Being a CPA and tax practitioner, I very often get involved in family issues involving my clients and the affect these issues have on their tax situations. One family issue that is always difficult is divorce. Besides the obvious problems, there are many misconceptions which arise when two people divide their personal and business assets and go their separate ways.
Innocent Spouse Rule
One issue that many people encounter during a divorce are the problems involving the "innocent spouse" rule. The innocent spouse provisions provide an exception to the general rule of joint and several tax liability that applies to the filing of a joint tax return. The rule is designed to prevent hardships that result when one spouse did not report income, usually leaving the innocent spouse to pay the tax deficiency. Very often, especially when there is a family business involved, tax deficiencies arise when there are IRS examinations subsequent to the divorce and unreported income is discovered.
Under section 6031(e), a taxpayer claiming relief as an innocent spouse must prove that he or she did not have knowledge or reason to know of the underreporting of income. In addition, section 6031(e) only allows for the relief of understatements attributable to "grossly erroneous items." In 1998, the IRS amended these provisions to allow for relief attributable to "erroneous items." The IRS also enacted section 6015(c), which provides that taxpayers who are unmarried when they claim innocent spouse relief must have "actual knowledge" of the understatement in order to remain liable, thus eliminating the "had reason to know" requirement.
Innocent spouse relief is not available when there is tax fraud. The IRS will almost always defeat any taxpayer alleging such relief when the taxpayer has some involvement in the family business. Very often, a corporate officer will designate a payroll to his or her spouse in order to enjoy the benefits of a joint income, such as the deductibility of IRA contributions, pension plan vesting requirements and so forth. But this is a double-edged sword. When a spouse receives income from a corporation, it is assumed that the spouse is being compensated for services rendered to the company, no matter how menial those services may be. To allege ignorance in the under reporting of income in a family business is difficult when that very same spouse, who had been on the corporate payroll in the past, is fighting for rights to those corporate assets in a divorce proceeding.
Children and Dependents
Another family issue relating to taxes and divorce is the deductibility of children and dependents. When filing a tax return, a preparer will always try to use the final divorce decree as a blueprint as to which spouse is allowed the deductibility of the children. Usually, the custodial parent is entitled to the dependency exemption. There are exceptions to this general rule, when there are either multiple support agreements, or custodial parent releases, giving the exemption to the non-custodial parent. Many spouses will conclude that they have the rights to deduct the children as dependents on their personal returns simply because they are paying child support. This may also allow a taxpayer to file their return as "head of household". Having such filing status when their gross income is under $26,450, the taxpayer can enjoy the benefits of earned income credits, very often receiving tax refunds in excess of taxes withheld from their income.
The IRS rules state that in order to deduct a dependent, the taxpayer must be able to prove that he or she provided over 50% support for that child, and that the child was living with the taxpayer for a majority of the tax year. Unless joint custody of the children exists, the IRS will almost always follow the support rules over the divorce decree. If the taxpayer cannot prove that he or she is providing more that 50% support for that dependent, the IRS will disallow the dependents and the "head of household" status. With all the problems associated with such a family crisis, the tax effects of a divorce are usually the final issues to consider. Unfortunately, these tax issues can sometimes become tax nightmares, long after the final divorce decree is signed.