Tax on Divorce Settlement - The Divorce Tax?

When is an asset not merely an asset? When the spouses fail to take into consideration tax on divorce settlement issues. Although not really a "divorce tax" (that term is typically applied when people believe a married couple pays more tax than they would as two single tax filers), taxes can erode the value of the assets a party receives, or in the case of a tax-favored account such as a Roth retirement account or an HSA, enhance its value.

Transfers of assets between spouses are not taxable events, which also means there is no step-up in basis after divorce. So being awarded an asset also means assuming responsibility for potentially years of accumulated taxes whenever the spouse decides to sell it. For more complicated marital estates, that makes obtaining tax returns, and potentially necessitates the assistance of a CPA to explain or testify as to tax issues.

The Colorado Family Law Guide has three in-depth articles on the role of taxes in family law cases:

• Tax on Divorce Settlement - This article.
• Alimony Tax & Child Support Tax Laws - discusses using tax documents to prove your case, and the tax consequences of family support.
• Tax & Divorce - Explains tax filing issues which arise in a divorce, from using tax returns to prove the existence of a marriage, to filing status after divorce, annulment or legal separation.

Mandatory Financial Disclosures Include Tax Records

In every dissolution of marriage case, the spouses are required to disclose three years of business and personal tax returns and records. See C.R.C.P. 16.2(e)(2), and the referenced Form 35.1 Mandatory Disclosure, which requires not just the returns, but "all schedules and attachments, such as W-2s, 1099s, and K-1." For a more detailed discussion of the disclosures required in family law cases, see our Financial Disclosures in a Divorce article.

Tax Records as Evidence of Assets

If there is concern that a spouse has failed to list all of his/her assets on a sworn financial statement, tax documents have a wealth of information which provide a good starting point to dig deeper into the possibility of hidden assets.

Form 1040 Income From Asset Means Asset Exists

The first page of the IRS Form 1040 U.S. Individual Income Tax Return contains boxes where a taxpayer must disclose not just salary income, but a variety of income.

Consider what income boxes can reveal:

• Line 3 Interest. There can be no interest income without an interest-bearing account, so review the 1099-INT Interest Income statement accompanying the tax return for details of the specific investment or account.
• Line 4 Dividends. The same principle applies to dividends - if there is dividend income, then review the 1099-DIV Dividends and Distributions to learn what asset actually generated the dividends.
• Lines 4 & 5 Retirement. If a party declares IRA distributions or pension income, that necessarily means there are retirement assets out there which need to be considered.
• Line 7 Capital Gains. Capital gains means assets which generate gains either still exist, or were liquidated during the prior tax year. Check the Schedule D Capital Gains and Losses for details on such transactions or assets.
• Line 8 Other Income. If this line has income listed, then look at Schedule 1 Additional Income and Adjustments to Income to see what the income is from. It could be from:
  • Business Income or Loss (Schedule 1, line 3) - this means reviewing the Schedule C Profit or Loss From Business to see if the party has a sole proprietorship business.
  • Rental real estate, royalties, partnerships, S corporations, trusts, etc (Schedule 1, line 5). That's a lot of different potential assets combined into one line, but it basically means you need to look at the Schedule E Supplemental Income and Loss, and obtaining business or real estate records to show what produced this income.
  • Stock Options (Schedule 1, Line 8.j). Employee stock options are a divisible asset.

Schedule 1 Tax Deductions As Evidence of Asset

if the taxpayer has adjustments to income in Line 10 of the Form 1040 above, then look at page 2 of Schedule 1 Additional Income and Adjustments to Income. Taking certain deductions means that she was making tax-deductible contributions into an asset which may be divisible as marital property in a divorce:

• Health Savings Account (HSA) (Schedule 1, line 13). If the taxpayer is taking a deduction for HSA contributions, it means he has an HSA, so review the Form 8889 Health Savings Accounts (HSAs).
• IRA (Schedule 1, line 20). If the taxpayer is deducting contributions into a traditional IRA, then that means an IRA exists and should have been disclosed.
• Archer MSA (Schedule 1, line 23). While Medical Savings Accounts have been phased out (hence we have HSAs), self-employed taxpayers with existing accounts can still contribute to them, and deduct the contributions, so a deduction means that an MSA must exist somewhere.

W-2 Evidence of Assets

The W-2 may contain a variety of codes in Box 12 which indicate employer contributions, or an employee's voluntary deferrals, into certain types of accounts, including:

• Retirement accounts, SIMPLE-IRA, etc
• Deferred compensation plans
• Medical Savings Account
• Stock Options
• HSA contributions

Here's a W2 sample showing Box 12 & Box 13 entries:

You will need to look up the Box 12 codes - that can be done on the IRS website, or, easier, this site has W2 Box 12 codes. In the sample above, two of the codes indicate there may be assets:

• W - Employer HSA Contributions
• AA - Roth 401(k) Contributions

And Box 13 being ticked also confirms that the employee was an active participant in an employer-sponsored retirement or stock plan.

