Tax Consequences to Consider When Writing Your Settlement Agreement
Writing your divorce settlement? The language within the document is essential so that you are set up for tax and asset success. We like to empower our clients – and the public – with items for which you may need to seek more tax advice on before finalizing your settlement agreement. We suggest consulting your tax advisor for specific, case-by-case information that may apply to your situation and read IRS regulations. Here are some general considerations when writing your settlement agreement.
Filing Jointly vs. Married Separately
It may be advantageous to file your taxes married jointly vs. married separately while going through a divorce. Generally, the tax rates that apply to married couples filing jointly are less than those for filing separately.
However, there are good reasons to file separately as well. For example, if you suspect your spouse is improperly reporting items or omitting items on your tax return you should consider filing separately, as you could be held liable responsible for the tax consequences when you file jointly. If you have already filed jointly and the IRS is holding you responsible for the underpaid taxes, penalties and/or interest, you may be able to obtain Innocent Spouse Relief. It’s very difficult to obtain innocent spouse relief as you may have to prove to the IRS you did not know and had no reason to know that the understated tax existed. As with all tax advice, you should seek an experienced, professional tax advisor for assistance.
Other tax related items to consider while drafting a settlement agreement may include the following items; however, this list is not intended to be exhaustive. You should ask a tax professional for additional items that may be relevant to your unique circumstances:
Permanent Periodic Payments such as Alimony vs. Lump Sum Payment
- Alimony is income taxable to the recipient and deductible to the payer where a lump sum payment normally is not taxable or deductible.
- Some payments under a settlement agreement may not be characterized as alimony. In order for payments to be considered Alimony they must meet several criteria established by the IRS, including cessation of the payments upon the death of the recipient.
- When alimony payments are reduced, ended by some triggering event and/or meet other criteria, the IRS may infer they were not in fact alimony payments, and, therefore, disallow the deduction, recapturing the deductions taken in previous years. The IRS regulations covering Alimony Recapture are complicated and should be interpreted by a professional tax professional.
Filing Head of Household vs. Single
- Tax rates for filing Head of Household are generally less than those for filing single. If you have paid more than half the cost of keeping up a home for the year and you can claim at least one “qualifying person” you may be able to file Head of Household. When both spouses meet Head of Household filing requirements, it’s important to specify in your settlement agreement who will claim “a qualifying child” for income tax reporting purposes. The regulations for “qualifying” a child are very specific and, therefore, you should seek the advice of a tax professional to determine if the requirements are met.
Seek a Tax Advisor
Again, we are not tax advisors, but these are examples of some tax and asset consequences we have seen while representing individuals going through a divorce. We strongly recommend speaking with a tax advisor. We regularly refer our clients to them.
If you’re just beginning your divorce – or considering a divorce – please reach out to our dedicated and experienced family law team. Starting early will help ensure your case is handled promptly while limiting the effects on dependents. Also, consult this helpful article to know what to expect during your initial divorce consultation with your divorce attorney at Barrow Law Firm.