SHOULD WE TRY A TEMPORARY SEPARATION?3 RISKS YOU MAY NOT HAVE ANTICIPATED

If you’re thinking about a temporary separation, to see if your marriage is reconcilable, then you’ve probably read our articles about the risks. On the one hand, a temporary separation allows you and your spouse some space to think about what you each truly want out of your marriage. On the other hand, a temporary separation can easily transform into a new, and bad, status quo, one in which you have doubled your living expenses and have removed yourself from your children, if you have them, and/or have set a pattern of supporting your soon-to-be-ex. While they may be helpful for the short run, every day must bring the two of you closer together or further apart –otherwise, the risks of confusing your children, establishing a support pattern and setting expectations that you will be the secondary, or “visiting,” parent take over.

Those are the most obvious risks, but there are less obvious, but just as common, risks, too:

Accumulating Assets – While you are separated, you should assume that any asset you and/or your spouse acquire, except some gifts and entirely segregated inheritances, are marital property to be divided equally between the two of you. This means, the furniture you bought to outfit your new place, your new TV, your contributions to your 401k, your interests in your pension, and so forth, are eligible for division – even after, in most states, a lengthy separation. This rule is not intuitive because most spouses will expect that their property rights were defined at the time they separated, since their decision to divorce is, in their minds, really an extension of their decision to separate. However, in most states, the rule is property is to be divided if it came to be between the date of the marriage and the date of the divorce, NOT the date of separation. While some states allow judges to fix the date at an earlier date, such as the date of separation or some date in between when it became clear the couple would not reconcile, this is but an exception to the rule. What’s worse – if you stop contributions toward your retirement to get around this rule, most states will treat your actions as “in anticipation of divorce” and will divide your retirement as if you had made those contributions. The best approach, therefore, is to make the separation short and decide soon whether to reconcile or file for divorce.

 Unanticipated Debts – Similarly, in most states, the debts either you or your spouse acquire are still considered marital debts to be divided between the two of you as of the date of divorce – again, not as of the date of separation. This may be intuitive for debts like the credit card the two of you have been using for gas, a medical expense for your child, or the home mortgage, but what about anticipated debts like a home repair while your spouse has resided in the home or a vehicle repair that went on a credit card or credit card spending your spouse claims is “all for the family” but you cannot track? Yes, in most states these too would be marital debt. While some states allow judges to fix the date to divide debts as of some other date, and to identify some debts as “purely personal” (after your time and money spent explaining to the judge why), this too is the exception and not the rule. You should assume that any debts your spouse acquires while you are separated from her are one-half yours.

Tax Filing Status – Unfortunately, these unanticipated consequences can, and often do, carry over to tax season. There is no rule that spouses must file their federal tax return with the status “married, filing jointly,” which is, generally, the most preferred tax filing status. Rather, either spouse may file with the status “married, filing separately” and take advantage of his or her own deductions, exemptions and refunds. If you and your spouse are not on speaking terms, you may no discover this separate filing until you file your return – long after he or she has claimed items for the home, and the children, and long after spending your  refund.

Then what are you to do if you and your spouse still intend to separate temporarily? First, establish a firm deadline for the separation – a month, two, etc. – at which time you will either reconcile or one of you will file for divorce. The longer your separation goes, the greater these risks grow. Second, consider a separation agreement. In some states, judges will enforce these as contracts, and in a minority they will not, but, either way, you and your spouse have set forth your expectations. (If you do not believe she will honor them, that is another sign you should file for divorce.)

Most of all, exercise caution every day of your separation – assume your assets during that time are one-half your spouse’s, her debts are one-half yours and taxes will be in-issue, and decide relatively soon to file for divorce if every day you are not growing closer together as a couple.

Just When You Thought You Were Through: Post-Divorce Mistakes and How to Avoid Them - Part 2

Mistake #2: You Cannot Claim Your Children

You may feel that, because you pay child support, you should be able to claim your children as dependents for tax purposes. Not so fast. Each child must be a “qualifying child” under the IRC to be a dependent. In most cases, because of residency requirements, children are “qualifying children” of their custodial parents, the parent with whom they spend more than one-half of their time. There is a special rule for divorced or separated parents. Under this rule, the non-custodial parent may claim the child if (1) they are divorced or legally separated, execute a separation agreement or have lived apart for the preceding six months, (2) the child received at least one-half of his support from the parents, (3) the child is in one parent’s or both parents’ custody for at least one-half of the year, and (4) the custodial parent signs a written declaration releasing the child for the dependency exemption, and the non-custodial parent attaches this declaration to his tax return. See IRS Publication 504. There are exceptions for pre-1984 divorces. If you want to claim your children, be sure your decree states, at a minimum, the year(s) you will claim each child, the documents you and your ex will have to execute to facilitate it, a continuing duty to cooperate and execute all reasonably necessary documents timely and in good faith, and the consequences if your ex refuses to release the exemption or is otherwise uncooperative.

