Minimize the tax consequences of divorce.

Divorce has become so prevalent many consider it part of the normal family life cycle. As emotionally devastating as divorce may be, CPAs must be prepared to offer the necessary tax advice to clients undergoing divorces.

Without advance tax planning, divorce also can be financially devastating. If the Internal Revenue Service recharacterized $75,000 in deductible alimony as nondeductible child support or as a property settlement, the cost to a taxpayer in the 33% tax bracket would be $25,000. (Interest and penalties also might be due.) Advance planning can make certain that doesn't happen.

To minimize the tax consequences of divorce, CPAs can offer planning suggestions on

* Filing status.

* Child custody and exemptions for dependents.

* Alimony.

* Child support.

* Property settlements.

* Deductibility of divorce costs.

CPAs also can analyze completed divorce agreements to explain the tax consequences and to assist attorneys structuring such agreements. This article discusses some of the issues CPAs face in counseling clients undergoing divorces.

MARRIED OR NOT?

Taxpayers are considered married when, as of the last day of the tax year, they are separated from their spouses but have not yet obtained a final decree of divorce or separate maintenance. Even if a taxpayer is separated under an interlocutory decree of divorce--a decree that requires a waiting period before it becomes final--he or she is considered married. Taxpayers are considered unmarried for the tax year if

* A final divorce decree was issued by the last day of the tax year.

* The taxpayers obtained a decree of annulment that holds a valid marriage never existed.

A divorce's validity generally is determined under applicable state law. For example, some states do not recognize divorces obtained outside the United States. Couples who reside in such states and obtain foreign divorces are considered married for filing purposes. A divorce also is not valid if the couple intends to remarry in the next tax year, as evidenced by their actually doing so. This prevents taxpayers from divorcing solely to avoid the marriage tax penalty.

Filing status. Married taxpayers are not required to file joint returns, but only married taxpayers can file such returns. Married persons living apart from their spouses (for example, abandoned spouses) for the last half of the tax year may be entitled to head-of-household filing status and the standard deduction amount as if they were single--rather than married persons filing separately. To obtain this benefit, taxpayers must

* File a separate return.

* Furnish during the tax year more than one-half the cost of maintaining a house-hold that for more than half of the tax year is the principal home of a son, daughter, stepson or stepdaughter.

* Be entitled to a dependency exemption for a child for the tax year.

If spouses are separated and file separate returns, they report only their own income, exemptions, deductions and credits. One advantage of separate filing is each spouse is held responsible only for the tax due on his or her return. There are, however, many disadvantages of filing separately:

* If one spouse itemizes deductions, the other will not qualify for the standard deduction and also must itemize.

* Neither spouse usually can take the child and dependent care credit.

* Neither spouse can take the earned income credit.

* If the spouses lived together for any part of the tax year, neither can take the elderly or disabled credit.

If, after filing separate returns, a separated couple wishes to file jointly instead, they may do so at any time within three years from the due date, not including extensions, of the separate returns. This applies whether the returns were filed under single or head-of-household status.

WHO GETS THE KIDS?

Internal Revenue Code section 152 establishes special rules for determining which divorced or separated parent is entitled to a dependency exemption (for children under age 19, or under age 24 if the children are full-time students). The rules generally presume the parent who has custody of the child for the greater part of the year provides more than half the child's support and thus is entitled to the exemption. The noncustodial parent, however, may take the exemption if either of the following applies:

* The custodial parent signs Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, and the noncustodial parent attaches it to his or her return.

* An unmodified decree or written agreement made before 1985 provides the noncustodial parent can take the exemption and he or she provided at least $600 for the child's support. The child cannot, however, be the subject of a multiple support agreement.

Allowing transfer of the exemption by written declaration provides the divorced or separated parents flexibility in allocating the dependency exemption. Generally, it will be prudent to assign the exemption to the higher income parent. However, for tax years beginning before 1997 the personal and dependency exemptions are phased out at higher income levels.

The special rules in section 152 apply only if

* The parents were divorced or legally separated under a decree of divorce or separate maintenance, were separated under a written agreement or lived apart at all times during the last six months of the calendar year.

* One or both parents provided more than half the child's support for the calendar year.

* One or both parents had custody of the child for more than half the calendar year.

If the special rules for divorced or separated parents don't apply, the exemption is allocated under the general dependency rules in section 152. The Tax Court held that the special rules did not apply to a divorced father providing support for two student daughters living on campus during the school year and living with their mother when not on campus (a "greater portion" of the year than they lived with their father). The court found that neither daughter was in the custody of one or both parents for more than half the year since they had reached the age of majority and were emancipated under Ohio law. The court still allowed the father to take the dependency exemptions, but he had to meet the general requirements under section 152.