Court Consideration of Tax Consequences of Settlement

A pre-tax retirement account, such as a 401(k), is clearly worth less than a post-tax cash asset, such as a bank account. And both a 401K and cash are less valuable then a tax-advantaged account, such as a Roth IRA. But will the court care?

While taxes are not specifically mentioned in the Uniform Dissolution of Marriage Act, the property division statute does direct trial courts to divide property "as the court deems just after considering all relevant factors." C.R.S. 14-10-113(1). And case law establishes that this can include considering the tax on divorce settlement issues.

Transfers of assets between spouses incident to a divorce are not taxable events. 26 U.S. Code § 1041. This means that no tax is owing upon the transfer, but there is also no step-up in basis, so each spouse will owe taxes on the assets awarded to them in the ordinary course of business.

Court Can Consider Tax Impact

Family law courts are not only permitted to consider the tax consequences of settlement positions, but sometimes even mandated to do so in the case of capital gains discussed below.

In Bayer, the trial court issued multiple rulings pertaining to taxes, all of which were upheld on appeal as a proper exercise of the trial court's discretion to determine an equitable distribution of property:

• The court reduced the value of the accounts receivable awarded to the husband by the income tax consequences he would face upon collection.
• The court did not reduce the value of certain retirement funds awarded to the husband by the tax consequences of early withdrawal, since there was no indication the husband actually planned to withdraw the funds, rendering the tax consequences hypothetical.
• The court awarded the husband the value of a condominium without reducing it by the capital gains tax the husband would owe if he were to sell the property, again because there was no evidence the husband actually intended to sell the condo.

There was an interesting result in Goldin, where the trial court did not consider the tax consequences of an asset awarded to one spouse, and the Court of Appeals reversed. But the grounds for reversal probably make this case of limited precedential value - apparently at temporary orders the court had ruled the tax consequences would be considered at final orders, but then it failed to consider them.

Need Consistency & Evidence of Tax on Divorce Settlement

In Powell, the trial court awarded the wife two savings accounts, reducing the value of the accounts based upon anticipated taxes, as evidenced by (1) her sworn financial statement which included a reduction in value for their tax liabilities, and (2) the wife's testimony.

The Court of Appeals, concerned about the lack of competent evidence and not uniformly considering tax consequences on other similar accounts:

"there appears to be no evidence in the record as to the amount of any tax liability or the tax rate, and no indication that other accounts similarly situated were similarly treated. Because the matter must be remanded in any event, the trial court should review all of the accounts and make appropriate further findings, conclusions, and adjustments, if any so as to treat them consistently."

Powell, at 960.

Tax and Divorce Consequences of Specific Assets

The more common types of assets which may have tax consequences include the following.

Pre-Tax Assets in a Divorce

Some retirement accounts, such as traditional 401(k)s or traditional IRAs, were funded with pre-tax money. And the increases in value on those accounts is also tax-deferred, with the result that all of the funds in those accounts will be taxed as ordinary income as money is withdrawn.

On cases where Graham.Law has utilized a CPA tax-normalize such accounts, the effect has been a reduction in value by 15-25%, depending upon the particular CPA's assumptions and parties' incomes. A 25% reduction in value would turn a $400,000 IRA into a $300,000 asset on a marital asset-debt spreadsheet - not a trivial difference.

If possible, this can be balanced out by dividing pre-tax assets roughly equally, so one spouse does not end up with more taxable assets than the other. But if such an agreement or division is not possible, then the spouse concerned would want a CPA to testify at the divorce hearing as to the after-tax value of those accounts.

Dividing Cash or Tax Neutral Assets at Dissolution

Bank accounts, cash, tangible property, etc, are all funded with post-tax money, so they are "neutral" - a $50,000 account is still worth $50,000 after factoring in taxes. So no adjustment should be necessary.

Assets with Accumulated Capital Gains Tax Owing After Divorce

Certain investments may be funded with post-tax money, but have accumulated capital gains which will be taxed when the asset is ultimately liquidated, including:

• Stock - A single share of Apple stock sold for as low as 4 cents back in 1984, and after adjusting for splits, that same Apple share was worth $1800 in 2021. A great investment, but once sold, the parties will owe long-term capital gains tax on pretty much the whole value. So a half million of shares at 15 or 20 long-term federal capital gains, plus 4.55% Colorado income tax, comes to $100K or more of accumulated capital gains owing at sale.
• Marital Residence - most houses appreciate in value, so the spouse awarded a house may owe capital gains taxes on the appreciation over $250,000 (for a single taxpayer, per IRS Tax Topic 701) upon selling the property.
• Rental Properties. As with a residence, rental properties will likely increase in value. From a tax perspective, not only can the capital gains not be rolled over into a new residence, but the properties will have been depreciated during the marriage, which means capital gains taxes will be owing on more of the balance.

