Family Law Taxation California Style

Preface

The following summary of Family Law tax issues was written in August 2002. It is provided to the public for the general purpose of spotting tax issues in a family law matter. It was written for California lawyers, although the tax code is a federal issue. The text set forth below cannot be relied on as a summary of current law. Tax law become outdated quickly and the Internal Revenue Code is amended frequently. Regulations are promulgated and court rulings affect the interpretation and application of tax law. Please contact a qualified accountant and/or tax attorney for current updates and specific application of the rules.

TAX TREATMENT OF SPOUSAL SUPPORT

A. General Rules (IRC § 71)

Spousal support payments originate generally for the following reasons:

Decree of separate maintenance (legal separation) – this generally occurs when the parties are not seeking an actual marital dissolution but are going to live apart, create an asset protection program, nullify presumptions of community income or asset creation, or the parties decide they would rather go this way instead of generating a postnuptial modification agreement.

Temporary support (pendente lite) – this generally occurs after the date of separation and before the final decree of dissolution or legal separation is entered. For purposes of taxation, this type of support has fewer restrictions on amounts paid and the consequences than a decree of separate maintenance or permanent support.

Permanent support – when the marital dissolution (as to status) is completed and a permanent plan is put in place concerning the obligation of the parties.

The Superior Court has subject matter jurisdiction to make spousal support orders either temporary or permanent. The basis for allowing a deduction for tax purposes arises from § 215 and 71 of the Internal Revenue Code of 1954 as modified.

“Alimony,” in general, are all payments that are deductible by the paying spouse and includable as income of the receiving spouse.

An alimony or separate maintenance payment, in general, is a payment received under a “divorce” or “separation” instrument. For purposes of the alimony rules, the term “spouse” includes a former spouse. These rules do not apply if the spouses file a joint income tax return together.

The requirements for whether a payment qualifies as “alimony” are as follows: There must be a divorce (dissolution) or separation instrument. If the parties have entered into an informal support arrangement, then this is not income to the recipient nor deductible to the payor. In order to deduct for taxes there must be a written agreement which is binding on the parties.

The payments must be in cash. These payments include checks, money orders and other current consideration, such as paying on behalf of the recipient their mortgage payment or property taxes, debt instruments, etc.

In some cases where each party has been assigned debt instruments and the payor party is worried that the recipient party will not pay the debt instrument, the order can be created requiring the paying party to pay the debt service on behalf of the recipient. This issue can get complex is when the recipient declares bankruptcy.

If the payor attempts to execute a note or give the use of property (use of family residence under a court order) as the basis of a support order, the payment will not be includable as income to the recipient.

The payments classified as support may not be required to be paid beyond the death of the recipient. This particular requirement was intended to prevent the deduction of obvious property settlements as support payments.

Another area of concern to the practitioner is payments which are made during life with a step-down after death. These payments are generated in an attempt to add to the Estate of the recipient for the purpose of ensuring money going to children, etc. In this type of case, the IRS would not only not allow any of the payments as support taxable to the recipient, but would also assert that if the money after death were to go to a minor child, that portion, independent anything else, was child support.

The two parties may not live in the same household. If this is a permanent order, the parties may not live in the same house. This would include the case where they live in separate wings of the house sharing the same kitchen or common areas.

For purposes of a permanent order, the IRS has allowed a grace period for reasonably exiting a house after the order was obtained. The literature suggests this subjective period is about one month.

If the support is under a temporary order, the above rule does not apply and the parties may live in the same house.

The agreement is controlling regarding if the support may be deductible. If the agreement between parties provides the payment shall not be included in income of the recipient then the payment cannot be deductible by the payor. This section of the code permits taxable and non taxable payments between the parties.

If The Payments Are Designated As Child Support, They Are Not Includable In Income By The Recipient And Not Deductible To The Payor. There Can Be Many Traps In This Area Where The Unwary Can Incur Nondeductible Payments.

If the parties file a joint return, then the payments are not deductible and includable as income. Obviously in filing a return, there would be zero benefit to having to include and exclude the same amount of income.

It is important to remember that IRC § 71 is the controlling section – if the recipient has to include the payment as income as to whether a payment is support. IRC § 215 which allows the deduction of support by the payor basically states that if the recipient has to report the income as support, then payor may take the deduction. In advising a client whether a payment is deductible, always look to whether the income is taxable to the recipient.

Spousal support to non resident alien subject to 30% withholding unless there is a tax treaty with foreign country.

Spousal support may be designated partially or totally nontaxable to the recipient and nondeductible to payor.

Excessive Front Loading of Spousal Support

General Principals.

The IRS does not allow property settlements to become support payments. As discussed above, support payments are includable in income by the recipient and deductible by the paying spouse.

Various methods have been used over the years to attempt to use arbitrage (difference in marginal tax rates) in an attempt to save taxes. This is an excellent planning tool. If done correctly, it can result in tax minimization and increase the cash flow available for support.

ONE OF THE CHIEF METHODS USED IN THE “OLD DAYS” WAS TO GENERATE LARGE PAYMENTS AS ALIMONY UP FRONT, WITH A REDUCTION AFTER A FEW YEARS TO A LOWER PAYMENT AMOUNT.

The treasury viewed this as nothing more than a disguised property settlement and attempted to disallow this type of payment. During the 1980’s the IRC was amended to specifically deal with this problem. The law was changed to require a five-year look back for determining if there was a “front-end loading.” This look back period has since been reduced to three years.

The look-back period of three years consists of an automatic formula-driven device for determining if a payment was front-end loaded. If the payments are determined to be front-end loaded, either partially or in total, then in the third year after payments began, the recipient is entitled to deduct as “alimony” the amount of overpayment and the payor must pick up the overpayment as alimony. Special disclosures on the returns are required disclosing this unusual occurrence.

From a practical point, if the recipient has reported the “payment” to the payor, the payor should be very conscientious to pick up the income, as a computer will generate the audit notice about 100% of the time.

The look-back rules are as follows:

The excess payment for the first post-separation year is any excess of the amount of alimony or separate maintenance payments paid by the payor spouse during the first post-separation year over the sum of (1) $15,000 plus (2) the average of the alimony or separate maintenance payments paid by the payor spouse during the second post-separation year minus the excess payments for the second post-separation year, and the alimony or separate maintenance payments paid by the payor spouse during the third post-separation year.

The excess payment for the second post-separation year is any excess of the alimony or separate maintenance payments paid by the payor spouse during the second post-separation year over the sum of $15,000 plus the amount of alimony or separate maintenance payments paid by the payor spouse during the third post-separation year.

What this means in is if the support payment changes by more than $15,000 from year to year during the first three years of support, look for an adjustment in year three in favor of the recipient.

It is important to remember that this restriction does not apply to temporary support under IRC § 71(b)(2)(C).

When support is contingent upon the profits of a business or investment, outside of the control of the payor, then the rule also will not apply.

