Issues

• Child Custody
• Parenting Time
• Child Support
• Property Settlement
• Alimony
• Tax Planning
• Glossary of Divorce Terms

Tax Planning for Divorced Parents

When a couple is going through a divorce, they need to look at the following five issues that will have tax ramifications.

Filing Status & Exemptions
Alimony and Other Payments
Childcare Concerns
Retirement Plans
Tax Carry-forwards

Filing Status & Exemptions

• A divorced or divorcing couple’s filing status is determined as of the last day of a tax year, usually December 31st.
• A couple is no longer married for tax purposes when a final divorce decree or a legal separation is issued.
• If you have custody of a child and are not remarried by the end of the year, you may qualify for Head-of-Household status even if the parent with custody is not claiming the dependency exemption for the child.

Personal Exemption – In 2005 is worth $3,200 for a parent and each child. The principal benefit of a dependency exemption is that it reduces taxable income by a specific dollar amount, which when multiplied by the parent's tax rate equals a tax savings. The tax savings depends on your tax bracket.

Dependent Exemptions - Available if a minor child resides with you more than half time or the primary parent has waived it to the non-primary parent. For adult dependent children, the test is whether you provide more than half of the support for the child. Parents of college children who maintain a residence for the child when away from school may qualify to take a child as a dependent or may trade it away if the other parent provides more of the support. If you claim your child as an exemption, he or she cannot claim an exemption on his or her tax return.

Eg. - if the exempt amount is $3200 and the tax bracket is 30%, the savings is $960. But if the parent's tax rate is 15%, the savings is only $480. So, the exemption is worth twice as much to the higher bracket parent.

*However, high income earners begin to see a phase out of this benefit above certain levels. In 2005, the phase out begins and is complete at the following levels:

This phase out of the dependent exemption benefit is itself due to begin phasing out by one-third in 2006 and 2007, then by two-thirds in 2008 and 2009, and will be gone in 2010. It really is a way to have people pay higher taxes without saying so and is essentially a tax only on high wage earning parents, not all high earners.

Alimony

• The basic rule is that alimony payments are deductible by the payer and includible by the payee when determining adjusted gross income.
• Payments must qualify as alimony as opposed to a property settlement.
• Alimony payments may be subject to recapture when payments decreased by more than $15,000 in the second or third year.  A CPA should be consulted regarding the calculation of the recaptured amount.
• Be aware that an alimony recapture can be triggered by failing to make scheduled payments, changing payment amounts due to adverse financial conditions, or reducing payments after a divorce decree modification.  You should also consult with your attorney and CPA regarding exceptions to the recapture rules and ways to avoid recapture. 

Child Care Concerns of Divorce

• Generally, the parent who has custody for the greater portion of the year may claim the child as a dependent, providing that both parents together provided more than 50% of the child’s support.  Custody for purposes of claiming a dependency exemption is first determined by the divorce decree.  If the divorce decree does not make a mention as to who should be the custodial parent, then the parent who has the actual physical custody of the child for the greater portion of the year may claim dependency exemption.
• Child Care Credit is available only to the custodial parent.  It is not available to the noncustodial parent even if the noncustodial parent can claim the dependency exemption.
• A custodial parent may relinquish the exemption by filing IRS Form 8332, Release of Claim for Child of Divorced or Separated Parents.  This form must be filed with the claiming parent’s tax return.  The exemption can be relinquished to a noncustodial parent for any number of years. 
• A Form 8332 is not needed when the divorce decree states that the noncustodial parent should have unconditional right to claim exemption.  Proper document must be attached to the claiming parent’s return.
• The Child Care Credit may only be claimed by a custodial parent.  Only expenses actually paid by the custodial parent qualify for the credit. 
• The Child Tax Credit goes with the dependency exemption.
• Regardless which parent claims dependency exemption, he or she may deduct medical expenses paid for the child.

The Child Tax Credit can only be claimed by the parent claiming the exemption. It is available to single or head of household taxpayers with income below $75,000. The maximum benefit is $600 per child. This too begins to phase out for higher income taxpayers. It usually does not result in a net refund (i.e. it can only reduce the tax to zero). However, for very low income parents (no regular tax or when the Child Tax Credit exceeds the regular tax liability), the parent might qualify for a refundable Additional Child Tax Credit, essentially providing a tax refund.

Credit for Child and Dependent Care Expenses. This credit is also tied to the dependent exemption. However, a parent who is the primary custodian, but who assigned the dependent exemption to the other parent using form 8332, can claim the Credit. The other parent, even if he or she has child care expenses, cannot claim those expenses for the same child.Beginning in 2003, both the maximum amount of expense allowed ($3,000) and the maximum percentage of expenses covered (35%) have increased. So this credit can now provide a nonrefundable credit of $600 to $1,050 for one child or $1,200 to $2,100 for two or more children. This credit is for child care or babysitting that is related to work or education or looking for work. The covered child must be under age 13.