Tax-Advantaged Accounts

Finally, there is the category of account which is most advantageous from a tax perspective - assets which are not only themselves tax-free, but where the growth is tax-free. Examples include Roth IRAs, Roth 401(k)s, and Health Savings Accounts, or HSAs. All can be transferred incident to divorce, even HSAs (see 26 U.S. Code § 223(d)(7) which explicitly authorizes an HSA to be transferred at dissolution without it being a taxable event).

But while it's straightforward for a CPA to say that a $400K traditional IRA is really only worth $300K after taxes, it's harder to see a court "gross up" the value of a tax-free asset by the taxes which won't be owing. So the best way to handle these assets is simply to ensure that each spouse receives a fair share of tax-advantaged accounts.

Tax Refund or Liability as Part of Marital Estate

In addition to considering the tax consequences of being awarded particular assets, if the parties are expecting a tax refund, that potential refund is an asset to divide, and if they have tax liabilities, those liabilities should also be included in the division of the marital estate. Prudence suggests that if the parties are reaching a financial settlement at divorce, they at least address what should happen to any refund or liability owing. At Graham.Law, our separation agreements normally contain language similar to this:

"Should the state or federal government issue a refund or other payment, or assess a liability, from a tax filing during the marriage which is not allocated herein, the Court retains jurisdiction to allocate such liability or refund. Absent agreement to the contrary, or one party filing a motion for an alternative division within 60 days of notice, the parties will share equally any such liability or refund/payment, and either cooperate to promptly sign/divide a check received, or if one party receives payment, that party shall promptly pay the other his/her half, along with the pertinent documents."

Splitting Tax Refund in Divorce as Divisible Asset

If the couple is owed a tax refund based upon a marital tax return, that is an account receivable, which needs to be reported in the Miscellaneous Assets section of the sworn financial statement, under "Money/Loans owed to you". And an account receivable is a marital asset, so this will need to be divided.

Moreover, a court can even order the parties to file a joint tax return. Lafaye ("The federal tax code provisions do not deprive the dissolution court of jurisdiction to enter orders as between the parties.")

Tax liabilities as Marital Debt

Should the couple owe the IRS or state department of revenue for a tax liability, that would be like any other marital debt, and subject to allocation by the court as part of the marital estate at divorce, notwithstanding the fact that the IRS may hold the parties joint and severally liable for the debt. Lafaye.

IRS "Innocent Spouse Relief"

The IRS has Innocent Spouse Relief which may be available to a spouse when the other spouse handled the taxes and underreported income without that spouse's knowledge, by filing an IRS Form 8857 Request for Innocent Spouse Relief.

Should a spouse qualify for innocent spouse relief, instead of holding both taxpayers jointly & severally liable for the taxes and penalties, the IRS may assess them against the spouse who was responsible for the underpayment.

However, in an unpublished decision, the Colorado Court of Appeals chipped away at the innocent spouse relief by approving a trial court order dividing the liability equally, rather than finding that the husband was to blame for not filing taxes, so should owe the money:

“The parties’ tax debt was indisputably incurred during the marriage. Whether husband engaged in misconduct or not, the taxes were due and owing and, if paid on time, would have been paid with marital funds. In other words, contrary to wife’s argument, the principal tax liability was not a result of husband’s misconduct but of his substantial income. Thus, dividing the marital property equally and then allocating all of the tax debt to husband would result in a windfall to wife.” ¶ 17.

Davis, ¶ 17.

In Davis, the specific issue on appeal was dividing the underlying tax debt. The court of appeals noted that had the wife been asking for the "fines and penalties" caused by the husband's failure to file to be assessed against him, "that argument would at least have had some logical appeal." ¶ 18. But since that was not her request, this language is only dicta, and there was no formal allocation of the penalties to the husband.

Loss Carryover as Asset

Another potential, though uncommon, asset in a divorce is an IRS loss carryover. When capital losses exceed capital gains in a certain year, the full loss is not reportable that year, but may be carried over and used in future years to offset future taxes. In that respect, the loss carryover has value. For more information about loss carryovers, here is a good primer at Investopedia. Or, better yet, talk to your CPA, because this is a detailed tax issue beyond the scope of family law advice.

In Lafaye, the trial court awarded one spouse the entire loss carryover indicating it can be awarded as an asset. However, in that case neither party provided much detail to the court about the loss carryover, so instead of trying to offset the value against other assets, the court merely took it into consideration as an "economic circumstance" for purposes of dividing the marital estate and determining maintenance.

FAQ - Tax on Divorce Settlement