This whole issue does not apply after year three.

Child Support

Child support is not income or deductible for support purposes. There are a number of Tax Court cases where taxpayers have attempted to deduct child support payments. The deductions are disallowed.

“A payment which under the terms of the divorce or separation instrument is fixed (or treated as fixed) as payable for the support of a child of the payor spouse does not qualify as an alimony or separate maintenance payment. Thus, such a payment is not deductible by the payor spouse or includible in the income of the payee spouse.”

In some cases the total amount of support given to a former spouse includes both spousal and child support and the delineation is not made directly in the support agreement. In cases like this, the IRS or FTB will look to the total agreement for language which will show a reduction in support happening at key dates in time.

“Where the instrument does not specifically provide that a portion of a payment is for child support, a portion will nevertheless be treated as child support to the extent the payment is to be reduced on the happening of a specified contingency that relates to a child.” Such contingencies would include reaching eighteen, graduating from high-school (in California a child is generally entitled to receive support until graduation from high-school), achieving some goal which will allow a parent to no longer be responsible for a child, child becoming emancipated, finding employment or leaving spouse’s household.

When payments are made for several children as well as for spousal support there are certain assumptions made when payment adjustments are made around the date that a child reaches certain milestone birthdays, etc. Generally speaking, if adjustments are made more than a year beyond or before these dates, there will be no sigma attached (assumption of child support for the adjustment). Otherwise, the taxpayer and the IRS will wind up arguing the issue.

A complete cessation of support or a termination at a customary anniversary under local rules also will not be challenged with success. This issue can be avoided if a key date comes before the child reaches eighteen. An example would be if the child is six and the total payment is $1,000 a month until the child is sixteen (ten years) and a reduction to $200 for two years. In this case there was no reduction by reason of a key date pertaining to the child and the IRS will not impute that $200 of each payment was for child support

Caution in those cases where a paying spouse is experiencing difficulties and is in arrears or only pays a portion of support payments, the IRS will treat the payment as applied against child support deficiency first and then toward deductible spousal support

Tax Planning Thoughts

Generally, the out spouse in a marital dissolution is in a lower tax bracket than the working spouse for the purpose of earned, short-term capital gains or ordinary income. The top bracket for regular income can be as high as 45% on a combined Federal and California basis. Out-spouses typically are in anywhere from a 0% to a 45% marginal tax bracket.

By careful planning of the difference between tax brackets of the parties, an arbitrage situation can be arranged where thousand of dollars of taxes can be saved which can be split between the parties. The only party that loses is the IRS and FTB.

Other possible areas of tax savings are the AMT (Alternative Minimum Tax) which can result in a similar savings as noted above for regular taxable income; NOL’s (net operating losses); loss of itemized deductions and various credits which can be lost if income levels are wrong.

A common way of paying for these items to arrange for tax savings is two-way support. This consists of having a taxable support payment going one way and a nontaxable support payment going the other.

One last area where, if more than one person is paying for the support, is to have a support sharing arrangement in place. Only one party may claim a child as a dependent and with putting the Social Security number of the child on the return when claimed on a return, the mistake of more than one person claiming a child as a dependent can easily be picked up by an IRS computer.

Spousal Support

A family support order, also referred to as a “Lester agreement,” is an order wherein child support and spousal support are combined without any amount being fixed for either. They may be made by agreement of the parties or order of the court.

Pursuant to C.I.R. v. Lester (1961) 366 U.S. 299, the entire amount of such payment is deductible as spousal support. The purpose of such an agreement is to utilize the difference in the parties’ respective marginal tax rates to, in essence, “create” additional income, which could then be shared by the parties so as to give each a higher after-tax income than they would have under a traditional spousal/child support order.

The combination of the Domestic Relations Tax Reform Act of 1984 (DRTRA), which fixed any payments which were associated with children as child support, regardless of the label (IRC §71 (c)), and the compression of the marginal tax rates, has reduced the usefulness of family support orders.

These orders still work provided the paying spouse is willing to accept an order which has no stepdowns relating to the children. This may mean that there is no built-in stepdown or that the stepdown occurs on a date that is not associated with children, such as the age of majority, graduation from high school, or graduation from college.

Another reason for not entering into a family support order is that these orders set up a status quo that may be higher than the “guideline” support order. These orders work because they shift the tax burden to the payee who is in a lower tax bracket or has deductions to offset the family support. If the deductions or tax brackets change, the family support order may not continue to work for the parties.

Consider entering into family support orders for temporary support or for a specified period of time, as long as the termination is not within a year of child becoming 18 or 21 years of age. Even if these orders make economic sense, they may not be practical. They are also hard to sell to the parties because it “looks like” the payor is paying more in support. The payor must change his/her exemptions so that there is available net income to pay the family support. There is also a required IRS form when requesting more than the standard exemptions. The payee must pay higher quarterly estimated taxes on the family support.

There is a safe harbor in Treas. Reg. 1.71-1T, Q-18 that tells us that a step down will not be treated as “relating to that child” so long as it takes place more than six months before or after a date that the child attains 18, 21 or the local age of majority. Attorneys and CPA’s disagree as to the effect of F.C. § 3901 on this safe harbor. The more prudent approach is to treat the date on which the parents’ child support obligation ends as the “local age of majority” for family support step down purposes.

Order for family support must terminate at death of the recipient spouse to be deductible by paying spouse as alimony.

F. Life Insurance Proceeds

Life insurance can be purchased to secure a future stream of support payments. Be sure that the supported spouse or child is the owner of the policy and that there is a Court order requiring the policy. Payments on the policy will then be held to be additional support and if and when the policy pays out, the proceeds will be nontaxable to the supported party.

“…Premiums paid by the payor spouse for term or whole life insurance on the payor’s life made under the terms of the divorce or separation instrument will qualify as (deductible spousal support) payments on behalf of the payee spouse to the extent that the payee spouse is the owner of the policy.”

G. Furnishing of Identifying Number

Although not a monumental issue, be sure that when you are paying support, you have a copy of the Social Security number of the supported party. In taking a deduction for spousal support, you are almost 100% sure of being audited or compared to the amount on the receiving party’s tax return. This is an area where it is important to be exact.

TAX TREATMENT OF A PROPERTY TRANSFER INCIDENT TO A DIVORCE

General Rule

Obviously, in most divorces or marital dissolutions that attorneys are involved in, there is income and there are assets and they both need to be accounted for and allocated in some fashion, either to satisfy the Court or to satisfy the parties.

Generally, when the parties are satisfied there is no need to go to Court other than for a formal ending of the whole process and the parties can be very creative to achieve their desired goals in dividing income and assets and liabilities.

When the parties are not satisfied and the Court must decide the allocation of income, assets and liabilities, then it is more difficult to be creative in the interest of both parties and particularly your client.

