax Code will trump a divorce agreement has been the way I was educated, but I’m a little confused about the last sentence in that paragraph which says ‘A local judge cannot overturn federal tax law.’  My understanding has been that the noncustodial parent who has been awarded the dependency exemption of the child can file a civil lawsuit against the now custodial parent to regain the dependency exemption.  That was verified by NATP & attorneys in my office. 

 

I’d appreciate it if you could just clarify that for me.”

 

Here is my reply to my fellow tax pro –

 

“Glad you found my article informative.

 

In answer to your question –

 

A non-custodial parent cannot claim a dependency deduction for a child unless the custodial parent provides a signed Form 8332.  The IRS will no longer accept the appropriate pages of a signed divorce agreement or decree with the exact same language as the Form 8332 as an alternative to a signed Form 8332.

 

It is my understanding that no divorce agreement or decree, and no local court judge’s decision or instructions, can force the IRS to allow the non-custodial parent to be able to claim a dependency exemption without a signed Form 8332.  A civil lawsuit award cannot in itself grant a non-custodial parent the dependency exemption.  Only a signed Form 8332 can grant a non-custodial parent the dependency exemption.

 

It is again my understanding that if a divorce agreement or decree says the non-custodial parent is entitled to the exemption, but the custodial parent does not provide a signed Form 8332, the “injured” parent can turn to a local court for relief and the court can require the custodial parent to provide a signed Form 8332 and penalize the custodial parent financially or legally for not doing so, or require the custodial parent to pay to the non-custodial parent the equivalent of the tax savings – but the local court cannot instruct the IRS to allow the non-custodial parent to claim the dependency exemption without a signed Form 8332.  

 

In my article I state –

 

‘If the divorce decree clearly states that the non-custodial parent is entitled to the deduction, but the custodial parent refuses to sign the Form 8332, the non-custodial parent must go back to the Court and get it to order the custodial parent to sign the form.  When negotiating a divorce settlement that gives the dependency deduction to a non-custodial parent there should be specific terms that require the signing of Form 8332 and outline what will happen if the custodial parent refuses to do so- such as the withholding of alimony payments or child support, or some other penalty.’

 

If you have any documentation or reference that indicates a local court can force the IRS to allow a non-custodial parent to claim a dependency exemption without a signed Form 8332 please let me know.”

 

As an aside – FYI the original article I submitted to NATP included the following paragraph in the beginning –

 

“Do you remember L.A. LAW?  While you would want Arnie Becker as the divorce attorney, the divorce agreement should be reviewed by Stuart Markowitz before it is signed.  For a more contemporary cultural reference - you would want David Lee as the divorce attorney, but have the final agreement reviewed by Will Gardner.”

 

However, despite my protest, this paragraph was deleted from the final published article.

 

So fellow tax pros – am I right?  Any thoughts and comments?

 

TTFN

 

 

 

 

 

 

 

THE NATP TAX FORUM AND EXPO IN PHILADELPHIA – PART II

At the NATP Tax Forum and Expo in Philadelphia last week I attended educational sessions on divorce, Schedule C, trusts, “wealthy” taxpayers, and current developments (of which there were really none, other than the inflation adjustments, that affect 2015 individual returns).  Here are some items of interest – not necessarily quoted from the sessions but “inspired” by items discussed in the sessions:

ü  In order to be claimed as a dependent as a “qualifying relative” your college student son or daughter over age 23, for whom you provide more than half of his or her support, must have gross taxable income of less than the current personal exemption amount.  For 2015 that is $4,000.  If that person’s only income is a W-2 reporting $3,942 in federal taxable wages it is ok – he or she is a dependent.  But if the total wages for the year are $4,009 he or she cannot be claimed as a dependent. In such a case $9.00 in income could cost you to pay at least $1,000 more in federal income tax.  So check on his or her wages at the beginning of December and tell him/her to stop working if he/she is already “close to the edge”.  You may even offer to reimburse him/her for lost wages if financially appropriate.