To learn more, visit http://www.irs.gov/uac/Top-10-Tax-Facts-about-Exemptions-and-Dependents

Just When You Thought You Were Through: Post-Divorce Mistakes and How to Avoid Them - Part 1

Frank and Betty were married for twenty years, two of which they spent divorcing.

Frank owned part of a profitable trucking company. As news spread that Frank and his business partners planned to sell the company, Betty eagerly pushed her attorney to retrieve a share of the cash. After protracted litigation and settlement negotiations, Frank, Betty and their attorneys arrived at a nineteen page settlement agreement. In exchange for Betty’s release of her marital rights in the business, Frank would pay her $25,000 within 30 days of receipt of the buyer’s first purchase price payment, then $202,000 in semiannual payments of at least $10,000 until the balance was paid in full. Frank thought the deal was solid. He negotiated the semiannual payments to coincide with the dates he anticipated receiving purchase price payments from the buyer. He even negotiated his payments to be conditional on the buyer’s, so that if the buyer failed to pay, he would not have to pay Betty. To Frank, Betty was a fool for accepting this deal – if Frank did not get his money, Betty would not get hers.

The problem? Frank did get his money, but not the $10,000 he hoped. Turns out, the buyer’s purchase agreement with Frank’s business included a loophole through which the purchase price would fall as the market price fell. The market tanked. Frank went back to his judge and complained that Betty should receive less because they either intended her payments to rise and fall as his from the buyer did (Betty guffawed) or, alternatively, a reduced price was only fair. judge thought the reduced price was fair, with sympathy for penniless Frank.

But Betty brought that written settlement agreement to the appellate court and pointed out exactly what they agreed – not a price reduction loophole to be found. The appellate court reversed the judge’s decision and rebuked Frank: “[Frank] wants the trial court to make a property settlement for him that he did not make for himself . . . . The only mistake of the parties was with respect to the final purchase price of the stock. . . . It must be assumed that the parties considered the risks of the property settlement agreement that they made . . . .” See Marshall v Marshall, 135 Mich App 702; 355 NW2d 661 (1984).

Frank would have no out from under that settlement agreement He owed Betty all $227,000, with interest, even though his business deal soured and he got a trifling of it.

In most states, once parties have negotiated and entered into a settlement agreement that the divorce court then incorporates into a decree, the court cannot modify the agreement absent fraud, duress or mutual mistake. So, what can you do to avoid Frank’s mistake and others like it? Here are some suggestions.

Mistake #1: You Forgot The IRS[1]

You know the saying, “There are two certain things in life: death and taxes.” Yet, when it comes to negotiating a divorce settlement (which sometimes feels like death), too many spouses fail to consider the tax consequences of their settlement. They focus on what appears to be a big win (keeping the house, getting the boat) without focusing on the tax costs. It may be obvious to you that a checking account with a $50,000 deposit and immediate accessibility is not the same as a $50,000 deferred compensation retirement account, but there are subtler tax issues to consider as you settle, too:

Transfers of property between spouses or former spouses incident to their divorce are generally tax free. See IRC 1041. This means the transferor spouse does not have to report a discharge of indebtedness, nor the transferee spouse income, for the transfer when filing the tax return for the year of the transfer. This does not mean, however, that there are no tax consequences. Under IRC 1041, the transferee spouse takes the transferor spouse’s basis and holding period in the property. The transferor spouse must provide the transferee spouse with sufficient documentation to determine the basis and the holding period. Treas Reg 1.1041-1T, Q7. When the transferee spouse disposes of the property, the transferee spouse pays taxes on the entire disposition. This is, in a sense, a delayed tax. For example, if during the marriage each spouse would have bore 50% of their stock’s $50,000 appreciation, after divorce the burden is 100% the transferee spouse’s. Therefore, be mindful of the basis and the holding period transferred to you whenever you accept property in your settlement.  

The most important thing for you to do is plan ahead. Consider all tax consequences early in your settlement discussions. A simple chart listing all of your property, with a column for fair market value, a column for outstanding debt, a column for pre-tax value and a column for estimated tax costs will help you and your attorney. So too will a tax adviser. Have you tax adviser review the final draft of your settlement before you sign it, and ask for a thorough assessment from a tax perspective. It is better to pay for these services now than to find out, ten years from now, that you have to report $50,000 of gain. The court will not listen to you complain that you did not anticipate the tax consequences. As the Michigan Court of Appeals said of an ex-husband making that argument, “His claim regarding unexpected income taxes is, of course, without merit. He either knew, or should have known, of the income tax consequences of his actions. . . . [W]e decline to permit plaintiff to use his income taxes as a basis for a [modification].” Couzens v Couzens, 140 Mich App 423; 364 NW2d 340 (1985).

MORE TO COME…

[1] You should contact a tax attorney and/or your tax advisor for a thorough assessment of the tax laws applicable to you. IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, be advised that any federal tax advice contained in this article was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Always consult a specialist for thorough tax advice.