In family law, the object of a property settlement is to have as equal as possible a split between the parties of the assets and liabilities based on their fair market value, which in itself is a phrase of art. Without further aid from the attorneys for both parties, the Court generally will not consider differences between an assets fair market value and its tax basis for the above allocation.

By way of example: The family residence is worth $1,000,000 and has a tax basis of $100,000. The portfolio of stocks held by the family is worth $500,000 and has a basis of $400,000. Husband’s business is worth $1,000,000, which includes goodwill of $200,000 and has a tax basis of $800,000.

Totally ignoring the tax issues of the difference between FMV and tax basis, in the old days the saying the “business for the house” would have achieved wife getting house plus half of the stocks with husband receiving the business and half of the stocks.

Under the rules in place for the sale of the family residence, if each party sold all of the assets simultaneously to an unrelated third party, wife would have $950,000 of capital gain, less the possible use of her once in a lifetime $125,000 IRC § 1034 gain exclusion or taxable income of $825,000.

Under the old rules husband would have $250,000 of gain which, depending whether he was selling a corporate shell or making a “bulk sale,” could be all capital gains or have a portion up to $200,000 as ordinary income (recapture).

Assuming the best case, wife has capital gain taxes at old rate of 28% Federal and 9.3% state on $825,000 or about $286,275 or combined Federal and State taxes.

Assuming the best case, husband has $250,000 of capital gain taxes at old rate of 28% Federal and 9.3% state or about $86,750 of taxes.

In this example there was potentially an unequal property settlement – wife should have received about $100,000 in property with a $100,000 basis as an equalization payment.

There have been changes to this story in 1997. The capital gains rate has changed, the holding period have changed; there is no IRC § 1034 as we used to know it, the effective exclusion on the sale of a residence has changed, however, the amount of the gain which wife would be taxed on would still result in an unequal distribution of the property, requiring an equalization note or a better allocation of the assets on hand.

In brief, while Family Law does care about an equal division of the property in a divorce (marital dissolution), income tax law could care less.

Up until 1984, the chief cases governing transfers of property between spouses were United States v. Davis (1962) 370 US 65, 82 S Ct. 1190 and Carrieres v. CTR 9th (Cir 1977) 552 F2d 1350. Case law proved to be unsatisfactory and Congress passed The Domestic Relations Tax Reform Act of 1984 (DRTRA). This essentially stated that transfers between spouses will not result in a taxable event (note: there are exceptions to this).

IRC § 1041 states in brief that a transfer between spouses is not a taxable event. This is a mandatory section of the code. You may not pick and choose assets and liabilities which will be subject to this section.

Major exceptions to the general rule are: if the property is being transferred to a nonresident alien wife or husband or the property being transferred is a submarine (liabilities exceed value of asset) in trust for one party. In the latter case, to the extent the property is upside down, the receiving party will have taxable income and will increase the tax basis of the property received to reflect this income.

When IRC § 1041 was created, it was contemplated that it would be used in situations of marital dissolutions. IRC § 1041 provides that transfers related to a divorce are included. It further recognized that these types of transfers occur over time – not necessarily at the time the dissolution occurs. Reg 1.1041-IT(b) states that: “Related to” the cessation of the marriage means the transfer is required under the divorce or separation instrument, and the transfer takes place within six years from the date of the divorce.”

The six-year requirement is a presumption which may be overcome by convincing evidence that a transaction falls under its provision you are subject to it without making an affirmative election. Dire results may occur when either spouse is unaware of this provision.

Notice and Record Keeping Requirement

Q-14 “Does the transferor of property in a transaction described in section 1041 have to supply, at the time of the transfer, the transferee with records sufficient to determine the adjusted basis and holding period of the property at the time of the transfer an (if applicable) with notice that the property transferred under section 1041 is potentially subject to recapture of the investment tax credit (There currently is no recapture.)?”

A.14 “Yes. A transfer of property under section 1041 must, at the time of the transfer, supply the transferee with records sufficient to determine the adjusted basis and holding period of the property as of the date of the transfer. In addition, in the case of a transfer of property which carries with it a potential liability for investment tax credit recapture (no longer applicable) the transferor must, at the time of the transfer, supply the transferee with records sufficient to determine the amount and period of such potential liability. Such records must be preserved and kept accessible by the transferee.”

As a practical matter, in a family law matter, if the in spouse does not provide adequate documentation as mentioned above, it will become facts and circumstances type question of who controlled the records in the family regarding an asset.

Effective Date

This section of the law was effective in July 18, 1984.

Transfers before July 18, 1997 are governed by prior law and may be taxable events.

MISCELLANEOUS DOMESTIC TAX PROVISIONS

A. Spousal Support Treated as IRA Compensation

IRA contributions are normally made based on “earned income.” An exception is made under IRC § 219(f)(1). This section provides that spousal support (maintenance) may be used as the basis for making an IRA contribution.

Although IRA contributions are limited to $2,000 per year, they represent a good long term investment opportunity.

If the client is able to save from current income sources or even convert previously saved money to IRA money, it generally makes good business sense.

The money being put aside is deducted from income currently which results in an immediate savings of “cash flow” of up to 45% of the amount saved. This income saved in an IRA is allowed to earn interest tax free until the funds are withdrawn. Withdrawal can start at any time after age 59 ? without penalty and must start by age 70 ?. In the case where a pure insurance product (annuity) is taken, the beginning age of the payout may be before age 59 ? without any penalty tax being imposed.

With current rules allowing withdrawals for emergencies, there is still a safety net.

Dependent Exemptions

Dependency exemptions have been indexed for inflation. For the year 2002, they are $3,000, adjusted for inflation in future years. A dependent cannot claim a personal exemption is claiming him or her as a dependent. There is a phase out of the personal exemption and other itemized deductions as the income of the taxpayer rises. Thus, the value of a deduction to a head of household taxpayer making $294,150 taxable income is $0. A single return pre cap is $259,800, and married filing separately is $164,250.

To claim a dependency deduction, the following five tests must be met.

The person must meet the relationship test. They must be a son, daughter or a decendent of either, a stepson or daughter, a brother, sister or stepbrother or stepsister, parent or stepparent or ancestor of either, uncle or aunt, nephew or niece, son-in-law or daughter-in-law, father-in-law or mother-in-law, brother-in-law or sister-in-law or member of a taxpayer’s household.

You cannot claim a complete stranger (although in some conditions this could qualify as a charitable deduction).

A husband of an aunt is not an uncle, a grandnephew or grandniece is not a nephew or niece and a foster parent does not qualify.

Once a person qualifies they always qualify, even with death, divorce or remarriage.

With the exception of minor children or children who are students, a dependent may not make more than the amount of the dependency deduction. For purposes of this test, social security (SSI), veterans’ pensions do not count as income.

Thus if your mother made $10,000 a year interest income, she would not qualify as a dependent.