ü  The status of “custodial parent” is determined for tax purposes not by anything written in the divorce decree – but by the number of nights the child or children sleep at a parent’s home.  As with the per diem deduction for business travel the determining factor is where the child, or children, lay their heads each night.  A child may spend all day – from 8 AM to 8 PM - at the home of his or her father, but if he or she returns to the mother’s home at night to sleep that day is counted to the mother.  It is important that divorced parents keep a detailed “sleep log” for each child to be able to substantiate a claim of “custodial parent”.

ü  In order for a payment to be deductible as alimony it is important that the divorce decree or agreement states that the payment will cease upon the death of the recipient ex-spouse.  While it may be implied or obvious, it must be specifically stated in the document.

ü  If the father is paying for the qualified child care costs of a child or children, and running the costs through his employer-sponsored dependent care flexible spending account (such that his federal taxable wages reported on his W-2 are reduced by the $5,000 maximum), but the mother is the custodial parent, the father must add $5,000 to his taxable wages on Line 7 of his Form 1040 (or 1040A).  Even though the expenses are “qualified” and are paid by the father he is not entitled to the credit or pre-tax treatment.  When you think about it this makes sense (my thoughts, not those discussed in the session) – the credit or pre-tax treatment is allowed because the cost of child care is incurred so that the person caring for the child can work.  Even though the father is paying for the care, because the child does not live with him the purpose of the payment is not so he can work, but so the custodial mother can work.

ü  The “shared responsibility penalty” for not having sufficient health insurance coverage, which took affect with 2014 returns, is still with us – except that the penalty amount is increased – possibly doubled – for tax year 2015.  And beginning with tax year 2015 insurance companies and employers are required to issue Form 1095-B (insurance company) and Form 1095-C (employer coverage) to those covered by insurance as a way of verifying to the IRS, and the tax preparer, the months of “minimum essential” health insurance coverage.  A single taxpayer may receive multiple 1095-Bs and/or 1095-Cs for the year.  Form 1095-A will continue to be issued to those who purchased health insurance coverage via the Obamacare “Marketplace”.  Give all Form 1095s you receive – whether A, B, or C – to your tax preparer along with your 2015 tax “stuff”.

ü  While income from rental real estate is considered to be “passive income”, and subject to the 3.8% Net Investment Income surtax assessed on “wealthy” taxpayers, “self-rental” (renting real estate you own to your company) is not passive for Net Investment Income purposes and is not subject to the 3.8% surtax.

ü  A final reminder – the deadline for filing 2015 individual income tax returns, and automatic extension requests – is April 18, 2016.  The District of Columbia celebrates Emancipation Day on April 16 and when that date falls on a Saturday, Friday becomes the official date.  Therefore, since the term “federal holiday” includes any legal holiday observed in the District of Columbia, all taxpayers will now automatically get their due date extended to Monday April 18.  In Massachusetts and Maine Patriots Day is celebrated on the 3rd Monday in April, which is April 18 for 2016.  Therefore, taxpayers in these two states get to file and pay on Tuesday April 19. 

TTFN

PAY THE SALES TAX AND AVOID THE DIVORCE LAWYER

Let me end the topic of Divorce with this rerun that provides some good advice for cheating husbands.

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In my reprint of a September 2001 post on the benefits of a national sales tax I mentioned that – “States like New Jersey have had much more success raising revenue from sales tax audits than from audits of income tax returns.”

A while back then Director of the NJ Division of Taxation Robert Thompson – who left office after being charged with “making discretionary decisions while under undisclosed conflicts of interest caused by their receipt of meals, entertainment, golf outings and other gifts” from OSI, the outside collection agency hired by the NJDOT to collect outstanding NJ taxes – told the NJ chapter of the National Association of Tax Professionals about NJ’s special sales tax audit initiative.

