Taxes

February 2019 : Tips on Providing for Joint Tax Refunds, Overpayments, and Estimated Taxes in a Divorce Context

Posted by Joseph W. Cunningham, JD, CPA

View / Download February 2019 Article – PDF File

With the tax return filing season getting into high gear, the following are tax matters often overlooked in divorce settlements. Where applicable, simply providing a copy of this article to a client with the recommendation to consult with a tax advisor is a potentially valuable service.

Joint Tax Refunds

Address on Tax Return— Most divorce settlements provide for the division of a tax refund on the final joint return. The check will be sent to the address on the return and will be payable to both parties. Thus, delay in receipt of a refund may result if the principal residence is used on the return and the refund is sent after the marital home is sold and the effective “forwarding address” period has expired. If this is foreseeable, use another address on the return (e.g. in care of the CPA/tax preparer).

Notification and Documentation— It is advisable to provide that the party who receives the refund check must notify the other party, provide documentation of the refund, and make payment of the other party’s share within a specified time frame – e.g., one week.

Take Away— Consider potential logistical problems concerning receipt and division of a joint tax refund and make appropriate arrangements, and provide for notification, documentation, and payment.

Joint Tax Overpayments Applied to Estimated Tax

Advantage of Applying an Overpayment— Many taxpayers apply for extensions rather than filing by April 15. And most with income not subject to withholding – LLC income; S Corporation income; investment income – must make estimated tax payments due April 15, June 15, September 15, and January 15 each year.

An overpayment from a prior year is deemed received by the IRS as of the April 15 initial due date even if the return is filed six months later at or near the October 15 extended due date. Thus, it is often advantageous to apply an overpayment to the succeeding year tax liability, especially if a taxpayer realizes late in the year when the return is filed that preceding estimated payments are insufficient to avoid the underpayment tax liability. This can be done with the entire overpayment, or just part of it with the balance refunded.

Parties Can Each Apply Part of Overpayment— Parties are free to agree on the application of an overpayment on a joint return to the next year’s tax. If the amount so applied is allocated 100% to the husband, nothing needs to be done on either spouse’s succeeding year tax return. However, if the overpayment is to be divided equally, husband will need to make an after-tax payment to wife to square things off.

If any of the overpayment is to be applied to wife’s tax, she must enter husband’s SSN in the appropriate space on page one of her Form 1040 followed by “DIV”. If wife has remarried, she must enter ex- husband’s SSN at the bottom of Form
1040 page one, again followed by “DIV”.

Take Away— If either party relies on estimated tax payments and an overpayment is possible, make provisions in advance for potential advantageous use of the overpayment.

Estimated Taxes

New Requirement for Many— Many recipients of taxable spousal support provided in pre-2019 divorce settlements have never needed to make quarterly estimated tax payments. However, since no income tax is withheld on spousal support payments, estimated tax payments are generally necessary to avoid (1) a large April 15 payment and (2) corresponding underpayment of tax penalties. This applies to both federal and state income taxes.

The underpayment penalty may be avoided if the amount paid in – via wage withholding or estimated tax payments – exceeds the party’s hypothetical prior year tax based solely on his or her individual income and deductions. This often applies in the first year of receipt of spousal support, but not generally to subsequent years.

Take Away— Attorneys should advise clients awarded taxable spousal support to contact his or her tax advisor regarding estimated tax payment requirements.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Tips on Providing for Joint Tax Refunds, Overpayments, and Estimated Taxes in a Divorce Context”
View / Download February 2019 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “February 2019 : Tips on Providing for Joint Tax Refunds, Overpayments, and Estimated Taxes in a Divorce Context”

January 2019 : 2019 Federal Income Tax Rates & Brackets, Etc., and 2019 Michigan Income Tax Rate and Personal Exemption Deduction

Posted by Joseph W. Cunningham, JD, CPA

View / Download January 2019 Article – PDF File

Federal Income Tax

In the Tax Cuts and Jobs Act, passed in December 2017, federal tax rates were reduced and the tax brackets were expanded effective for tax year 2018. Also, the standard deduction was almost doubled while the deduction for personal exemptions was eliminated, as were some itemized deductions.