Your dependent must not file a joint material return with anyone (son or daughter filing a return with husband or wife). A material return is one that was filed for some other purpose other than receiving back any withholding which was taken because there was no tax on the return.

You must provide more than one half of the support for the person who is a dependent. This would include food, clothing, medical expense and most important college tuition The dependent must be a resident of the United States or Mexico or Canada or a US citizen. A foreign exchange student living in the United States does not qualify.

A child who is born and dies during the year is a dependent on the parent’s tax return.

Being able to take a dependency deduction implies that the medical expenses relating to the dependent are deductible as an itemized deduction, if the pertinent requirements are met.

In a community property state dependency deductions may be allocated between spouses filing separately any way they choose.

In other instances, whether no one person has paid more than one half of the support for a dependent (four children equally taking care of mother), then an agreement can be made between the supporting parties allowing one person to claim the exemption. The official IRS form is 2120. If filled out, it will substantiate this type of agreement.

In the case of a marital dissolution, or a legal separation, the parent who has child custody more than half the year is presumed to be the parent who qualifies for the dependency deduction, no matter who supplies most of the support. This default status can be changed by the parties, if the custodial parent supplies a statement to the non-custodial parent releasing the exemption for the year and the statement is attached to the return of the parent claiming the exemption, or if the child is subject to a multi-party support agreement (above). The official form to use for this is an IRS form 8332. The actual pages of a decree signed by the custodial parent attached to the return will also meet this transfer requirement, which grants the exemption to the non-custodial parent.

The exemption is phased out as the income of the party claiming it increases. The decrease is 2% for every $2,500 that taxable income is greater than $181,800 if married filing a joint return, $151,000 if filing as head of household, $121,200 if filing as single, and $90,900 if filing as married filing separately. (Note, these change annually).

It is very important to remember that if you have one child and the custodial parent gives up the exemption to the non-custodial parent, the status as filing head of household will be lost.

Medical Expense Deduction

You are entitled to take the deduction for any medical expense incurred by you or by you for your dependents.

Included in the cost of medical expenses are actual doctors, dentists, and other medical practitioners, medical supplies, prescriptions, mileage and lodging costs incurred in seeking medical help, and medical insurance expense. Be sure to check if the medical insurance expense paid by any employer was out of your client’s wages or out of before tax dollars. If it was out of your client’s wages (subject to income tax by your client), then it is includable in the gross amount of medical expense.

Subtracted against this amount is seven ? % of gross income as an exclusion. If you have a greater amount of remaining medical expense, you have an itemized deduction.

Do not count medical IRA payments or any other tax deferred payments used for medical purposes, unless the source of the payment is also included in income (IRA’s cashed out for medical hardship).

Head of Household Status

This status gives the taxpayer the advantage of a lower tax rate than filing as “single.”

A requirement is that you maintain a residence for a child for more than six months of the year or, in the case of whether two people are separating, the person who had custody the last five months of the year gets the status.

In the event that the taxpayer has filed a document giving away the exemption for the qualifying child, they may not use that child for filing as head of household.

One of the more common alternative uses of this filing status if you maintain a household for your parent and the parent is a dependent, then you are head of household. You do not have to live in the same household with your parent to qualify for this status.

When a couple has two or more children and shared custody, they can each claim head of household status if arranged properly.

Innocent Spouse Rule

“Each spouse is jointly and severally liable for the tax, interest, and penalties arising from a joint return, except in the case of fraud and in the case of the application of the innocent spouse rules, an innocent spouse may be relieved of liability for the substantial understatement of taxes attributable to the grossly erroneous items of the other spouse of which the innocent spouse had no knowledge.”

For a year that was filed jointly, even after a marital dissolution, both parties are liable for the tax, interest and penalties. An indemnification clause, the type that is usually asked for in a marital dissolution, is worthless with the IRS.

A very common past tax tragedy is the tax associated with a deferral of gain on the sale of a personal residence, for which a new residence is never purchased. Even if this residence is the separate property of one of the spouses, the tax on sale is a liability of both parties.

An innocent spouse will be relieved of liability under the following circumstances:

If a joint return is filed – both parties must have executed the return. If one spouse did not sign the return, but it is shown that, that spouse normally did not sign the return, then this will not be as important a factor (fruit of the tree . . . ),

There is a substantial underpayment – don’t invoke this status unless there is a major deficiency which would destroy the innocent spouse and;

The other spouse is clearly the source of the erroneous information – if the “guilty spouse” had a business and the under-reported income came from that business;

The innocent spouse didn’t know about it – if this was the only source of income and they lived well and “innocent” never saw the income reported on the return and never asked the question “What are we living on?” it will be difficult to qualify, and; It would not be equitable to make the “innocent spouse” pay.

Guidelines established by the Treasury require the understatement of tax to exceed $500 and the amount of misstatement of income must be more than 10% of AGI is less than $20,000 or 25% if greater than $20,000 of AGI.

Something which is related to “innocent spouse” is the question of what happens to the out spouse’s share of community income when he or she does not have any records to determine what the income is, if any, or what the magnitude of the income is.

Quite often, the in-spouse is running a community asset business, a marital dissolution has been going on for quite some time (over one year), the out spouse is getting the run around from the in-spouse’s attorney about getting information about the income of the business or, more commonly the out-spouse receives a report of income which looks unbelievably low. What to do?

§ 66(c) of the Internal Revenue Code states:

“(c) Spouse relieved of liability in certain other cases

Under regulations prescribed by the Secretary, if

(1) an individual does not file a joint return for any taxable year,

such individual does not include in gross income for such taxable year an item of

community income properly includible therein which, in accordance with the rules contained in § 879(a), would be treated as the income of the other spouse,

the individual establishes that he or she did not know of, and had no reason to

know of, such item of community income, and

taking into account all facts and circumstances, it is inequitable to include such

item of community income in such individual’s gross income, then, for purposes of this title, such item of community income shall be included in the gross income of the other spouse (and not in the gross income of the individual).”

In a case of a well-contested marital dissolution, quite often the accountant advising the out spouse will send well-documented letters to the attorney for the in spouse, the accountant for the in spouse or the in spouse seeking the above information. The accountant is really hoping they will all do the litigation thing – not answer the letter, not give the information, give exceedingly low income, etc. When I do get information, I do use it in the tax return and the cash available for support calculations I prepare for the out spouse. I send a letter with out-spouse’s tax return to the IRS and FTB advising then that out spouse is invoking IRC § 66(c). Because of the nature of any underpaid taxes – either in spouse did not report all of the income or under reported, when the audit notice comes, it is his/her separate problem.

