Taxes During a Divorce



In Divorce, potential tax liability can frequently become the tool for one spouse to use against the other spouse. If improperly used, this tool can destroy all of the marital assets. In the worst case, tax liability can seriously impact the future financial security of either spouse and subject them to criminal sanctions. Just another reason I keep harping upon the fact you need a tax attorney, especially if you are getting divorced and especially if you are a Federal (CSRS or FERS) employee.

First Scenario – Spouse Owns a Business

The most common situation where taxes become an issue in a divorce is when there is a family business. The owner – spouse may have hidden cash receipts or engage in a practice of recording inflated expenses. This common practice by many business owners is a fraudulent attempt to minimize taxes. The other spouse is often aware of and approves of this practice. During the marriage, minimization of taxes results in higher household income and a better lifestyle for the couple.  Anyone who has ever watched Season 5 of the Sopranos can identify with this.  Tony has been hiding legal and illegal cash since long before he and Carmela were married.  In order to get the cash “out in the open” so she can claim her share, Carmela would have to expose her own complicity in being a willing tax evader herself.

This common practice of overstatement of expenses and hiding of money is normally illegal. During the marriage it is a secret between the married couple. In general one spouse can’t be made to testify against the other.  But during a divorce each spouse may try to use past tax behavior to gain an advantage. The owner – spouse wants to minimize past income in an effort to lower child support, alimony, or division of marital property. Of course the other spouse wants to prove the opposite.

The result is a game of chicken – with one spouse threatening to turn the other spouse in to the IRS. This is a dangerous game for all involved. Do it yourselfers will find the situation blowing up in their face. People with ethical attorneys may find the attorney reluctant to deal with the situation.

Potential Problems: 

  • An attorney cannot assist the owner/spouse commit the crime of tax evasion.
  • The non-owner spouse may end up liable for half of the back taxes, penalties, and fines.
  • The divorce court Judge may decide to turn everyone in.
  • In an extreme situation, everyone can go to jail.

Possible Solutions:  There aren’t a lot of good legal options here.  Tax cheating is a crime and if a substantial amount of money is involved you can bet that the IRS will be after both marriage partners like white on rice.  If you’re in a situation like this:

  • Stop cheating the government
  • Agree between the divorcing parties in advance how to:
  • Divide assets
  • Provide maintenance
  • Provide for child support

A tax attorney can provide valuable guidance but make sure you do not ask the attorney to be a party in your criminal activity …he/she can’t do so.

Many spouses try to use the technique discussed next.  Rather than admit they knew what was going on and that they were a wiling partner in tax evasion, they claim they were an innocent bystander to the whole affair.  Sometimes they even were an innocent bystander.

Second Scenario – The Spouse’s Tax Cheating Comes As A Surprise

This is another common situation in divorce: the sudden realization that a spouse is a tax cheat – and you were completely unaware until the divorce.

Potential Problems:

• Each Spouse may end up owing the IRS half the overdue taxes.
• Either Spouse may end up owing the IRS the ENTIRE tax bill.
• The overdue tax bill may be double the actual unpaid taxes, due to penalties, fines, and interest.

Potential Solutions:  The IRS has a provision called Innocent Spouse Relief. This provision gives complete or partial tax forgiveness to an innocent spouse. However, this isn’t a “home free all” kind of issue.  The definition of “innocent” is technical, elusive, and difficult to understand.

An innocent spouse generally has available two forms of tax relief:

  • Innocent Spouse Relief – Discharge of Liability: This form of relief wipes out your tax debt in part or full. You must have not had any knowledge of the incorrect or fraudulently prepared tax returns. That means you cannot look like you were aware of any part of the return. Also, you must not have benefited from the hidden income.  What kind of car did Carmela lease?  And how much income did the Sopranos claim?  You get my drift.
  • Separate Tax Liability for Each Spouse: This form of relief is slightly easier to get. If you qualify, the IRS will separate the tax liability of your income from your spouse’s hidden income. This may also have the effect of wiping out some fines and penalties, but you are going to have to pay honest taxes on honest income.

The Bottom Line:

The financial effect of divorce can be far worse than the divorce itself. If you believe this type of problem is in your future, start preparing immediately.

  • Do not sign a joint tax return for your upcoming tax filing.
  • File married-filing-separately (the amount you might lose in excess taxes is peanuts compared to what you might avoid)
  • The moment you suspect a potential tax liability, whether or not divorce is in sight also, begin to separate your financial life from your spouse’s financial life and consult a qualified tax attorney.  If you are going through divorce and your divorce attorney is not tax qualified you may not be using the right attorney … or you should certainly seek a referral.

Disclaimer

As always remember that this site, although written by a retiree with substantial experience in the school of hard knocks, it is for personal, lay opinions and informational purposes only. If you have a legal question you should seek help from a legal professional. If you have questions involving current or future values of pensions you need an actuary or competent pension valuation expert. If your questions are tax-related, seek a competent tax advisor. In other cases, I recommend the base chaplain.

You can comment on this post, you can email me at: davestarr (at) gmail (dot) com or you can call me at: 1-719-423-8872

If you really need an accurate reading on a case involving these issues, I’d suggest you call Bill — 719-475-7529




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