Even if the custodial parent waives the dependency exemption, he or she may still qualify for the earned income and child care credits. The medical expense deduction likewise is available to the parent paying a child's medical expenses regardless of which parent claims the dependency exemption. Since medical expenses are deductible only to the extent they exceed 7 1/2% of adjusted gross income, the lower income spouse may want to claim this deduction if he or she is able to pay such expenses.

ALIMONY

Alimony is deductible by the payer and taxable to the payee spouse. However, not all payments under a divorce or separation instrument are alimony. For example, the following do not qualify:

* Child support.

* Noncash property settlements.

* Payments that are the payee spouse's part of community property income.

* Use of property (but cash rent payments to a third party qualify as alimony).

* Payments to keep up the payer's property.

* Voluntary payments.

If both alimony and child support are called for in a divorce or separation instrument and the payer pays less than the total required, the payments apply first to child support and then to alimony.

Payments that otherwise would qualify as deductible alimony don't have to be treated as alimony if the parties agree to different treatment. Alimony treatment normally is preferred if the payer has a higher income and pays taxes at a higher rate. The payee, who will include the alimony in income, usually will accept this arrangement because the tax advantages allow the payer to pay more alimony. If, however, the payee is subject to a higher effective tax rate, the divorcing spouses will not want the payments characterized as alimony. This situation might arise with a payer who is well-off but has relatively little taxable income because of income fluctuations or because much of the income is tax-exempt. Furthermore, the payer may have so many other deductions the alimony deduction will be of little value.

Alimony payers also will want to avoid alimony treatment if they might be subject to the special front-loading rules in IRC section 71. Under these rules, if alimony payments in the second postseparation year exceed payments in the third year by more than $15,000, or alimony payments in the first postseparation year exceed the average of payments in the second and third years by more than $15,000, the excess amounts generally are recaptured in the third year by requiring the payer to include them in income and allowing the payee a deduction for the excess payments. See the exhibit on page 100 for a calculation of excess payments.

The excess payments will not be recaptured if they

* Cease due to death or remarriage before the end of the third postseparation year.

* Are received under a temporary support order before a divorce or separation.

* Are made pursuant to a continuing liability to pay a fixed part of income from a business or property or from compensation for employment or self-employment.

Front-loading limitation on alimony payments

Example: Dan and Janet Jones were divorced on January 21, 1992. Dan pays Janet the following alimony under the terms of the divorce decree:

Year                                       Amount
1992 (first postseparation year)         $100,000
1993 (second postseparation year)          60,000
1994 (third postseparation year)           40,000

Dan's recapture of second year payments is computed as follows:

                       Year 2
Payments in the second year               $60,000
Less: Payments in the third year           40,000
                                           20,000
Less: $15,000                             15,000
Amount of second-year payments
subject to recapture in the third year,
1994                                      $ 5,000

The amount of second-year payments used in computing the recapture for the first postseparation year is $55,000 ($60,000 - $5,000 recaptured).

                       Year 1
Payments in the first year                     $100,000
Less: Average payments made
in the second and third
years ([$55,000 + $40,000] [divided by] 2)       47,500
                                               $ 52,500
Less: $ 15,000                                   15,000
Amount of first-year payments
subject to recapture in the third year,
1994                                           $ 37,500

Thus, Dan deducts alimony of $100,000 in the first postseparation year and $60,000 in the second. In year three, he must recapture $42,500 ($5,000 + $37,500), which exceeds his third-year payment of $40,000. Therefore, he has income of $2,500 in 1994. Janet has gross income of $100,000 and $60,000 in 1992 and 1993, respectively. In 1994, the recapture of $42,500 exceeds the $40,000 alimony received--therefore, Janet has a $2,500 deduction.

CHILD SUPPORT

Child support payments are neither deductible by the payer nor includable in the payee's income. However, characterization of payments as child support isn't entirely determined by the divorce or separation instrument. For post-1984 divorce and separation instruments containing a provision reducing alimony on the occurrence of a child-related contingency, an amount equal to the reduction is treated as child support. Examples of contingencies in the regulations include reaching a specified age, marrying, dying, leaving school, reaching a specified income level, leaving the house-hold or getting a job.

Careful tax planners can avoid having alimony reductions treated as child support by not including the listed contingencies in the divorce or separation instrument. However, the rule requiring treatment as child support also applies to reductions that can be clearly associated with a child-related contingency. The regulations describe two situations in which alimony reductions are presumed to occur at a time associated with a child-related contingency. (In all other situations, alimony reductions won't be treated as clearly associated with such contingencies.) The two situations are when

1. Payments are to be reduced not more than six months before or after a child reaches the age of 18, 21 or the local age of majority.