IRC § 6015(b) provides relief from joint liability if five conditions are met:

A joint return was filed;

On the return, an understatement of tax was attributable to erroneous item(s) of the spouse (i.e., the nonrequesting spouse) with whom the spouse requesting relief (i.e., the requesting spouse) filed the return;

The requesting spouse established that at the time that the return was signed, he had no knowledge or reason to know of a tax understatement;

Taking into account all the facts and circumstances, holding the requesting spouse liable for the understatement would be inequitable; and

The requesting spouse elected the benefits of Sec. 6013(b) no later than two years after the date collection activities began as to him.

Relief is not available to a spouse whose income or deductions or both are the cause of the tax increase.

Allocation of Increased Tax

Sec. 6015(c) allows a requesting spouse to elect to allocate a tax deficiency if;

a joint return was filed and,

at the time of the election, the requesting spouse was no longer married to, was legally separated from or had not been a member of the same household as the nonrequesting spouse at any time during the 12month period ending on the date the election was filed. For § 6015(c) purposes (unlike for § 6015(b) and (f)), whether the election is equitable or inequitable is irrelevant.

Relief under § 6015(c) is limited. First, a § 6015(c) election would be invalid if the assets were transferred between the requesting spouse and the nonrequesting spouse as part of a fraudulent scheme. Second, relief is not available to the extent that the requesting spouse had actual knowledge of an item giving rise to a deficiency at the time he signed the return. Third, relief is available only to the extent that the liability exceeds the value of any disqualified assets (as defined in § 6015(c)(4)(B)) transferred to the requesting spouse by the nonrequesting spouse.

Relief Due to Inequity

Under procedures prescribed by the Secretary, if(1) taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or, any deficiency (or any portion of either); and (2) relief is not available to such individual under subsection (b) or (c), the Secretary may relieve such individual of such liability.

Procedure for Requesting Innocent Spouse Relief

To request innocent spouse relief, a spouse must file Form 8857,

Request for Innocent Spouse Relief, within two years of the first collection activity against the requesting spouse after July 22, 1998. If the IRS denies the request, the requesting spouse must file a petition with the Tax Court during the 90day period beginning on the date on which the Service mailed (by certified or registered mail) a determination notice denying relief.

If the IRS fails to issue a valid notice of determination within six months of filing a relief request, the spouse could file a petition with the court during the 90day period beginning after the expiration of the six month period (Sec. 6015(e)(1)(A)).

Gift and Estate Tax

Gift Tax.

There is an unlimited marital deduction. So long as the transfer occurs before marriage is dissolved.

Marital deduction does not apply to a terminable interest, unless the doner receives a Qualified Terminable Interest (OTIP). The donee agrees to receive income for life and includes the value of their federal estate tax return.

Non resident aliens do not have marital deduction, but the terminable exclusion is $100,000 – not $10,000.

$10,000/year is excluded – up to $10,000 for couple (inflation to $11,000 on 2002.

Up to $1,000,000 in total gifts can be included;

IRC § 2516 renders gift tax not applicable to divorce if there is a written agreement.

The divorce must occur within the three year period keeping or the due one year before the agreement was entered into.

Does not apply if marriage is not dissolved or either spouse dies before entry of agreement.

Does not apply to transfer pursuant to a court decree.

Estate Tax

No estate tax after 2009 phase out up to that time.

An estate can deduct present value of obligations to former spouse.

Legal Expenses

The general rule is that attorneys, accountants, appraisers and other experts in connection with divorce, child custody and paternity matters are not deductible.

Court costs such as filing fees are also non-deductible. United States v. Gilmore (1963) 372 U.S. 39. On occasion a client will attempt to pay fees for the divorce through their business.

Divorce related attorneys fees are not a business expense and therefore non-deductible.

Attorneys fees incurred in connection with a divorce are personal expenses, even though the litigation may have important business implications.

For example, if fees are expended for the purpose of protecting a family business, they are still considered personal. (Melat v. Commr., TC Memo. 1993-247 — Husband cannot deduct cost of fighting value of his share of unpaid law firm contingency fees)

Attorney’s fees incurred in connection with a divorce are deductible in a few circumstances.

They are treated as “miscellaneous itemized deductions.”

They are deductible only to the extent they exceed 2% of adjusted gross income and are subject to a phase out when the adjusted gross income exceeds a certain amount.

They cannot be taken into account in computing the alternate minimum tax.

It is suggested that in order to take advantage of the 2% rule, the client should pay all deductible legal fees in one year.

Attorney’s fees and other litigation costs are deductible to the extent they are incurred to produce income that is includable in the recipient’s gross income.

Because spousal support is includible in gross income, the fees incurred in obtaining the spousal support or in collecting delinquent spousal support are deductible.

Note also that an accountant’s fees will be tax deductible to the extent their work involved obtaining spousal support.

Possibly the fees for a vocational counselor would also be deductible to the extent they were used to produce spousal support.

Fees and costs in connection with modification proceeding are also tax deductible.

Attorney’s fees incurred for obtaining an interest in the spouses retirement plan are also be deductible.

The fees incurred in obtaining royalties, residuals and other income taxable to the client would also be tax deductible.

Fees are also deductible to the extent they are paid for tax planning advice. Rev. Rul 72-545, 1972-2CB 179 The following advice may be allocated to tax planning:

Costs of structuring a property division to produce desired tax effects, i.e. advice re: rollover of residence, the one time tax exclusion of capital gain for taxpayers 55 and over, etc.

Costs of determining the adjusted basis of assets in the property settlement.

Costs of planning an alimony trust or annuity agreement to avoid some of the restrictions on deductible spousal support.

Costs of estate planning which relate to assure proper estate and gift tax consequences for the payment or receipt of support or property divisions.

Costs of preparing settlement agreement to assure deductible support payments during the separation period.

Costs of maximizing the deductible portion of spousal support or of minimizing the taxable portion of spousal support.

Costs of allocating dependency exemptions.

Costs of obtaining advice regarding the tax consequences of divorce or separation instrument; or of gathering information for and actual preparation of tax returns.

Costs of drafting a QDRO and submitting it to the plan administrator for approval.

Fees incurred in establishing or defending title to property may be capitalized and added to the basis of property.

The best way to handle the deductibility of attorney’s fees is by separately itemizing the services in your client’s bills that involved tax advice and the “production or collection of income”. If you are qualified to do so, send the client a letter at the conclusion of the case that expressly identifies the deductible vs. non deductible services rendered; in the event the client’s deductions are disputed, the IRS must receive such allocation letter in evidence. Otherwise provide the date to the client’s accountant.

By tax planning, parties can use the tax deductibility of attorney’s fees to allocate fees between the spouses. If, for example, Husband pays to Wife $10,000 as temporary spousal support (to avoid recapture rules) and Wife pays her attorney’s fees from this money and she is able to deduct a significant portion of her fees, the transaction benefits both parties. It gives incentive for Husband to pay Wife’s attorney’s fees by making them tax deductible as spousal support and gives Wife the partial tax deduction for attorney’s fees when incurred for production of income or for tax advice.