The program would target NJ businesses where pretty much 100% of gross receipts are subject to sales tax – like pizza parlors, liquor stores and taverns. NJDOT would get purchase information from vendors who supplied the business selected for audit with “cost of goods sold” items (i.e. wholesale pizza dough and liquor purchases), get a price list or menu from the business being audited, verify inventory numbers, and, using industry standards for spoilage and theft, “back into” what the business should have reported in gross sales subject to sales tax. If this was more than what was actually reported on quarterly sales tax reports the business would receive a bill.

It was not the goal of the program to put the pizza parlors, liquor stores or taverns being audited out of business. The sole purpose was to collect more tax. No criminal or other action was brought against the business by the State and the bill was not overloaded with penalties.

This program was very successful.

Bob Thompson told of the audit of one pizza parlor, which happened to be located around the corner from the NJDOT headquarters in Trenton. The Division asked the parlor to submit a menu, which was reviewed by the auditors. One auditor then visited the parlor and asked the owner, “How come if the menu you sent us says you charge $2.00 for a slice of pizza, when I come in here for lunch you charge me $2.75?” Apparently the owner was not too bright!

My favorite story concerns the state's attempt to collect “use tax” on out of state purchases.

A sales tax is a “consumption” tax assessed and paid at the “point of purchase”. The State of NJ current charges a 7% sales tax on the purchase of qualifying items made within the state. You go to a local McDonalds in Jersey City and buy a Big Mac and you pay NJ state sales tax on the purchase. The sale takes place in NJ and you “take possession” of the Big Mac in NJ – so it is subject to NJ sales tax.

If a New Jersey resident purchases a taxable item in New York and will walk out of the store with that item in hand he/she will pay New York state sales tax on the item, even though the item will ultimately be used in New Jersey, and will not owe any tax to NJ.

But if a NJ resident purchases an item from a New York vendor and has the item shipped to a New Jersey address he/she does not pay New York state sales tax at the point of purchase. That person then must pay a use tax on the purchase to the State of New Jersey.

NJ use tax is paid by any individual who “stores, uses, or consumes” within the borders of the state of New Jersey tangible personal property subject to NJ sales tax that was purchased from an out-of-state seller and no local sales tax was paid at the “point of purchase” to the out-of-state seller. Got that?

So if you order a bracelet from a New York jeweler and have it shipped to your New Jersey address you would not pay sales tax to New York, but you would be liable for New Jersey use tax on the purchase.

Individuals pay any NJ use tax liability as part of the filing of the NJ-1040 state income tax return. Most state tax returns will have a line where the taxpayer can enter an amount for use tax due. Many of these states, NJ included, require that if a resident is not declaring a use tax liability he/she must enter “0” on the appropriate line – so that the taxpayer is “going on record” that he/she does not owe any use tax.

And that is what the story is about.

The NJ Division of Taxation got a hold of the records of a jewelry store located in New York (possibly as a result of a NYS audit of the store – I don’t remember the actual details) and made a list of all purchases where the items were shipped to a New Jersey address and no NY state sales tax was paid. The Division then sent a bill for the appropriate amount of use tax to the registered NJ residences of all those on the list.

One of these bills arrived at the home of a married doctor and was opened by the wife. After she reviewed the bill she immediately called the NJ Division of Taxation.

“I have just received a bill for use tax from the Division of Taxation and I think you have made an error,” she said.

“What is the error,” the DOT employee asked.

“My husband only gave me one diamond bracelet!”

So the moral of the story – if you are going to give your wife and your mistress the same expensive gift don’t buy both at the same time, and be sure to pay state sales tax on the gift for your mistress!

TTFN

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I WILL BE BACK FROM TEXAS TONIGHT - NEXT WEEK I WILL REPORT ON MY TRIP AND WHAT I LEARNED AT CONFERENCE.