The following are inflation adjusted tax rates and the standard deduction for 2019 as announced by the IRS:

2019 Federal Income Tax Rates & Brackets and Related Information

2019 Federal Income Tax Rates & Brackets and Related Information

Standard Deduction

  • Single $12,200; $13,850 if 65 Years Old
  • Married Filing Jointly $24,400; $25,700 if one spouse is 65, $27,000 if both are
  • Head of Household $ 18,350; $20,000 if 65

Personal Exemption

There is no personal exemption. It was eliminated by the Tax Cuts & Jobs Act.

Estimated 2019 Long-Term Capital Gain Rates

  • 0% for taxpayers in the 10% or 12% brackets.
  • 15% for:
    • Single filers with taxable income between $39,475 and $519,300
    • Married Filing Jointly with taxable income between $78,951 and $612,350
    • Head of Household with taxable income between $52,850 and $510,300
  • 20% for taxpayers with taxable incomes exceeding the high end of the above ranges

2018 Tax Forms – 2018 federal income tax forms are accessible at www.irs.gov

Michigan Income Tax

Tax Rate

The Michigan income tax rate remains unchanged at a 4.25% flat rate.

Personal Exemption

The number of personal exemptions a Michigan taxpayer could claim had previously been tied to the number claimed for federal tax purposes. With the elimination of federal tax personal exemptions, Michigan enacted Senate Bill 748 (Bill), signed by Governor Snyder on February 28, 2018.

Under the Bill, the reference to federal exemptions is removed and the Michigan personal exemption deduction is increased from the $4,000 2017 allowance as follows:

  • 2018 – $4,050
  • 2019 – $4,400
  • 2020 – $4,750
  • 2021 – $4,900

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “2019 Federal Income Tax Rates & Brackets, Etc., and 2019 Michigan Income Tax Rate and Personal Exemption Deduction”
View / Download January 2019 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “January 2019 : 2019 Federal Income Tax Rates & Brackets, Etc., and 2019 Michigan Income Tax Rate and Personal Exemption Deduction”

December 2018 : Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes

Posted by Joseph W. Cunningham, JD, CPA

View / Download December 2018 Article – PDF File

The 2017 Tax Cuts and Jobs Act limits the annual itemized deduction for state and local taxes to $10,000. Such taxes include (1) state and local income tax, sales tax, and property tax.

The $10,000 cap does not apply to taxes on land used for farming or a rental property. It does, however, apply to second homes – e.g. a cabin up north – and to investment property.

In the year of divorce, for which each party will file a separate tax return, it is common for real property taxes to have been paid from a joint account before date of divorce. Under federal tax law, payments made from a joint account in which both spouses have an equal interest are presumed made equally by them.

That presumption can be rebutted by evidence that funding of the account was other than equal.

Example

  • Assume that H, the higher earning spouse, contributed 80% to the account and W 20%. The property tax deduction is allocated accordingly.
  • But as the higher earner, H will have higher state (and possibly local) income taxes.
  • Depending on the amount of these taxes relative to the $10,000 cap, it may be advisable to split the deduction 50:50 even though H provided substantially more funds to the account.
  • This also provides W with 50% vs. 20% of the tax deduction if she itemizes deductions on her tax return.

Observations

So, as a practical matter, the parties have some flexibility on the allocation of the property tax deduction. Factors to consider are:

  • Amount of other taxes of each party relative to the $10,000 limit.
  • Funding of the joint account from which taxes were paid prior to the divorce.
  • Whether either party will likely use the increased standard deduction.

It is often advisable to provide for the allocation in the property settlement agreement to avoid post-divorce problems at tax return preparation time.

The following summarizes some general aspects of payments of mortgage interest and property taxes in a divorce context. It is drawn from the author’s Taxation Chapter in ICLE’s Michigan Family Law.

Payments Made in a Divorce Context

The deductibility of mortgage interest, property taxes, utilities, maintenance, etc., in a divorce context depends on the following:

  • ownership of the home
  • use of the home as a personal residence
  • liability on the mortgage loan
  • whether payments are made pursuant to a qualifying divorce or separation instrument.