Year of Divorce and Reporting Considerations

If you are divorced at any time during a year, then for that year (related to that spouse) you are single.

Both parties can better their filing status by arranging, if they have children, that they both qualify as head of household – two head of households is better than one joint filing or two single filings.

Quite often one spouse has been ordered to pay the mortgage and taxes on the family residence and allowed the exclusive us of residence in a temporary support order. If the order did not characterize the payments on the mortgage and the taxes – left their status to be resolved at the time of the final order, then there are grounds for both parties to claim a portion of the mortgage and taxes – (out spouse will pay his/her share on a charging/reimbursement schedule).

Make sure when you have this type of situation that either the out spouse pays the mortgage payment as additional support, or the payments are categorized as included in the support paid, or the payments are for a community obligation and will be charged to the parties when the Watt Epstein computations have been made at the time of trial.

When the parties in the year of a divorce take inconsistent positions on tax issues, the likelihood of an IRS audit increases dramatically.

When you are preparing permanent support orders, do look at the marginal tax brackets of the parties to determine if any support order should be categorized to maximize the tax savings of the parties. Nothing better than to leave your client in cahoots with their former spouse to deprive the IRS and FTB of legally avoidable taxes.

VALUING AND DIVIDING RETIREMENT PLANS AND STOCK OPTIONS

A. Types of Plans

Retirement plans are divided in to two categories: Defined Benefit Plans and Defined Contribution Plans.

1. Defined Benefit Plans are plans where the amount of the ultimate benefit received by the employee is determined by a formula in the retirement plan. Usually, the benefit to be received is dependent upon a number of factors such as: years of credited service, age of retirement and highest salary. Although some governmental plans require employee contributions, most private plans do not.

2. Defined Contribution Plans.

The ultimate benefit that the employee will receive is a function of the amount contributed for the employee’s account, plus growth in the account. The contributions may be made solely by the employee, as in an individual retirement account (IRA) or Keogh Plan; solely by the employer, as in a profit sharing plan; or by both, as in many tax deferred annuities and 401(k) plans, where a portion of the employee’s contributions are matched by the employer.

a. What You Get is What You See.

These plans are comparable to a savings account and the services of an actuary are generally not required to value them.

b. Tax Effect Not Immediate and Specific.

The assets contained in these plans generally will not have been taxed and therefore the recipient spouse should realize that there will be tax due upon receipt. Unless the employee is about to retire, the amount of this tax will usually not be considered by the courts in determining the value of the community interest in the plan, as the tax is not “immediate and specific.” c. Roll Them Over.

Usually these plans may be divided by dividing them into two portions, one for the employee and one for the spouse using a QDRO. The spouse will usually be able to take her share and roll them over into a rollover IRA in her name alone without immediate tax consequences. There is no need to prepare a QDRO for IRAs, they can be rolled over into the other party’s rollover IRA. The financial institution has a form for this transaction.

B. Dividing Benefits

There have generally been three ways in which pension benefits have been divided over the years:

1. Reservation of Jurisdiction.

Under this method, the trial court simply defers the issue of the division of the pension plan to another date, usually after the employee retires, or is eligible to retire. At that later time, the court will make an order determining the nonemployee spouse’s share in the retirement benefits, usually based on the time rule. This is no longer an approved way to handle pensions. Now they are either awarded to one party, divided at the time of trial or settlement, or the benefits are paid to the parties at retirement according to the time rule.

2. Inkind Division.

In this method, also referred to as the “time rule” or “formula approach,” the court defines a formula for the future apportionment of the retirement benefits, as and when received. This formula determines the portion of the retirement benefits earned during the marriage and before separation and awards the nonparticipant spouse a share generally onehalf. Usually the time rule is used, unless the benefits are unrelated to the time served, in which case some other approach which fairly allocates the benefits between the separate and community property efforts used to earn them may be used.

3. “Cashout” or Actuarial Present Value.

Under this approach, the court assigns the entire pension to the employed spouse and awards other community assets equal in value to the community interest in the retirement benefits to the nonparticipant spouse.

C. Valuation Strategies

1. Variables in Arriving at a Present Value.

a. Use of actuarial tables and discounts for ill health of party. In re Marriage of Bergman, supra.

b. Variations in the Use of Interest Rate based on the current prime rate and other variables. Bergman, supra.

c. Taxation of Proceeds not Considered.

D. Qualified Domestic Relations Orders

A Qualified Domestic Relations Order (QDRO) is used to accomplish “in kind” division of Defined Benefit Plans.

1. Exception to Rule Against Non-Assignment.

29 U.S.C. 1056 states “… [nonassignment and alienation provisions] shall not apply if the order is determined to be qualified domestic relations order. Each pension plan shall provide for the payment of benefits in accordance with the applicable requirements of any qualified domestic relations order.”

2. Definition and Rules.

Qualified Domestic Relations Order (QDRO) is defined in 29 U.S.C. 1056 as follows:

Each pension plan shall provide for the payment of benefits in accordance with … any qualified domestic relations order. (B) For purposes of this paragraph

(i) the term “qualified domestic relations order” means a domestic relations order

(I) which creates or recognizes the existence of an alternate payee’s right to … receive all or a portion of the benefits payable with respect to a participant under a plan …

(ii) … (I) relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child or other dependent of a participant, and

(II) is made pursuant to a State domestic relations law (including a community property law).

(C) A domestic relations order meets the requirements of this subparagraph only if such order clearly specifies

(i) the name and the last known mailing address (if any) of the participant and the name and mailing address of each alternate payee covered by the order,

(ii) the amount or percentage of the participant’s benefits to be paid by the plan to each such alternate payee, or the manner in which such amount or percentage is to be determined,

(iii) the number of payments or period to which such order applies, and

(iv) each plan to which such order

applies.

E. Problem Areas of QDRO

1. Jurisdiction over Plans.

State and federal courts have concurrent jurisdiction to review administrator’s determination that order is not a QDRO.

2. Participants Account May Not Be Charged.

ERISA plan may not charge participant’s account for reasonable administrative expenses incurred in qualifying QDROs..

3. Plan Rules Must be Followed.

The QDRO must comply with the Plan rules, so the Plan Administrator must approve the QDRO. The Plan rules must not violate ERISA. The alternate payee must make an application for a distribution i f required by the Plan rules.

4. Fees and Sanctions Not Available Against Plan.

Pursuant to 29 USC § 1132, attorney’s may be awarded against the plan which must be joined. In re Marriage of Olivarez (1986) 188 Cal.App.3d 336 holds that the plan may deduct the fees from the employee’s account. This result seems absurd and should only be permitted when the plan is acting on behalf of the employee. Smith v. CMTAIAM Pension Trust (9th Cir. 1984) 746 F.2d 587 allows fees if the litigant succeeds on any significant issue. It is not clear how to reconcile this case with Olivarez, supra. Does it mean that it would be better to sue the plan in Federal Court where you would be entitled to fees? In re Marriage of Shelstead (1996) 50 Adv.Cal.App.4th 1579 also discusses the issue of who is responsible and the factors involved in awarding fees . That case was granted review by the Supreme Court on February 26, 1997.

