8 Tax Areas to Factor into Divorce Negotiations

Ferrone & Associates CPAsBlog

This article addresses eight tactics that may be used to affect your spouse’s net worth, which will directly affect your final financial settlement. You need to be aware of these so that you can gain assurance that all aspects of your spouse’s financial assets are fairly and accurately valued and disclosed on their net worth statement. This will enable your attorney to properly and equitably split your joint assets as needed.

1. P.S. 58 costs

When an employer pays the premium on a life insurance policy for the benefit of an employee, the “P.S. 58 costs” are normally applied to determine the taxable benefit passing to the insured employee. Such costs are documented by a Form 1099-R. The dollar amount of the 1099-R is usually immaterial, but it may translate to a large insurance policy.

Why this is important: Many divorce agreements require that life insurance be held until certain conditions/terms are met. So, if there is an existing policy already in place with your client’s spouse’s employer, this will likely reduce the need for a new or additional policy. Also, the policy may have some cash value, which will be an additional marital asset to be split. Furthermore, if there is a policy in place, you will want to confirm who is selected as a beneficiary on the policy.

2. $15,000 annual gift limit

Each year, taxpayers can give up to $15,000 to anyone they want — without any income or gift tax implications. Keep in mind that the recipient will pay tax on any income they earn from this money in the future, but they do not have to pay any tax on the actual gifted money when they receive it. Your client’s spouse is excluded from this as unlimited gifting is allowed between spouses.

Why this is important: If your spouse has been giving money to their friends and family, over the annual limit to reduce their net worth then that will need to be factored into the settlement. Excluding the assets from their net worth is a big concern here, and it is critical that these funds are included and part of any settlement. 

3. Applicable federal rates

If you lend someone a substantial amount of money, you must include interest to make it stand up as a valid loan. In this instance, many people would use the IRS applicable federal rates which represent the absolute minimum market rate of interest a lender could consider charging a borrower to prevent unnecessary tax complications. There are three AFR tiers — short-term (for loans with a repayment term up to three years), mid-term (loans with a repayment term between three and nine years), and long-term rates (for loans with a repayment term greater than nine years).

Why this is important: If your spouse is claiming that someone has lent them money, this will directly reduce their net worth and they likely reported it as a liability on their net worth statement. Any loan they report on their net worth statement needs to have supporting documentation. So, the first thing to check is to see if the loan documents include an interest rate, at least at the minimum AFR rate corresponding to the term of the loan. If not, then this is not a valid loan, and the amount should be added back to their net worth statement and be deemed part of their assets.

4. Section 179

This is the IRS section that allows a taxpayer’s business to deduct the cost of certain property as an expense when the property is placed in service. Generally, this applies to real property, improvements and tangible personal property such as machinery and equipment purchased for use in a trade or business.

Why this is important: If your spouse is claiming that the business had lower profits last year and therefore their business is worth a lot less, they need to examine the business tax return. It is possible that their spouse took advantage of Section 179 depreciation, which reduced the business net taxable income. 

5. Form 1099-MISC

If a business engages independent contractors, and that independent contractor or entity is an unincorporated business, to “validate” the business deduction, the business will need to prepare and file a 1099-MISC form with the IRS. This lets the IRS know that the business incurred a business deduction, and the recipient of the form should include it in their income.

Why this is important: While doing due diligence on the records of your spouse’s business, if you find that payments were made and a 1099-MISC Form was not prepared, then your spouse is likely trying to reduce their business income with non-business expenses. These amounts should be added to the net income of the business and will likely increase the value of the business.

6. 529 plans

Contributions to 529 college savings plans are covered under the gift tax rules — the $15,000 annual maximum outlined above — with one exception. Individuals may contribute as much as $75,000 to a 529 plan in 2020 if they treat the contributions as if it were spread over five years. 

Why this is important: Legally, once the funds are deposited into the 529 account, the funds belong to the beneficiary, likely your child. Many times a spouse thinks the funds are theirs and will try to withdraw the funds from the 529 account at a later date, without telling the child, and not use it for the child’s education. You need to make sure that these accounts are tracked and that the funds are used for their original intent.

7. 1031 exchange

Simply put, Section 1031 allows an investor to defer paying capital gains taxes on an investment property when it is sold.

Why this is important: It is critical to understand the correct tax basis of each property to ensure that assets are split equitably. For example, let’s assume you own two investment properties, each with a fair market value of $1 million. Both properties were purchased at a cost of $900,000. One property was recently purchased for cash and the second property was acquired using a 1031 exchange where your client deferred $500,000 of gain, from a property they owned for many years. If they sold the first property, they would have a taxable gain of $100,000. If they sold the second, their taxable gain would be $500,000. While these properties are equal in current fair market value, they are not equal in after-tax fair market value — which is critical to a fair and equitable split of assets.

8. Equity-based compensation and awards

Equity-based compensation comes in many forms, but most equity-based compensation awards are made under some form of a written plan. The plan will provide a full understanding of compensation, including the value and terms of the awards. Vesting rules and transferability limitations are also crucial. Vesting is, in effect, when the award is actually “owned” by the recipient. So, if the award is for $100, but the employee is only 25 percent vested, they only own $25. The key issue is to understand when they “own” the other $75. Transferability refers to the rights and limitations around the ability to transfer the ownership of the award to others.

Why this is important: Equity awards are complicated rights governed by multiple authorities. They can be a significant portion of the marital estate. Unfortunately, there is no method of valuation of equity awards that is widely recognized and accepted — so, you should be prepared for multiple rounds of information gathering and analysis. Just understand that many award-related actions have a taxable impact, many of which are very significant.