Ownership. While some homes may be owned individually by one of the spouses during marriage, it is more common that a marital residence is owned by the spouses as tenants by the entireties, a form of ownership that is not severable and that provides survivorship rights for each party. A tenancy by the entireties is converted to a tenancy in common incident to divorce under Michigan law unless an alternative provision is made in the governing divorce instrument. MCL 552.102. Tenants in common do not have survivorship rights but do have a severable half interest in the home. It is not unusual for one of the parties to be awarded the family residence, often the custodial parent in cases involving minor children. It is also common for such a home to be owned as tenants in common subject to sale when the youngest child reaches the age of majority or graduates from high school.

As explained below, the form of ownership may affect the deductibility of payments related to the residence.

Use of the Home as a Qualifying Residence. IRC 163(h) permits the deduction of home mortgage interest, or “qualified residence interest,” on a taxpayer’s principal residence and a second qualifying home used by the taxpayer as a residence. If a noncustodial parent vacates the family residence and lives elsewhere, he or she may select the family residence as an “other residence” provided he or she uses the home for personal purposes for at least 14 days during the year. In this regard, the use of the home by a taxpayer’s child—again, for as little as 14 days—is attributed to the taxpayer. IRC 280A(d)(1).

IRC 164(a) allows a taxpayer to deduct property taxes that he or she (1) pays and (2) is personally obligated to pay. The obligation to pay generally tracks with ownership.

Liability on the Mortgage Loan. Spouses who own their marital residence as tenants by the entireties usually have joint and several liability on the mortgage loan on which the home is pledged. It is also not uncommon for both parties to remain jointly and severally obligated on the loan after the divorce since lending institutions often will not release one party from the debt even if the other has been assigned full responsibility for its payment in the divorce settlement.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes”
View / Download December 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “December 2018 : Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes”

November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2018 Article – PDF File

As previously reported in this column, the 2017 Tax Cuts and Jobs Act (Act), signed into law in December 2017, radically changes the tax treatment of alimony/spousal support beginning in 2019. The other changes made by the Act affecting divorce took effect January 1, 2018.

Thus, there is a small window within which to decide whether to have existing law – or the new law – apply to divorces that can be finalized this year or next.

The New Law

In a total reversal, alimony/spousal support will not be deductible by the payer or taxable to the payee for divorce and separation judgments and decrees entered on or after December 31, 2018.

This also applies to modified judgments of divorce or separation effective after 2018.

Additionally, it applies to divorce and separation decrees entered before December 31, 2018 if the parties elect to have
the new law apply.

The Act is Not Applicable to Divorce and Separation Decrees Entered Before December 31, 2018

For all existing divorce settlements and those entered by year-end, alimony will continue to be taxable/deductible.

Hence, a window of opportunity before year-end for the many situations in which the alimony payer is in a meaningfully higher tax bracket than the payee. This has set the stage for creative uses of “Section 71 payments” under which the disparity in tax brackets can be used to provide a tax subsidy. Examples include using Section 71 payments to:

  • Divide non-qualified deferred compensation on a taxable/ deductible basis.
  • Structure installment payments of a business buy-out of the non-owner spouse’s marital interest on a taxable/deductible basis.
  • Pay attorney fees on a taxable/deductible basis.

However, after 2018, these opportunities and similar others will no longer be available. In situations where there is significant disparity in brackets, using Section 71 payments in such circumstances may no longer be beneficial.

Effect of Judgment Amendments Post 2018

If a pre-2019 divorce or separation judgment or decree is amended on or after December 31, 2018, the new nontaxable/nondeductible law applies.

Query: Would this be the result even if the amendment does not pertain to spousal support? If the answer has not become clear by year-end, the distinct possibility of losing taxable/deductible status of spousal support payments must be considered before advising the post-2018 amendment of a pre-2019 judgment providing for taxable/deductible alimony.

Fundamental Change in the Dynamic of Alimony/Spousal Support

When the alimony deduction was enacted in 1948, the theory was that, if a former family’s income is split between the parties in some manner post-divorce, the tax treatment should correspond.

The result in many cases has been less combined tax paid on the payer’s income. Because of budgetary concerns—including the enormous cost of the Act—eliminating the alimony deduction became a revenue raising option to help alleviate the Act’s deficit-increasing effect.