5. Follow the Rules.

a. TSA is not a Rollover IRA.

Blatt v. Commissioner (1993) 66 TCM 1409 – Husband’s dissolution judgment provided that a QDRO would be drafted to transfer $194,304 from his Tax Sheltered Account (TSA) with TIAA-CREF into Wife’s pre-exiting TSA. The tax court found that because Wife did not transfer the funds into a rollover IRA or an annuity she did not meet the requirements for a qualified transaction and she was taxed.

b. Rollover Must be Accomplished Within 60 days.

Spouse who did not roll over QDRO-based distribution of stock into IRA within 60 days must include distribution and dividends in gross income.

F. Tax Ramifications of QDRO

1. Tax and Penalty Free to Alternate Payee.

The general purpose of the QDRO is to transfer funds from the retirement plan of one spouse to the other spouse without incurring a penalty or a tax.

2. Cash Distribution Allowed.

Funds will either be rolled over into the spouse’s rollover IRA or distributed as cash to the spouse. When the money is distributed as cash, it is taxed to the receiving spouse, but there is no penalty if done properly. When cash is distributed, the plan must withhold 20% for Federal Taxes.

VALUATION OF A CLOSELY HELD BUSINESS ASSET

A. Valuation Approaches

1. Components of value.

a. Goodwill. “The “good will” of a business is the expectation of continued public patronage.” Goodwill is usually found to exist where a business’ or professional’s profitability exceeds that of others similarly situated, as a result of factors such as: “General public patronage and encouragement which it receives from constant or habitual customers, on account of its local position, or common celebrity, or reputation for skill or affluence, or punctuality, or from other accidental circumstances, or necessities, or even from ancient partialities or prejudices…”

b. Accounts Receivable.

They are subject to discounts for collectibility and taxability. They can be paid to the spouse as they are collected or they can be combined in a lump-sum as part of the valuation.

1. Assigning Accounts Receivable.

Under the assignment of income doctrine, if one spouse receives all the accounts receivable in exchange for other property, the spouse transferring the interest in receivables is liable for the income tax on one-half of all accounts receivable earned prior to separation.

c. Book Value.

This includes equipment, books, real estate, leases, art work, inventory, investments, intellectual property and buildings are just a few of the items that would go into a determination of book value. It is often not the true value of a business and the numbers can be very deceptive. Depreciation, sundry accounting practices, fraud, and poor bookkeeping may require the account to adjust the book value.

B. The Family Business

1. If there are insufficient assets to equalize the division of the community property, sometimes the only practical way to divide the property is give the non-operating spouse a continuing ownership. A spouse may be willing to continue ownership if they receive a share of the profits. This can be a form of spousal support to make it tax deductible to the owner spouse. If a spouse maintains an ownership interest in the family business, they are likely to share in the capital gains tax when it is sold. Likewise, if the equalizing payment from one spouse to the other involves a payment of a percentage of the proceeds they might be unwittingly liable for the tax on their share. To avoid the tax, the equalization payment should be a sum certain.

2. Stock Redemptions or Getting Funds Out of the Corporation

In a closely held business it is often difficult to buy out the spousal community property interest in the business because there is not enough cash or property to equalize the division of the property. Through a corporate stock redemption, the corporation can redeem the spouses shares without the spouse being taxed on the gain. If not done properly, the owner spouse can be held to have received a constructive dividend.

To work out a redemption, the parties must agree in a Marital Settlement Agreement of Stipulated Judgment to divide the shares of stock in the business. There can be no obligation for the Corporation to redeem the spouses shares once they have received the shares. Once the Judgment is signed and the owner spouse transfers the shares, then the Corporation can redeem the stock. IRS Private Letter Ruling 9427009 gives very specific guidelines as to how to do a corporate redemption.

C. Professional Corporations

1. In re Marriage of Lopez (1974) 38 Cal.App.3d 93, disapproved on other grounds, In re Marriage of Morrison (1978) 20 Cal.3d 437, 453) found that the components in valuation of a professional law practice were “(a) fixed assets, which we deem to include, cash, furniture, equipment, supplies and law library; (b) other assets, including properly aged accounts receivable, costs advanced with due regard to their collectability; work in progress partially completed but not billed as a receivable, and work completed but not billed; (c) goodwill of the practitioner in his law business as a going concern; and (d) liabilities of the practitioner related to his business.” (Id. at p. 110.)

2. Subchapter S corporations IRC § § 1361(c)(4)

If both members of a divorcing husband and wife shareholder team want to own a part of the business but only one spouse is active in the corporation, they can divide their shares equally, and the nonactive spouse may exchange his or her voting shares for nonvoting shares.

3. Number of Shareholders

Husband and Wife are considered one shareholder until they divorce. On divorce, their status must be adjusted keeping in mind the 35 shareholder limit.

ETHICS AS IT RELATES TO TAX CONSEQUENCES IN DIVORCE

A. Rules of Professional Conduct

1. Fiduciary Relationship.

The fiduciary relationship between an attorney and a client requires that an attorney may not disclose the client’s secrets and confidences.

2. Confidential Statements.

Confidential statements made by a client to a lawyer are privileged for purpose of subsequent legal proceedings.

3. Duty to Court.

An attorney in a civil nonjury trial has no duty to inform a trial court if the attorney knows that the client has committed testimonial perjury, but the lawyer must promptly try to convince the client to consent to divulge the perjury to the trial court. If the client does not consent, the lawyer must withdraw (without disclosing the confidence), and if the attorney is unable to withdraw, the perjured testimony can’t be used to support a client’s claim.

4. No Duty to Represent Perjuring Client.

A lawyer told a client that if the client told the Judge that the defendant had a gun, he would tell the Judge the client was lying and withdraw or impeach the defendant if he insisted on proceeding with his testimony. The Defendant did not mention the gun in his testimony and was convicted. The Supreme Court of Iowa upheld the conviction under the Iowa Rule of Ethics and the ABA Model Rules. The Eighth Circuit reversed saying that an attorney’s duty to zealously represent an accused criminal overrides ethical considerations. The Supreme Court reversed reinstating the Defendant’s murder conviction. In the lead opinion, the court held that an attorney who refuses to cooperate with a client’s plan to commit perjury does not violate a criminal defendants Sixth amendment right to effective assistance of counsel.

