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The Tax Prophet Newsletter   Issue #46 February, 2007

REDUCE TAXES!
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In This Issue:
Introduction
No Basis Step Up
Business Buy-Out
Alimony
Retirement Plans
Dependents
Conclusion


Selected Divorce
Tax Traps


Introduction

IRC Section 1041(a) provides that no gain or loss is recognized when property transfers from an individual to a spouse or former spouse, if the transfer is incident to a divorce.

The transfer is treated as a gift, which means the adjusted basis in the property remains unchanged (it is "carried over" to the transferee).

The following examples illustrate some of the tax traps lurking in divorce settlement agreements.

No Basis Step Up

An unexpected tax liability may arise when property initially received tax-free in a divorce is later sold: any gain will be fully taxed to the selling spouse.

Example: Husband has $10,000 in cash and stock worth $10,000, with a basis of $100. Husband transfers the stock to wife as part of a divorce settlement. Each spouse now has an asset worth $10,000, correct?

Not quite. If wife then sells the stock for $10,000, she will have a $9,900 taxable gain.


Business Buy-Out

Purchasing a spouse's interest in a family business can lead to unanticipated tax consequences, depending on how the buy-out is structured.

Example: As part of a divorce agreement, the husband agreed to buy-out his wife's interest in a corporation. But instead of paying his wife directly, the husband directed the corporation to pay her.

IRS ruled that payments made by the corporation were considered taxable dividends to the husband because the corporation had no valid business reason to pay the wife directly.

Instead, the wife should have received her share of the corporate stock and then entered into a redemption arrangement with the corporation. That way, the wife would have been taxed on the redemption of her stock, presumably at a long-term capital gains rate (15% federal).


Alimony

Alimony payments are deductible by the payor and are considered taxable income by the recipient, but to receive this tax treatment, the payments must meet strict requirements.

For instance, a husband claiming he was bound by an oral agreement to pay alimony and made the payments with a joint credit card, ran afoul of two alimony requirements: (1) the payments must be required in a written divorce decree or property settlement; and (2) the payments must terminate upon the recipient's death.

IRS ruled that with credit card payments, the husband would be obligated to pay the credit card debt even if his ex-spouse died; therefore, the payments did not constitute alimony.


Retirement Plans

The division of retirement plans must also comply with strict rules. Otherwise, the spouse who owns the retirement plan will be taxed on the distributions.

To avoid this result, there needs to be a "qualified domestic relations order" establishing the non-owner spouse's legal rights to the retirement plan and liability for taxes on distributions.


Dependents

In joint custody situations, it is important to have a written agreement stating which parent is entitled to claim the child as a dependent. Tax benefits pertaining to a child, such as the dependency exemption, the Hope Scholarship and the Lifetime Learning Credits may be received only if the child is claimed as a dependent on the parent's tax return.


Conclusion

Tax issues arising from divorce property settlements can have both unexpected and significant impact. Often, because of the animosity that accompanies a divorce, it could be difficult to fix any "mistakes" after the agreement is signed.

The lesson: Understand the tax consequences of the property settlement and the right to claim deductions and credits for dependents before signing the final agreement.



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All contents copyright (c) 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet TM is a trademark of Robert L. Sommers.