Presented to The Ohio AAML Program
By Thomas J. Murphy
June 24, 2005
Terms of divorce decree do not bind the IRS.
Emphasize to clients that having one spouse assume tax liabilities is only the first step in resolving their tax issues.
Watch out for taxes that are dischargeable in bankruptcy when one spouse agrees to assume tax liabilities.
Many taxes are dischargeable in bankruptcy. Beware of the spouse who assumes the tax debts — that spouse can file for bankruptcy, get most or all of the taxes discharged and leave the other spouse fully liable for the taxes even though the decree states otherwise.
Watch out for taxes that are NOT dischargeable.
Be very wary of advising clients that bankruptcy may be the answer since many taxes are NOT dischargeable.
Non-dischargeable taxes fall into four categories:
- 3 year, 2 year, 240 day rule — 11 USC 523(a)(1)
3 years: Pretty simple — the due date of the return must be at least three years ago. 11 USC 507(a)(8)(A)(I). Any extension that was granted extends the 3 years.
2 years: If filed return late, 2 years must have passed since the return was filed. This applies only to Chapter 7 bankruptcies. 11 USC 507(a)(8)(A)(i)
240 days: Cannot have an assessment (“we have changed your return”) within 240 days of filing for bankruptcy. 11 USC 507(a)(8)(A)(ii)
- No tax returns filed.
No return, no discharge. 11 USC 523(a)(I)(B)(I). However, in a Chapter 13 “super discharge”, you can file returns after bankruptcy petition and get discharge if due date of return was more than 3 years ago. 11 USC 1328
- Payroll taxes
Never dischargeable for a responsible person. 11 USC 508(a)(8)(C), IRC 6672
- Tax liens
A properly recorded tax lien survives a bankruptcy filing. In Re Isom, 901 F2d 744 (9th Cir, 1990); 26 USC 6325(a)(1)
Practice tip — always order an IRS transcript of your clients’ tax history to see if returns have been filed, if there are back taxes owed or if there is a tax lien that the client may not know about. Client can do this by visiting the Taxpayer Assistance desk at any IRS office or attorney can do this if a form 2848 (the IRS power of attorney form) is completed.
Where Is The Money Coming From?
If client is making a lump-sum distribution, the attorney needs to ascertain the source of the funds. This can have huge tax ramifications.
Is the money coming from a corporate account? If the corporation is a “C” corporation, the distribution will almost always be taxable as ordinary income. IRC 316. With an “S” corporation, it will be taxable if the distribution exceeds the taxpayer’s basis in the corporation. IRC 1368.
Is the money coming from the selling of corporate assets? Most clients understand that there may be a capital gain if property has appreciated in accordance with IRC 1231. But watch out for “recapture” whereby the accumulated depreciation is, in effect, added to the gain. IRC 1016.
Is the money coming from a retirement plan? Leaving aside any QDRO issue, remember that this money has never been taxed.
Is the money coming from the sale of a primary residence? For a single taxpayer, proceeds from the sale are generally tax-free as long as the gain (not the sales price) does not exceed $250,000 ($500,000 for married couples). IRC 121.
Watch out for Offers In Compromise.
Two problems. One is that obtaining relief through an OIC is an extremely slow process, often taking in excess of two years. Collection activity stops when an OIC is pending. This makes it easy for clients to “forget” about the looming problem so make sure nothing is pending. Secondly, if the couple was successful in obtaining relief through an OIC, the taxpayers agree to remain in compliance for 5 years. Will both spouses remain in compliance (ie, timely file and pay in full) after the divorce?
Make sure that beneficiary designations on retirement plans are updated after the divorce.
The provisions of ARS 14-2804 (where the divorced spouse is disinherited) does NOT apply to 401(k)’s and other ERISA plans. See the recent case of Egelhoff v. Egelhoff, 121 SCt 1322 (2001).
Have client draft a new will or trust while divorce is pending.
This is imperative if the spouses have no children from the marriage. If no will and no children from prior marriages, the surviving spouse takes the entire estate. If there is a will, are children or other family members adequately provided for in view of the divorce? Should an inter vivos or testamentary trust be drafted to protect the interests of the children, such as with a family member or close friend as trustee?
Protecting the low-income spouse from pre-marital tax debts.
ARS 25-215(b) — an extremely useful but often underutilized tool. Typical scenario — low-income spouse comes into the marriage with a pre-marital tax debt. IRS wants to levy on that spouse’s one-half community property interest. This cannot be done since ARS 25-215(b) says that liability only attaches on community property “to the extent of the value of that spouse’s contributions to the community property”. So if the tax-debtor spouse is making $25,000 and the non-debtor spouse is making $75,000, then the IRS can only look to 25% of the community property.
Divorce with the nursing home looming.
If one spouse is about to enter a nursing home, divorce is seldom an effective resolution. Divorce will only work if the healthy spouse has a large amount of separate property.
My advice is for clients to hold onto as many records as they can for as long as they can. The IRS can always audit for three years. IRC 6501. The Arizona Department of Revenue can go back four years. ARS 42-1104. So four is the absolute minimum. But the federal and state statute of limitations is open for six years if there is 25% underreporting of income. IRC 6501(e)(1)(A) & ARS 42-1104(b). A tax lien remains in effect for ten years. IRC 6502. This is important since many times your client may not know that there is a tax lien since the IRS need only mail notice once and to the last known address. IRC 6303. And for a fraudulent return or where there is a willful attempt to evade the payment of taxes, there is no statute of limitations. IRC 6501(c). Likewise, the statute never begins to run if a return was never filed.