THIS WAS A REAL NICE CONFERENCE

So I got to the Woodbridge Hilton (in Iselin, not Woodbridge), signed in, found a spot at a table in the back with two empty seats, went through the continental breakfast buffet, and was back at the table just as the New Jersey chapter of the National Association of Tax Professionals Annual Conference got underway.

A few minutes into the introductory remarks someone sat in the empty seat next to me (which, the way we were seated in semicircle around a round table, was actually behind me), but I took no particular notice of the person.

About an hour into the presentation on the dreaded Alternative Minimum Tax there was a tap on my shoulder. I turned around and the person seated next to me said in a low voice, “Robert Flach?”. He took off his glasses and I looked at him closely to see if I recognized him. After a few seconds we both said, at the same time, “Jackie”, as his identity hit me.

Jack was one of the college students that worked with my mentor, James P Gill, during the tax filing season way back at the beginnings of my career. I began with Jim in February of 1972 and he joined “the firm” a couple of years later. He stayed with us for several seasons, and had come back on occasion to visit and help out after settling in to full time employment elsewhere.

The last time I had seen Jack was about 20 years ago when I ran into him and his then young (and now college graduate) son at the Hudson Mall.

He had recognized my neat handwriting, and the fact that I used a ruler to write straight, as I was making notes on the presentation!

Who would have thought!

This year’s conference consisted of a full day of presentations by one speaker, Alice Orzechowski, a CPA, CMA (Certified Management Account – not Country Music Award winner) and EA, with a brief annual meeting (and election of Board Members; I was running and lost – I knew I should have voted for myself) in between topics. Over the course of the day Alice covered the dreaded Alternative Minimum Tax, discussing case studies and tax planning strategies, the Minimum Tax Credit, Form 1041, Settlement (Closing) Statements, and real estate transactions.

I few items of note that deserve mentioning –

* Throughout her presentations Alice referred to specific applications that tax preparation software will do automatically and those that it will not do, requiring the user to enter some special information or make special calculations, and discussed the various problems she had encountered in the past with tax software and specific calculations, instances where the software did not produce the correct answer and in one situation actually made a math error.

All the more reason why the “uninformed” should not rely on tax software as a substitute for knowledge of the Tax Code or a tax professional, and why tax pros using software should not automatically accept what a program spits out as being correct without careful checking and verification.

* Under Internal Revenue Code Section 1.266-1(b)(1) a taxpayer can elect to “capitalize” (add to cost basis) real estate taxes paid on a vacant lot instead of claiming a deduction on Schedule A. This election can be made on an annual basis, capitalizing the expense one year and deducting it in another. In order to make the election the taxpayer must attach a statement to this effect to the appropriate Form 1040.

Taxes of any kind, state income or sales, personal property, and real estate, are not deductible under the dreaded Alternative Minimum Tax. A taxpayer with a vacant lot on which he/she pays real estate tax should elect to capitalize the tax in a year in which he/she falls victim to the dreaded AMT.

If the tax were claimed as an itemized deduction it would provide absolutely no tax benefit, as it would not be deductible under AMT – the deduction would be totally lost. By capitalizing the payment the expense can be claimed and a tax benefit realized when the lot is eventually sold.

As with any option in such a situation you should calculate the regular and AMT federal income tax and the state (and local if applicable) income tax both ways, with and without the current deduction, and compare the net combined federal, state and local tax liabilities.

* Alice reminded us that taxpayers should take into consideration the AMT when determining who gets to claim a dependent child in negotiating a divorce settlement – as personal exemptions are not allowed under the dreaded AMT.

Often times divorced parents will alternate claiming a dependent, the custodial parent claiming the exemption one year, and the non-custodial claiming the exemption the next. If one parent is a victim of AMT one year but not the next this should be taken into consideration when deciding who will get the exemption for a particular year.

This just goes to point up that it is very important when negotiating a divorce agreement that you choose an attorney who is well versed in tax law as well as divorce law, or have a tax professional consult with you and your attorney as part of the ongoing process. Using a well-qualified and experienced divorce attorney who knows everything there is to know about divorce law but diddly-squat about tax law, and not also using the services of a tax professional, could end up being very expensive.