For those with "cafeteria plans" at work, or qualified fringe benefit plans with child care options, up to $5,000 of income can be received tax free for spending on child care. At the highest tax brackets, this can result in a tax savings of $1,955. You cannot use this benefit AND take the Credit for Child and Dependent Care, above.

The Hope Credit and the Lifetime Learning Credit. These credits may be taken on the tax return of the person claiming the student as a dependent exemption, whether the expenses were paid by the student or by one or both parents. The benefits are phased out at $43,000 to $53,000 of income for a single taxpayer or $87,000 to $107,000 for married joint filers. The Hope Credit is good for up to $1,500 for the first two years of post-high school education. The Lifetime Learning Credit is worth up to $2,000 per return for costs beyond the first two years. The credits are not available if expenses are paid with tax fee money such as public assistance or tax-free educational savings.

• For 2005, if the total qualified education expenses for a student are less than $7,500, it will generally be to your benefit to claim the Hope credit.
• For higher income households, it may make sense for the student to take him or herself as a dependent since there may be no benefit to the parent and the use of the credit might wipe out any tax liability from even a part time or summer job of the student.
• Be careful to know if health care benefits for adult children are dependent on the tax filing status . If coverage is only available when the child is a dependent on the employed parent's tax return, the cost of a loss of this benefit will outweigh the tax savings of the child taking their own exemption.

Earned Income Credit - The Earned Income Tax Credit (EITC) is a refundable Federal tax credit for lower income eligible individuals and families who work and have earned income under $33,692 ($34,692 for married filing jointly). The EITC reduces the amount of tax owed, and it may give the claimant a refund. The claimant must have earned income during the year. The earned income and modified AGI must each be less than:
*$11,750 ($13,750 for married filing jointly) if no qualifying children, or;
*$31,030 ($33,030 for married filing jointly) if one qualifying child, or;
*$35,263 ($37,263 for married filing jointly) if more than one qualifying child.

This credit requires that the qualifying child live with the taxpayer more than half of the year, but the child need NOT be claimed as that person's dependent exemption. It may be worth having a CPA look at whether there could be a “win-win” for both parents where one parent may make use of the EITC and the other of the dependency exemption and Child Tax Credit, especially where the low wage earning parent cannot make full beneficial use of all three. So much for “simplified” tax forms, eh?!

Certain U.S. Savings Bonds - Can be used to pay for college expenses and exclude from taxable income. However, this benefit is only available to the person claiming the dependent exemption.

Negotiations of Dependent Exemptions

• First prepare an estimate of the anticipated tax savings and potential child tax credits, dependent care expense credits, and educational tax credits for each parent.
• Second the parent with the greater dollar benefit in terms of overall tax savings should claim the exemption, and take credits consistent with the exemption. Remember that other credits are not tied to the exemption and may be left with the custodial parent.
• Third, get advice from a competent tax preparer or accountant where more than one credit or deduction is in play.
• Finally, split the value of the credit(s) and or exemption(s) between the parents equally or in some equitable fashion. The parent who could have claimed the exemption should not end up paying more tax or receiving a lower refund because of the assignment. If the tax brackets of the parents are different enough, the benefiting parent and the paying parent will both be better off. 

Division of Retirement Benefits

• A Qualified Domestic Relations Order (QDRO) is a court order that is used to assign the benefits of a qualified retirement plan to a nonemployee alternate payee.  A plan administrator is required to determine if an order meets QDRO requirements within a reasonable period of time after the receipt of the order and is to notify the spouses and any alternate payee of that determination.
• The tax consequences of QDRO payments include:
• Payments are taxed to the spouse or former spouse when received unless rolled over to an IRA.
• A pro-rated share of the original participant cost is used to figure the taxable amount of the payments
• Lump-sum distributions to a beneficiary may be eligible for special averaging or capital gain treatment if the original participant would have been eligible for that treatment.
• The 10% early distribution penalty does not apply.
• When an IRA is transferred between spouses, the receiving spouse is treated as the owner of such an account upon date of the transfer.
• Alimony constitutes earned income for purpose of computing the IRA contribution limit.

Tax Carryovers

• Capital loss carryovers are allocated based on each spouse’s separate capital losses.  Gains and losses on jointly owned or community property are generally divided equally between the spouses.
• A joint charitable contribution carryover is divided between the spouses with the same ratio of what separate carryovers would have been if the couple had filed the return married-separately.
• A joint net operating loss is divided between the spouses based on their separately computed income.
• There is no published authority on how to allocate AMT carryforward credits.
• Suspended passive activity loss is to be added to the underlying property’s basis.  Therefore, it is entirely allocated to the spouse who has the property.

This page prepared by:

Stefforia & Associates, P.C. CPA's
Ann Arbor, MI
734-747-8863