This creates a new paradigm for divorce practitioners and alimony guideline providers. That is, we will need to think in terms of after-tax dollars for spousal support, similar to child support.

How to Avoid Paying Alimony with After-Tax Dollars Under the New Law?

One approach is to negate the adverse tax consequences of the new law by using 401(k) funds. As we know, more and more employees have 401(k) accounts than in years past.

Example

  • H, 40 years old, is a middle-management employee at a small company. He earns $60,000 a year. He has a combined 26% federal-state income tax bracket.
  • W is a stay-at-home mom who works part time and earns $10,000 annually. Hence, as head-of-household, her standard deduction offsets her income for federal taxable tax. Her income is subject to minimal Michigan tax.
  • The parties agree on alimony of $1,250 a month, i.e., $15,000 annually, for 5 years when their youngest child will be either working or in community college.
  • H has a 401(k) balance of $150,000, which is split evenly with W receiving $75,000 and H receiving $75,000.
  • In addition to W receiving her $75,000 share, the parties agree that H will transfer his $75,000 share of the 401(k) to W in lieu of spousal support. She can withdraw $15,000 annually, paying approximately $2,000 in tax. H will pay W $2,000 per year to reimburse her for the taxes she will pay on her withdrawals. Thus, W will have $15,000 per year, which is $1,250 a month after-tax spousal support.
  • While W ends up with $15,000 a year after tax either way, using the 401(k) account saves H tax as follows:
Not Use 401(k) Use 401(k)
Payments Over 5 Years:
Payments $75,000 $10,000
Tax at 26% to Provide Funds $26,000 $3,500
401(k) Funds 0 $75,000
Total Cost to H $101,000 $88,500

Observations

  1. The example shows that, in relatively modest circumstances, use of a 401(k) account can result in considerable tax savings.
  2. It provides a means of using pre-tax dollars to fund aftertax obligations – an advantage where there is disparity in brackets.
  3. In the example, the tax on H’s $75,000 share of the 401(k) was shifted to W – at her lower bracket – incident to satisfying his after-tax spousal support obligation.
  4. At 40, H has ample time for his 401(k) account to be replenished.
  5. Using 401(k) funds for a spousal support obligation as shown in the example requires that the plan allow for annual withdrawals, Many plans do not do so. But, a small business plan, as in the example, often does.
  6. A 401(k) account can be used for other purposes, such as buying out the other spouse’s marital interest in (1) a business or (2) a cottage up north.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Beware: Spousal Support Tax Treatment Changes January 1, 2019”
View / Download November 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019”

October 2018 : Stock Redemptions

Posted by Joseph W. Cunningham, JD, CPA

View / Download October 2018 Article – PDF File

— With the Elimination of Taxable/Deductible Section 71 Payments Effective January 1, 2019, the Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations.

General

Section 71 payments have provided a means by which one spouse buys out the other’s marital interest in a business with pretax dollars. But, with the 2017 Tax Act’s repeal of the alimony deduction, this method will no longer be available beginning in 2019.

However, use of a stock redemption can be a “tax-smart” way to structure the buy-out. To do so, the owner spouse transfers stock to the non-owner, and it is then immediately redeemed by the corporation. The difference between what the non-owner receives and the owner’s carryover tax basis in the stock is taxed favorably as a capital gain or loss. Stock redemptions can be particularly suitable in the following circumstances:

  • The company has excess liquidity.
  • The stock has a relatively high tax basis (which is not uncommon if the company is an S corporation).
  • The spouse who will not end up with the business individually owns stock.
  • The owner spouse may not draw more compensation because of “reasonable compensation” tax constraints or legal restrictions.
  • The dilution, if any, caused by the redemption will not be problematic for the owner spouse.

Other than in a divorce context, this approach would be treated by the IRS as a step transaction—the non-owner spouse’s stock ownership would be considered merely transitory and lacking independent legal significance, which would result in a constructive dividend to the owner spouse. However, this technique is available in a divorce setting because of an expansive IRS interpretation of IRC 1041 incorporated in regulations the IRS issued in 2001. Treas Reg 1.1041-2.

