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Learn how the Tax Cuts and Jobs Act affects personal exemptions, standard deductions, alimony, 529 plans, and Subchapter S corporations during divorce. Gain valuable insights to better advise your clients.
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Love and Taxes: How to counsel your clients in sticky romantic situations. By: Michael March Phone: 410.649.4991 Email: Mmarch@rosenbergmartin.com
The Tax Cuts and Jobs Act • What is it? • On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (“TCJA”), and provided the largest updated to the tax code in nearly two decades. • Changes we will not discuss: Lowering of the Corporate Tax Rate Section 199A Deduction for Qualified Business Income Opportunity Zones Removal of the individual mandate • Link to other materials: Tax Articles
The Tax Cuts and Jobs Act • Personal Exemption • Prior to the TCJA, each taxpayer, spouse, and applicable dependent, received a personal exemption that lowered their adjusted gross income. In 2017, individuals born after January 2, 1953, with an income of less than $156,900, received a personal exemption of $4,050. For a family of three, their personal exemption lowered their adjusted gross income by $12,150. • The TCJA effectively and completely removed the personal exemption, thus making the $12,150 deduction for a family of three no longer available. • Increased Standard Deduction • Typically, a taxpayer decides whether they are going to itemize a portion of their deductions (more on this later) or use the standard deduction to lower their adjusted gross income. The following chart displays the updated standard deductions: • For changes to itemized deductions please read my article: The Tax Cuts and Jobs Act: What Everyone should know before filing their 2018 Taxes.
Alimony • Prior to the TCJA, alimony was considered income to the recipient pursuant to 26 I.R.C. § 61. • The payer of the alimony could take a deduction based on 26 I.R.C. § 62. • What does this mean?
Alimony • Post TCJA, alimony is no longer included in gross income and it is no longer a deduction to the payer. Thus, the payer of the alimony is significantly disadvantaged.
Alimony • Results: • But Why? • Recipients were not reliable at reporting the taxable income. • Alimony is not reported to IRS in form of 1099 or W2. • Alimony payor is usually in a higher tax bracket (raises revenue for IRS).
Alimony • Interestingly, the alimony must be related to a divorce decree executed after December 31, 2018. For divorce decrees existing prior to December 31, 2018, alimony is still considered income to the recipient and a deduction to the payer. • “Grandfather Clause” • An interesting situation arises if a pre-existing alimony award is re-negotiated after December 31, 2018. • The modification expressly provides that these amendments made by the TCJA will apply to that modified agreement.
529 Plans • Due to the increase cost of a college education, 26 I.R.C. § 529 ("529 Plan") was created to allow earnings held within a 529 Plan to be spent tax free when used for college. • The TCJA expanded the application of a 529 Plan and now allows earnings to be tax free when used for tuition in connection with enrollment or attendance at an elementary or secondary public private or religious school. Meaning, a taxpayer can apply the proceeds of a 529 Plan to certain educational costs related to kindergarten through 12th grade, in addition to college. This provides for immense tax planning techniques for parents with children, especially those attending private institutions. • Just as important, the withdrawal limit for kindergarten through 12th grade is $10,000 per year. Beneficiaries in college do not have a limit on the amount of withdrawals available.
Subchapter S Corporations and Divorce • During a divorce proceeding courts will analyze an individual’s actual income to determine the amount of alimony, marital property, and child support to award. Actual income is income derived from any source. • SeeMd. Code Ann. Fam. Law § 12-201(b)(1). • This inherently creates problems for shareholders of Subchapter S corporations who are going through a divorce. Due to the tax structure of an S corporation all income of the corporation flows through to the shareholders and is reported on the shareholder’s personal tax returns. Thereafter, taxes associated with that income are the responsibility of the shareholders. • However, often this is not the reality of the situation. Generally, S corporations retain some or most of the corporation’s income to ensure the business maintains liquidity. This can create a retained earnings balance in the corporation.
Subchapter S Corporations and Divorce • Maryland Courts have held that as a general rule, pass through income, which is not actually distributed to the shareholder, is not included in actual income unless the shareholder is using the corporate form to manipulate his or her income. • SeeWalker v. Grow, 907 A.2d 255 (Md.Ct.Spec.App. 2006). • SeeQuinn v. Quinn, 276 A.2d 425 (Md.Ct.Spec.App. 1971). • The burden of proof is on the individual seeking to exclude pass through income from their actual income. See Walker at 281. • To determine whether a shareholder is manipulating their income trial courts will examine: • Retained earnings and distributions are truly ordinary and necessary expenses to produce income and thus not income available to the spouse. See Md. Code Ann. Fam. Law 12-201(b)(2). • Whether the shareholder is a minority shareholder, and thus does not have control of the distributions, although this is not determinative. • Governing documents and the business and non-business relationship among the shareholders to determine whether control is available. • The purpose of the retained earnings account. EXPERT WITNESS!!!!!
