It’s that time of year again – tax season. Taxes can often be a common area of concern for recently divorced couples and those with pending divorces. In this episode, Brian Walters and Jake Gilbreath address some of the most frequently asked questions they receive regarding taxes and how that can impact a divorce case.
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Your hosts have earned a reputation as fierce and effective advocates inside and outside of the courtroom. Both partners are experienced trial attorneys who have been board certified in family law by the Texas Board of Legal Specialization.
Brian Walters: All right, well thanks for tuning in to ‘For Better, Worse or Divorce’ our podcast where we’ll provide you tips and insights on how to navigate divorce and child custody situations. I’m Brian Walters. I’m here with Jake Gilbreath. And today we’ll be discussing some frequently asked questions that get asked as we approach tax season and how that could impact you if you’re heading into a divorce or family law situation. This is mostly for divorce, but it could impact you if you had the custody case or a modification of a custody arrangement. And so just out of coincidence, right before I popped on here, I was finishing up a final argument letter to an arbitrator over a six figure tax bill that came due for some folks that were divorced four years ago and thought that was all behind them. The IRS didn’t think so and that’s who matters.
And so, now four years after a very difficult divorce they are now having to sort out who’s going to pay that very large tax bill. Which is, I can assure you not anybody’s idea of a good time four years post-divorce. So we’ll talk about not that specific case, but how we can avoid that type of situation and things related to that. I guess the basic concept, and it’s really confusing, I constantly have to explain it in great detail to my clients, which is not surprising. They’re not lawyers or tax accountants typically. It’s an interplay of several different things. First of all, we’re in Texas, so we don’t have state taxes to deal with fortunately, but we do have the IRS and that’s federal law. And one of the confusing concepts is that the divorce court in Texas, while it seems to have a lot of power and can tell people what to do, for the most part, it actually can’t tell the IRS what to do about your taxes.
And so the divorce court cannot say, “Oh, you only owe this much tax, or No, you’re not married, or, yes, you are married on back in time.” So these are concepts that you have to understand going into it. The divorce court has limited power. It can make you a single person. That’s one of the three things that happens in a divorce when you have children is changing your legal status, which is probably in many ways, most importantly your tax status from married to single. But it cannot tell the IRS how to calculate taxes or tell the IRS who to go after if there are tax issues, the husband or a wife or spouse or whatever the situation is. So we’ll get into all that. That’s kind of the big picture items. So I’ll throw out some questions or some things that are related to how your taxes are impacted by divorce filing.
So one of the issues that commonly comes up is, “Well, I’m in the middle of a divorce. Do I file as married status or do I file a single status?” Well, the answer is you have to file married because you’re married and you determine that as by your legal status on the last day of the calendar year. So on December 31st, are you married or divorced? If you get divorced on January 1st, you’re still married for the whole prior year. Likewise, if you get divorced on December 30th, you’re single when you file that coming year. Although that raises a number of other issues we’ll have to get into. But generally when you’re in the middle of a divorce and so you’re still married and a tax filing comes due, let’s say in mid-April, generally you have to make a decision. You have to file married, because you are married and do you file jointly, which is what most people do when they’re married happily, or do you file married filing separately?
That’s one of the first questions you have to do. And this is a good example, the divorce court cannot tell you to file married filing jointly. You have that right. That’s your choice to do it. And oftentimes if you do it, if each person files married filing separately, we get into a lot of questions and issues in taxes where, okay, well who gets the deduction for the children? Who gets the deduction for the house mortgage payments or any other charitable deductions or whatever the other cases are. So Jake, instead of me doing all the talking, I’ll kind of throw it over to you for a minute and ask you, when this comes up and we’re recording this right before March, so we’re about to handle a lot of this issue here shortly in our cases. How do you typically deal with that and what are the most typical issues that you deal with on that?