Regulations and Illustrations

The following example explains the essential provisions of the regulations by way of illustration:

  • H and W each own 50 percent of ABC Company. They agree that H will continue to own and operate the company while W will tender her stock for redemption.
  • H has at no time assumed a “primary and unconditional obligation” to acquire W’s stock.
  • He has agreed, however, (1) to cooperate in his role as a corporate officer and shareholder so that the company implements the planned redemption and (2) to guarantee the company’s payment of the redemption proceeds.
  • Because H does not have a “primary and unconditional obligation” to acquire W’s stock before ABC redeems it, the redemption is not a constructive distribution to him.
  • Thus, W will be taxed at the long-term capital gain rate on the difference between the redemption proceeds she receives and her tax basis in the stock.

In the above illustration, both spouses own stock in the company. It is more common, of course, for the interest in the company to be owned by only one of the spouses. The regulations do not directly address the situation involving (1) one spouse—say, H—owning 100 percent of the stock and (2) a divorce settlement providing for the following transactions:

  • H’s transfer of 50 percent of his stock to W
  • W’s tender of the stock to the company for redemption of her newly acquired stock interest

Though not specifically addressed in the regulations, it appears that the tax treatment for this fact pattern would be the same as that which applies when both spouses initially own stock as follows:

  • The form of the transactions—(1) the nontaxable transfer under IRC 1041 of stock from, in our example, H to W, followed by (2) the redemption of W’s stock taxable at capital gains rates—will be honored provided H does not have a primary and unconditional obligation to pay W for her interest in the stock.
  • Alternatively, if there is such a primary and unconditional obligation, the redemption distribution would be deemed constructively received by H and taxed to him as a dividend.

To illustrate, assume that H is the sole owner of the company and that, as part of his divorce settlement with W, they agree he will transfer a 50 percent interest to her which she will tender to ABC in exchange for redemption proceeds. Though not expressly covered in the regulations, this fact scenario would appear subject to the following tax treatment:

• Provided H does not have a preexisting primary and unconditional obligation to pay W for her marital interest in the stock, the form of the two-step transaction will be honored for tax purposes.
• In effect, the transfer of the 50 percent interest from H to W as part of the divorce settlement will be tax free under IRC 1041, and the redemption distribution.

A principal reason to assume the above tax treatment will apply when one spouse owns all the stock is the following statement in the background section of the regulations:

“By enacting the carryover basis rules in section 1041(b), Congress has, in essence, provided spouses with a mechanism for determining between themselves which one will pay tax upon the disposition of property outside the marital unit. For example, assume Spouse A owns appreciated property that he or she wishes to sell to a third party. The spouses may agree that Spouse A will sell the property to the third party and recognize the gain. Any subsequent transfer from Spouse A to Spouse B of the sales proceeds will be nontaxable under section 1041. In the alternative, the spouses may agree that Spouse A will first transfer the property to Spouse B. This transfer is nontaxable under section 1041, with Spouse B taking a carryover basis in the transferred property. Spouse B will then recognize the gain or loss on the sale of the property to the third party because a sale to a third party is not covered by section 1041. In this latter scenario, the tax consequences of the sale are shifted to Spouse B.”

 

66 Fed Reg 40,659 (2001).

Viability of Redemptions in Divorce

Certainty of Tax Treatment. Provided there is no such primary and unconditional obligation, the parties may structure a divorce-related redemption with certainty of the tax treatment. Nonetheless, because things change, including the minds of divorcing parties, a savings clause appears advisable.

Guarantee Allowed. With the IRS’s clear statement that a primary and unconditional obligation does not include a guarantee
of another party’s performance, there should be no concern to provide that the remaining shareholder guarantee the corporation’s performance under the redemption agreement.

This is highly significant because, without a guarantee, it is conceivable, particularly where the remaining spouse would transfer a minority interest to the other spouse, that the remaining spouse would use his or her influence to obstruct the redemption, leaving the other spouse with a minority interest in a closely held company.

More Useful Post 2017 Tax Act. Though rarely used in the past, the redemption approach to a buyout will be the best alternative in many situations from a tax standpoint beginning in 2019. That said, redemptions are a good fit presently in some divorce settlements.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Stock Redemptions”
View / Download October 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “October 2018 : Stock Redemptions”