* Certain closing costs paid on the purchase of a rental property that are deemed to be “expenses in obtaining a mortgage” can be amortized over the life of the original mortgage. These expenses are generally listed under Section 800 on the Closing/Settlement Statement and can include lender’s title insurance reported on Line 1101 of the Statement.

Just like with points paid on the purchase of such a property, any “unamortized” closing costs can be deducted in full on Schedule E in the year that you refinance the mortgage with a new lender.

You have $1,500 in qualifying “expenses in obtaining a mortgage” on the purchase of a rental property that you have been deducting over the 30-year term of the mortgage at $50 per year. Four years down the road you refinance the mortgage. The original mortgage was with Wachovia and you refinance with Chase. You had previously deducted $150 in amortization on Schedule E. In the year you refinance you can deduct the remaining $1,350 on Schedule E, plus the applicable amortization of the costs of obtaining the refinanced mortgage.

As usual the NJ-NATP conference was well done. I especially look forward to the chapter’s annual New Jersey State Seminar in January.

TTFN

PS – To any tax professionals out there who are reading this, if you are not already a member of the National Association of Tax Professionals you should be! If you decide to join please mention my name as a “referral” and I will get a gift from NATP.

CLAIMING CHILDREN OF DIVORCED OR SEPARATED PARENTS

Bruce recently discussed IRS Form 8332 (Release of Claim to Exemption for Child of Divorced or Separated Parents) and divorced clients who “share” the exemption(s) for their child(ren) – perhaps every other year - in the post “Release of Claim to Exemption” at his TAX GUY blog.

As Bruce points out “This is a pretty basic information form, but one that gets both abused and ignored. A lot of divorced parents aren’t even aware that it exists.” Bruce explains that this is usually because “they never really explain their situation fully to their preparer, or they are still doing their own returns, not knowing what this is”. Bruce goes about explaining the form in his post.

The July issue of NATP’s “TAXPRO Monthly” reported on a Tax Court opinion in the case of William N. Ward v. Commissioner (TC Summary Opinion 2008-54) that applies to the requirements for a non-custodial parent to claim a child as a dependent.

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The rules for Form 8332 state that a substitute for the form can be used, and must be attached to the return. According to IRS Publication 504 (Divorced or Separated Individuals) the substitute can be a divorce or separation decree or agreement that states all of the following -

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1. The noncustodial parent can claim the child as a dependent without regard to any condition, such as payment of support.

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2. The custodial parent will not claim the child as a dependent for the year.

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3. The years for which the noncustodial parent, rather than the custodial parent, can claim the child as a dependent.

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Under item number 1, if the decree or agreement has a condition placed on it it cannot be used as a substitute to Form 8332.

In the case discussed in the NATP publication the separation agreement stated that the father could claim his two children as dependents on his Form 1040 “so long as [he] is current in the payment of his child support obligations”. The father was current and claimed the children as dependents. But the mother, who was the custodial parent, also claimed the children on her 1040. The mother had not provided the father with a signed Form 8332, so he had attached a copy of the separation to his return.

Because the agreement specifically stated the condition that the father had to be current with all child support payments in order to claim the exemption the IRS did not allow it as a substitute for Form 8332. So as there was no Form 8332, or qualifying substitute, attached to the return the IRS disallowed the exemptions for the children. The Court decided for the IRS.

Was the father screwed? In this case the answer was no. He took his case to the Juvenile and Domestic Relations District Court in his county and the Court ordered that the mother reimburse the father for the tax benefit of claiming the children as dependents, which is this case was $2,326.00.

So if a custodial parent does not provide a Form 8332 to the non-custodial parent, as required by the divorce or separation decree or agreement, and the decree or agreement will not qualify as a substitute for Form 8332, the non-custodial parent should seek relief from the appropriate State or County court.

TTFN