Valentine’s Day Gifts • Gifts to a Wife that is a US Citizen • No annual exclusion. • Gifts to Girlfriend • Annual Exclusion is $15,000. • Based on the Fair Market Value of the gift at the time of • If you’re gifting an amount above this limit you need to file a gift tax return (Form 709) along with your income tax return (Form 1040). • General Questions: • The Donor generally is responsible for paying the gift tax unless a special circumstance exists. • What can be excluded from gifts? Less than the annual exclusion, tuition or medical expenses you pay for someone, gifts to a political organization. Annual exclusion for you and spouse in 2019 is $30,000.
Innocent Spouse Relief Requests • What is it? • Used by Taxpayers to request relief from a tax liability involving a spouse or a former spouse. • Requirements to file: • Tax returns must be filed Married Filing Joint which created an understatement of tax. • Understatement of tax must be due to erroneous items of the non requesting spouse. • Factor Test • Inequitable to hold requesting spouse liable.
Innocent Spouse Relief Requests • How to file: • Form 8857 • Generally measured through a 7 factor test which labels each category, positive, negative or neutral. • Extremely Fact Intensive Process
Innocent Spouse Relief Request – Factors: • Marital status: • When the requesting spouse is separated, whether legally separated or living apart, or divorced from the non-requesting spouse, this factor weighs in favor of relief. • SeeRev. Proc. 2000-15 § 4.03(1)(a). • Economic hardship: • Generally, economic hardship exists when collection of the tax liability will render the requesting spouse unable to meet basic living expenses. See Rev. Proc. 2000-15 § § 4.03(2)(b). • This factor will weigh in favor of relief where the requesting spouse will suffer economic hardship absent relief. • This factor may be neutral where the requesting spouse would not suffer economic hardship if relief were denied. • A requesting spouse’s current income, expenses, assets, age, employment status or history, and ability to earn are considered to determine whether the requesting spouse will face economic hardship. • Knowledge or reason to know • Knowledge exists when the requesting spouse knew or had reason to know that the non-requesting spouse would not or could not pay the tax liability at the time of filing the joint return. See Rev. Proc. 2013-34, § 4.03(2)(c)(ii)). • Abuse Cases.
Innocent Spouse Relief Request • Legal obligation • Generally, this factor favors relief where the non-requesting spouse has the sole legal obligation for the liability and is neutral where both spouses have a legal obligation to pay the liability or the divorce decree or other legally binding agreement is silent as to any obligation to pay the liability. • See Rev. Proc. 2013-34, § 4.03(2)(d). • Significant benefit • A significant benefit is any benefit in excess of normal support. • SeeRev. Proc. 2013-34, § 4.03(2)(e). • The U.S. Tax Court treats the lack of a significant benefit as a factor favoring relief. • See, e.g., Boyle v. Commissioner, T.C. Memo. 2016-87, at 16. • Compliance with income tax laws • This factor considers whether the requesting spouse has made a good faith effort to comply with the income tax laws in the taxable years following the year for which relief is sought. • See Rev. Proc. 2013-34, § 4.03(f).
Innocent Spouse Relief Request • Mental Health Factor • This factor favors relief where the requesting spouse was in poor mental or physical health at the time the return was filed or at the time relief was requested. • SeeRev. Proc. 2013-34, § 4.03(2)(g).
Injured Spouse Relief Request • What is it? • Allows requesting spouse to get back their share of a joint refund when the joint overpayment is applied to a past due obligation of the non requesting spouse. • Ex: You file a tax return with a status of Married Filing Joint. The return shows a refund. However, the refund is applied to the non requesting spouse’s tax liability from another year. • IRS will offset entire refund against a spouse’s previous tax debt. • Form 8379. • Community Property State: Community property is everything a husband and wife own together. Assets are split 50/50 upon divorce. Creates a presumption that property received by the spouse is community property. Therefore allocating income the IRS will assume that the items on the return are community property unless the taxpayer proves otherwise: this includes income, deductions or credits. See Rev. Rul. 85-70. • Maryland is an equitable distribution state (not a community property state). Considers what is fair and just based on the circumstances. • IRS will refund injure spouse’s share of the refund if claim is successfully filed. However, there is no requirement for the IRS to do so.
Injured Spouse Relief Request • The Tax Formula: • Injured Spouse Separate Tax Liability / Total of Spouses Separate Tax Liability X Joint Tax Liability Shown on Return = Injured Spouse’s Share of Liability. • Allocation of Credits. • Refund cannot exceed the overpayment on the joint return. See Rev Rule 85-70. • Basically, would you have received a refund if you filed on your own.
