Tax Considerations-Dividing Divorce Property – Part I

Marital Estate Division Offers Challenges And Opportunities For Advisors

The emotional aspects of a divorce often interfere with planning for the efficient distribution of the marital estate. The shock and ill feelings may create a barrier between spouses that prevents even discussing issues. Tax practitioners need to know how to explain to a divorcing client the tax realities, to avoid any post-divorce tax surprises. Mistakes in property division or fraud can produce consequences that the tax practitioner may be unable to reverse.



This Blog Post will appear in three parts.  See Part II and Part III.

Opportunities for CPAs

Divorce engagements can require CPAs to act in either or both of two roles. One role is that of a forensic accountant in locating all assets and liabilities for marital division. The other role requires the CPA to apply his or her tax expertise to separating marital assets and payments. In the forensic role, the CPA investigates and analyzes financial evidence and interviews parties to ensure all marital assets are included to prevent fraud. This forensic examination may be used as evidence at trial. Many states require forensic accountants to register as private investigators. The tax adviser role of a CPA helps divorcing couples make an orderly division of marital assets with the least tax burden.

Since divorcing spouses may have competing interests, CPAs with clients in divorce must take care to avoid professional conflicts of interest or their appearance. Generally, this means that although tax advisers may have represented both spouses in the past, they should represent one party but not both, or else obtain conflict-of-interest releases. The same consideration should extend to other family members who, as a result of the divorce, may have competing interests (see AICPA Code of Professional Conduct Rule 102, “Integrity and Objectivity”, especially Interpretation 102-2.03, “Conflicts of Interest”). Rule 102 provides examples of situations in which an AICPA member’s objectivity could be impaired. One is “a member has provided tax or personal financial planning (PFP) services for a married couple who are undergoing a divorce, and the member has been asked to provide the services for both parties during the divorce proceedings.

Division of Marital Assets

For wealthy couples, particularly, the distribution of property often is the most important aspect of a divorce or separation agreement. Unless they meet the requirements of Sec. 1041 or Sec. 2516, property transfers included in a divorce decree are subject to income taxes or gift taxes, respectively.

Property acquired by the spouses during their marriage (e.g., family home, retirement plan assets) generally qualifies as marital property. With the exception of qualified retirement plan assets covered under the Employee Retirement Income Security Act (ERISA), state laws ultimately govern the division of marital assets in a divorce, and state laws differ radically on who gets what when the marriage ends. The division of assets differs according to whether the divorce takes place in an equitable distribution (common law) state or in a community property state. Currently, nine states (listed below) are community property states, and the remaining 41 are common law states.

Equitable Distribution States

In the 41 equitable distribution states, the courts decide what is a fair, reasonable, and equitable division of assets. A court may decide to award a spouse anywhere from none to all of the property value. The courts focus on factors such as how long the marriage lasted, what property each party brought into the marriage, the earning power of each spouse, the responsibilities of each spouse in raising their children, the amount of retraining needed to make a spouse employable, the tax consequences of the asset distribution, and debt allocation. If the couple signed a prenuptial agreement or an agreement during the marriage, they have more control over how the property is divided. Additional aspects of an equitable distribution that should not be overlooked include:

1.  Every asset acquired during the marriage and not covered by an agreement is subject to division. The name on the asset title or the source of the money used to acquire assets is not controlling.
2.  The parties to the divorce have the burden of identifying and proving the existence of assets.
3.  One spouse may prove to the satisfaction of the court that the other spouse transferred assets with divorce in mind and have an equal amount of assets awarded to him or her.
4.  Each spouse is responsible for any debts incurred during the marriage.

Thus, equitable distribution is considered a fair, but not necessarily equal, distribution of marital property.

Community Property States

Community property is a form of concurrent ownership between a husband and wife created by statute in nine states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin (Alaska also allows a full or partial community property election). Community property laws, however, also are important for individuals residing in non-community-property states because property acquired in community property states and brought into non-community-property states ordinarily remains community property for state law and tax purposes. In addition, the separate property of each spouse brought into a community property state remains separate property, as long as it is properly segregated and identifiable.

However, some states, such as California, may treat the property as community property for purposes of division during a divorce if it would have been community property had it been acquired in the community property state (see Cal. Fam. Code §125). The earnings of the divorcing couple are considered community property and thus are equally divided between the spouses. The same is true for assets bought by one spouse during marriage with funds earned during marriage.

Separate property in community property states may include property owned before marriage and, in some states, property acquired during the marriage with proceeds from the sale of separately owned assets. State law also may permit each spouse to inherit or receive by gift property that will not become community property.

Full Disclosure Required to Divide Marital Assets

Almost all states require the parties to disclose all material information needed to allow them to negotiate and agree upon a division of marital property. For example, California law states that because married couples are subject to the fiduciary rules imposed on persons in a confidential relationship (Cal. Fam. Code §721), this creates an obligation for a spouse to “make full disclosure to the other spouse of all material facts and information regarding the existence, characterization, and valuation of all assets in which the community has or may have an interest” (Cal. Fam. Code §1100(e)).

To ensure clients comply with the full-disclosure requirement, tax advisers should recommend that the divorcing couple inventory all property, including intangible assets such as advanced degrees, goodwill, and patents, that can result in substantially increased income in future years. Consideration of intangible assets in property settlements is becoming more important as courts express an increased willingness either to classify the intangibles as property subject to distribution or to require spouses to pay for reimbursement.

by Ray A. Knight, CPA, J.D. and Lee G. Knight, Ph.D. (April 2013)

Edited and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)

Dr. Goedde is a former college professor who taught income tax, auditing, personal finance, and financial accounting and has 25 years of experience preparing income tax returns and consulting. He published many accounting and tax articles in professional journals. He is presently retired and does tax return preparation and consulting. He also writes articles on various aspects of taxation. During tax season he works as a volunteer income tax return preparer for seniors and low income persons in the IRS’s VITA program.

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