To Irs, Divorce Just A Business Deal Gone Real Bad

To the couple involved, a divorce is a terrible personal turmoil. To the Internal Revenue Service, it is a business deal.

How big a tax bite the IRS will take in a divorce, as with other types of business deals, depends largely on how it is arranged. Unfortunately, not all lawyers who know the ins and outs of custody and visitation rights understand the sometimes arcane tax rules surrounding divorce.

“The financial stuff is probably mishandled 80 percent of the time,” said Dennis Casty, who designed a computer program that sorts out tax consequences in divorce. “This is a very, very technical area, and a lot of mistakes get made.”

Just ask Marian Bellama of Bowie, Md., who at the time of her divorce gave little thought to the future of $121,000 in the Constellation and 20th Century funds she was awarded.

Years later, when advised to diversify her portfolio, she had $94,000 in capital gains from the highly appreciated funds and had to sell some shares to pay her $36,000 tax bill, which was greater than her annual income as a full-time clinical social worker. “I was stunned,” she said.

Melvyn B. Frumkes, a Miami lawyer who specializes in divorce taxation, said the potential for appreciation of the funds should have been considered at the time of the divorce. “She didn’t really get $121,000,” he said. “She got the difference between $121,000 and the basis.”

That is by no means the only common tax error in divorce cases. One apparently simple rule, that alimony is deductible to the payer and is taxable income to the recipient, often leads to problems, lawyers say. Simply forgetting a required phrase in a document can negate the deductibility of alimony.

“If the husband sets up a stream of payments and doesn’t stipulate that the payments end upon the wife’s death, then it’s not deductible to the husband,” said Marjorie A. O’Connell, a Washington lawyer and divorce tax specialist. Those payments are then not taxable to the wife.

From a tax standpoint, alimony is generally better for both parties than other forms of payment because the high earner gets the deduction, while the low earner, who has a lower tax rate, pays the taxes. But alimony also raises a red flag for the IRS.

If large sums are paid in the first or second year and much less is paid in the third year, the IRS will frequently make a spouse pay taxes that he had avoided thanks to the alimony deduction.

Couples who did not cooperate well in marriage must learn to do so in divorce or suffer the tax consequences. When couples divide property, they have to divide tax breaks as well. One example is the one-time tax break that allows qualified homeowners 55 or older to exclude $125,000 in capital gains on the sale of a home.

If a divorcing couple is still married when their house is sold, both must agree to take the exclusion, and neither one can take that exclusion again. If the couple sell the home after the divorce is final, either spouse can take the $125,000 without affecting the other’s ability to use it in the future, or both can take it for a total $250,000 exclusion.

It takes only one uncooperative spouse to bring the IRS down on both halves of a dissolved couple. “The parties must cooperate,” said James J. Podell, a Wisconsin lawyer specializing in divorce taxation. Podell cited a client who deducted his alimony but whose former wife did not report the income.

In an all-too-common scenario, Podell said, “The IRS brought action against both of them. They tell the husband, ‘We are disallowing the deduction,’ but tax the income to the wife. They call it the ‘whipsaw maneuver.’ ” Both the former husband and the former wife were taxed and penalized, even though the husband violated no rules.

The IRS does have an “innocent spouse” exception that can save one spouse from having to pay taxes and penalties when the other lies on a tax return. But the wronged spouse has to prove that he or she neither knew about the misreported income or deductions nor benefited from them, and that to be held accountable would prove grossly unfair. Courts tend to be skeptical.

Finding a divorce lawyer familiar with the difficult tax issues may be nearly as hard as finding a suitable spouse. Lawyers recommend “The Best Lawyers in America,” published by Woodward/White of Aiken, S.C., as a reliable starting place. There are also specialists who are accredited by the American Academy of Matrimonial Lawyers in Chicago, which requires members to have completed 10 years in divorce practice and to pass a two-tiered oral and written examination that includes tax questions.

There are also qualified lawyers outside the 1,525 members of the academy. To find one, O’Connell said, ask the prospect to explain the rules governing deductibility of alimony, the rules for property transfer, and under what circumstances one would not want the custody deduction.

“These are pretty chocolate and vanilla questions,” she said. “If the lawyer gives you a glazed look, you need someone else on the team.”

As with most tax problems, good planning is the best way to avoid undue taxes in a divorce, although the solution may be thoroughly unromantic.

“Some lawyers say there is an answer to all of these tax problems facing divorcees,” said Susan Jacksack, a lawyer with CCH Inc., a financial publisher. “That is a good prenuptial agreement.”