5. Be Careful When You Are Not Practicing Law.

When nonlegal business activities with a client involve a fiduciary relationship (such as accounting or real estate brokering), the attorney “must conform to the professional standards of a lawyer” even if those activities could legally be performed by a nonlawyer. California Rules of Professional Responsibility include entering into a business transaction with client, the attorney must (1) insure that terms are fair and reasonable to client, (2) disclose terms and potentially adverse consequences to client in writing and obtain client’s written consent, and (3) advise client to consult independent counsel and give reasonable opportunity to do so, and rule 3-331- requires full disclosure of attorney’s financial, business, or professional interest in subject matter of the client’s case, including potentially adverse consequences of nonlegal relationship.

Issues of Referrals

If the client is harmed as a result of a referral, compliance with the ethical rules will not insulate the attorney from civil liability for breach of fiduciary duty, negligence or legal malpractice.

If you make a referral for a fee, Rule 3-31-(B)(4) requires written disclosure to client of member’s legal, business, financial, or professional interest in the subject matter of the case, by disclosing the terms and amount of the compensation agreement, and any adverse consequences, or other opportunities. Rule 3-300 when a member acquires an interest adverse to client, they must (1) insure that terms of the transaction are fair to the client, (2) advise and give client opportunity to seek independent counsel, and (3) obtain client’s written consent to transaction.

Competence to Provide Advice. Counsel has an affirmative duty not to undertake representation in matters they are not competent to handle. Rule 3-110. There is a duty to inform the client. If all reasonably apparent legal problems were through beyond the scope of the retention agreement. This includes advising client on tax implications of Marital Dissolution.

B. Conflicts of Interest

1. Client Commits Fraud

An attorney who discovers that client is engaged in ongoing fraud and is asked to write a misleading letter to forestall complaints about the fraud. The attorney disclosure of the fraud would violate B& P Code § 6068 (e). On the other hand B&P Code §??????6068(d) requires that the attorney act truthfully and refrain from misleading the trial Court and California Rules of Profession Conduct, rule 3-210 must not advise their client to break the law which includes writing a letter. Instead the attorney must advise the client that his actions are fraudulent, explain the possible consequences, and assist in rectifying any earlier representations. If the client refuses to desist from the fraudulent activities, the attorney must either withdraw (after taking reasonable steps to avoid prejudice to the client) or limit the scope of representation to matters that do not involve or further the fraud.

2. Lawyer’s Friend is Not Protected By Attorney Client Privilege in Wife Beating Affair.

In People v. Gionis (1995) 9 Cal 1196 after being served with a petitioner by the defendant called an attorney who he had a business relationship and a friendship. The attorney refused to represent him, and he reluctantly agreed to see Gionis after stating he would not represent him. During the visit, Gionis made threatening statements about hiring someone to hurt his wife. A year later he was charged with conspiracy and assault in connection with an attack on her. At his trial, the attorney testified for the prosecution about Gionis’ statements to him. Gionis filed an appeal and the 4th district reversed finding that the attorney’s statements had violated the attorney-client privilege. The Cal. Supreme Court granted review and reversed finding that the Evidence Code 954 attorney-client privilege did not apply because the Defendant had made the statements after the attorney had made it clear he would not represent him.

3. Conflicts of Interest

IRC § § 7701(a)(36) defines “income tax return preparer as anyone “who prepares for compensation, or who employs one or more persons to prepare for compensation, any [tax returns or refund claim, or who prepares] a substantial portion of a return or claim for refund.” Attorneys are not exempt, and the definition may cover the preparation of a lawyers’ bill that is itemized for tax purposes with opinions as to the deductibility of the charges. An income tax return preparer is required to provide the client with a copy of any return prepared for the client and to keep a copy of each return in the prepare’s own office. IRC § 6107. In California tax preparers are covered by B&P Code § 22250 et seq., but attorneys and their employees are exempted from the requirements of those sections, by B&P Code § 22258(b).

C. Attorney-Client Confidentiality vs. Inquires for Disclosure from IRS

The attorney-client privilege may not apply to the IRS if you assisted in the preparation of the tax returns. The work product would be fully discoverable if used in the preparation of the tax returns.

TAX ISSUES OF THE MARITAL RESIDENCE

A. Transfers of Property Between Spouses/Incident to a Divorce

General Rule. Under IRC § 1041, no tax if incident to divorce except that transfers to non resident aliens taxable because IRC § 1041 does not apply.

Taxable Transfers

a. Reason for Tax

Asset has declined in value and transferor waits recognized loss.

Property has appreciated in value and the transferor wants to recognize and obtain stepped up basis with larger depreciation. Transfer may have net operating loss coming forward, gain or transfer would not be taxable and would enjoy stepped up basis. How to arrange taxable transfer.

Must not be incident to divorce.

Or, it must not be between spouses – if they are partnership or corporation.

5 Rules – Not incident to divorce.

Must occur a year or more of when dissolution is final and cannot relate to cessation of marriage.

(a) Cannot be mentioned or referenced decree.

(b) It should be disposed of. The transfer should be made after one year and the contract should recite business reasons related to the divorce if any exist.

Wait six years to be really careful if called for in the dissolution agreement.

d. Arrange for transfer from third party.

(i) Transfer from partnership or corporation to party unless it is a step transaction.

Sales to third party taxable, except if

(1) Transfer required by separate agreement

(2) Transfer is reached at request of spouse or former spouse

(3) Do not have spouse or former spouse give transferor a written consent to third party stating rules of 1041 apply:

(4) See expert in tax law to conduct this transaction properly.

B. Sale of Residence

Each time a principle residence is sold, each spouse is allowed to have a gain of up to $250,000 without having to pay taxes ($500,000 for married couples on joint return) If the gain is greater than these limits, records substantiating basis, improvements, etc. must be maintained for purposes of determining the actual gain and paying taxes on the amount over the above exclusion amount(s).

Taxpayer must have lived in the house two out of the last five years. This deals with most marital dissolutions where one spouse moves out of the house and the house is later disposed of and out spouse can not claim an exclusion because the house was not his/her residence. Out spouse is treated as owing the house for the period of in spouse.

If an old residence was sold and rolled into the one currently being sold, the holding period will go back to the first residence.

If one spouse does not qualify – sold a residence within the last two years, then the other spouse may still take the $250,000 exclusion related to them.

The old rules pertaining to sale of residence by a taxpayer over the age of 55 and receiving a once in a life time exclusion of $125,000 no longer exist.

You will have to return depreciation taken (office in home) after June 8, 1997 taken on a residence as long term capital gain.

Sales or exchange of principle residence after May 6, 1997. California law confirms.

Ownership two years, use for two years, no prior sales two years.

Hardship rules re two year ownership – change of health or employment – separation may not qualify – reduced exclusion permitted.

If residence was used as business 5121 does not apply.

Other Tax Issues Relating to The Residence

Mortgage interest deduction and property taxes increase/decrease support on guidelines.

Property Tax – No reassessment on transfer incidents in marriage dissolution or legal separation. Make sure the property is transferred before status is terminated.

No reassessment between parents and children.

The party awarded the residence will be responsible for all capital gains associated with the residence. There is no step up in basis.