2. Payments are to be reduced on two or more occasions that occur not more than one year before or after a different child of the payer reaches a certain age between the ages of 18 and 24, inclusive. This age must be the same for each child but doesn't have to be a whole number of years.

Even if these presumptions apply, they can be rebutted by showing the time at which the payments are reduced was determined independently of any child-related contingencies. For example, showing alimony payments were made for the period customarily provided in the local jurisdiction--such as one-half the period the marriage lasted--rebuts the presumption. The six-month presumption can be rebutted conclusively if the reduction is a complete cessation of alimony or separate maintenance payments during the sixth postseparation year or on the expiration of that 72-month period.

WHO GETS WHAT?

No gain or loss generally is recognized on a transfer of property to a spouse or former spouse as long as the transfer is incident to a divorce. The cost basis of the transferred property to the transmitting spouse carries over (remains the same) to the receiving spouse. "Incident to a divorce" means the transfer must occur within one year after the marriage ends. However, this general rule does not apply if the spouse is a nonresident alien or if the property settlement is a transfer in trust. If a transfer in trust is made, capital gain must be recognized to the extent the liabilities assumed by the trust, plus the liabilities to which the trust property is subject, exceed the adjusted cost basis in the property transferred.

For example, assume Jim Gordon owns property with a fair market value of $25,000, and an adjusted basis of $10,000. The property is subject to a $15,000 liability. The recognized gain on transfer of the property in trust to Jim's spouse Mary is $5,000--the $15,000 liability less the $10,000 adjusted basis.

Generally, a transfer of property in exchange for the release of marital rights is subject to gift tax. The transferor must report the transfer on a gift tax return for the calendar year the transfer is made. However, a transfer of property in exchange for the written release of marital or property rights or for child support is not subject to gift tax when

* It qualifies for the $10,000 annual exclusion.

* It is for qualified tuition or medical care.

* It qualifies for the estate tax marital deduction.

* It is required by the divorce decree.

* The spouses are divorced within a specified period.

Employee retirement benefits such as qualified employee pensions, individual retirement accounts and military pensions often are a taxpayer's biggest asset and should not be overlooked in a divorce settlement. Unfortunately, the rules on transferring qualified retirement benefits are complex and strict (and thus beyond the scope of this article).

THE COST OF FREEDOM

Legal fees and court costs incident to a divorce generally cannot be deducted. However, legal fees paid for tax advice in connection with divorce and legal fees to get alimony that must be included in income may be deductible. In addition, fees paid to CPAs, appraisers and actuaries for services in determining the correct tax or in collecting alimony also may be deductible. However, these fees may be deducted only as miscellaneous itemized deductions on schedule A of form 1040 and thus are subject to a 2%-of-adjusted-gross-income floor.

Nondeductible fees include costs incurred for personal advice, counseling or legal action in a divorce--even if the fees were paid, in part, to arrive at a financial settlement or to protect income-producing property. However, certain legal fees paid specifically for a property settlement, such as filing a deed to put title to the house in one spouse's name, may be added to the property's basis.

PART OF THE CYCLE

CPAs should be ready to offer tax advice to clients contemplating a divorce. Their expertise is invaluable to clients trying to determine the tax consequences of completed divorce agreements and to attorneys structuring such agreements. While some CPAs may not have offered such services in the past, they can fill a need during a stressful period in clients' lives and give them the assurance they have, at least taxwise, made the best decision possible.

EXECUTIVE SUMMARY

* BECAUSE SO MANY MARRIAGES end in divorce, CPAs frequently are asked to do tax planning for clients in divorce situations. Proper planning can minimize the tax consequences of divorce.

* AMONG THE FACTORS TO consider in divorce planning are marital status (when is the couple no longer married for tax purposes?), child custody (who gets the dependency exemption?), alimony and child support (how will payments be characterized for tax purposes?), property settlements and the deductibility of divorce-related expenses.

* CPAs' EXPERTISE CAN BE invaluable in structuring divorce settlements. Alimony deductions may be jeopardized if the timing of any payment reductions is incorrect and alimony may be improperly characterized as nondeductible child support under certain circumstances.

* IN A DIVORCE, NO GAIN OR LOSS generally is recognized when property is transferred to a spouse or former spouse. The cost basis of transferred property carries over to the spouse who receives it. For transfers in trust, gain must be recognized to the extent liabilities the trust assumes exceed the property's adjusted basis.

* GENERALLY, LEGAL FEES related to a divorce are not deductible unless they relate to tax advice or to obtaining taxable alimony. Any deductible fees are taken on schedule A and are subject to the 2%-of-adjusted-gross-income floor.