Jake Gilbreath: I mean as a general concept, I always encourage people of course to talk to a CPA about trying to figure out what the liability or refund or whatever would be. As a general proposition, this is why I tell clients, it always comes with the lawyer premise of I’m not an accountant, I’m a lawyer. I’m not even a tax lawyer, I’m a family lawyer, but I mean talk to your CPA. My understanding is most of the time, if not all the time, it’s going to be an advantage to file jointly. An overall advantage to the overall community liability. But that can be difficult because there’s a lot of mistrust that’s going on in the middle of a divorce, that’s natural. Somebody that you’ve promised to spend the rest of your life with, in a partnership, you’re going through a divorce. And then somebody may be behaving differently than you ever thought they would or it’s just a natural tendency that you have.
You’re living in two different houses and then you have lawyers and so there’s just kind of a weariness about it. And so, I have a lot of clients that say, they’ll come to me, and they’ll say, “Well, all during the marriage my husband prepared the tax returns. I’ve never reviewed them. I mean he just put it in front of me and I sign them and that’s how we did it. I’m not doing that while we’re going through a divorce. He’s going to game the system, he’s going to do this, he’s going to do that.” Which is fair to have that concern. And so, what I usually tell people is, file married. Because like you said Brian, you have to file married if that was your marital status at the tax year that you’re filing for. I usually tell people, “You’ll talk to your CPA because it’s probably going to be beneficial overall for y’all to file joint leave.”
Maybe not. Maybe there’s a scenario where it’s not but probably will be. But rather than just do what y’all did during your marriage, which is your husband just prepares it and you sign it, let’s see if we can agree on a CPA. It’s going to be a little bit of an expense to have a CPA, a joint CPA prepare it. But if there’s a lawyer on the other side that I work with routinely, she and I or he and I are probably going to have the same list of CPAs that we’d like that aren’t going to charge an arm and a leg, but do a good job that both parties can kind of coordinate with.
And there’s CPAs that would do that. So that’s usually while if a tax return comes due during a divorce for the prior year, I usually encourage people to, let’s talk about having a joint CPA prepare y’all’s returns. Prepare in the most advantageous way filing because what people forget, people will go off and say, “Well, I want her filing her tax return because she’s got all this liability and her income, I don’t. I paid my quarterlies or something like that, and so I want to file married filing separately, because my taxes are going to look better than her taxes or his taxes are going to look.”
It’s still an overall obligation. Well, the divorce court can’t say, “Y’all filed it this way.” The divorce court can certainly say, this is who’s responsible for the liability or take that into consideration in the overall division of the estate. So it’s better off for the community overall. Even with that distrust, it’s usually better off for the community overall to go talk to a joint CPA and work on it together to reduce the tax liability. Because I mean, I was taught as a first-year lawyer, no matter how much people dislike each other in the middle of a divorce, we all dislike the IRS more.
And so, we can figure out some way to reduce the tax liability for the couple overall in dealing with that year where they were married, even if they’re going through a divorce now. But like I said, back to that mistrust, think about getting a joint CPA or something or if wife says, “I’ve always prepared the tax returns.” She can return them, but then agree that the husband or wife or whoever has the right to take the return and get it reviewed by an independent CPA. And that kind of helps with a lot of that mistrust.
Brian Walters: Totally. And the most common issue I see when somebody doesn’t want to sign a tax return that I think is very valid and might even be wise to do, is when there’s a business that’s owned. Well, it’s community property probably, but maybe one of the spouses founded the company and works in it and the other one doesn’t. And maybe during the course of the marriage, the business has been used for what I call gray expenses. So, running things like maybe some of your personal expenses through the company that maybe the company pays for vacations or pays for some cars or phones or that type of thing, that depending on the IRS rules might or might not be legitimate tax deductions. Or maybe there’s cash involved that’s not being reported. That’s common in certain businesses for sure. And what that does, is that decreases the profit of the company in the prior years, which means less taxes. And maybe the other spouse was unaware of that or just really doesn’t worry about it too much because less taxes, more money for the family.
But now that the divorce is happening, generally what happens when there’s a business like that, that one of the spouses works in and the other doesn’t, generally the spouse that’s working in it will end up with the company. And it’ll be valued, and they’ll have to buy the other spouse out of the community portion. But that lower profit that we’re talking about because of either cash or expenses is going to mean the value of the business is less. And so, that’s a problem for that spouse who’s not involved in the business and probably isn’t going to end up with it.
They want the company now to show a maximum amount of profit because that’s going to increase their payout. It’s totally normal and rational. And then they may be presented with the tax return that when they look at it, they think to themselves, well, I know there’s a bunch of cash that’s not reported. Or, hey, there’s a bunch of personal expenses that are run through here and that’s going to affect me, so I’m not going to sign that return because that’s going to basically be an…
Well, they wouldn’t sign the corporate return necessarily, but I’m not going to sign the married filing jointly return, which includes the corporate profit because that’s going to be me endorsing what I think are improper numbers. And like I said, I think that’s valid and you can deal with that, the corporation can file its return and you could file married filing separately and the spouse that’s working in the business can just take all that income and pay it, so that there’s actually a return filed. But I can understand in that case in particular, not wanting to file married filing separately. Very understandable.
Jake Gilbreath: And people do play games in a divorce. It’s a legitimate concern. I had one where the husband always filed the returns and so he filed the return while they were going through divorce for the prior year and they were due to get some $50,000 refund. And rather than get the refund, he just told the IRS to apply it to the next year, which they would’ve been divorced. And if nobody had paid attention to it, then he was hoping that they’d apply it to his social security number. He assumed that we would’ve agreed. We’ll talk about what to do the year of the divorce in just a second. But he assumed they’d be filing not only married filing single because they would’ve, but that they would’ve partitioned their income and he would’ve gotten it under his social security number. But that was a game that he played, pretty clever game.
We caught him on it. We caught him on it at the courthouse, because he had to produce documents pursuant to a subpoena that we sent. And you’ll appreciate what this means, Brian. It came out almost at the start of the hearing when we got the documents in front of Judge John McMaster, which those listening that know Judge John McMaster can wonder and guess how that went. And it went very poorly for the other side very, very rapidly. But had we not been paying attention, had we not issued the subpoenas, had we not sort of known to look for that trick, it would’ve been a $50,000 windfall or I guess $25,000 windfall to the other side. And it was an intentional game during the divorce that got caught by us. Or if we had said, “Hey, let’s have an independent CPA do this.” Then that independent CPA probably would’ve caught it as well. Like you said, Brian, there are reasons to mistrust the other side and sometimes it’s just the natural consequence of a divorce that maybe you want to trust but verify.
Brian Walters: A hundred percent agree. In this case I mentioned at the beginning has a zero behind that number. And that’s exactly the allegation, is that it was purposefully done. So that’s quite the thing. So, I think that covers a lot of the issues of taxes when you’re in the middle of a divorce. And it’s in some ways simpler, in some ways more difficult, but it’s just the law, which is Texas doesn’t have legal separation. So, all the tax liability that’s occurring, or all the taxes that are being paid or prepaid are community assets or debts. And so, it’s not until you’re actually divorced, even though you may have separated years ago, you may have filed your divorce years ago or a year ago. In some ways, if everybody’s open or everybody’s careful about what’s happening, that’s all going to kind of come out in the wash. And we’re going to have a final spreadsheet which is going to show here’s the tax liability or here’s the tax credit for next year that’s been rolled over or whatever.
And so, that should be able to be dealt with fairly well. Again, if everybody’s transparent or they’re not, you’re doing your job as a lawyer to figure all that stuff out. I think more serious problems occur post-divorce. So at that point, the day you’re divorced, let’s say you’re divorced July 1st, the middle of the year. So then what does it look like in the coming years? So let’s say you’re divorced last year, 2022 on July 1st, and now you’re getting ready, you’re going into April of 2023 here shortly when we’re recording this, what do you do for your taxes? Well, as we talked about earlier, you’re going to file as a single person unless you got married really quickly by the end of the year, which I don’t think most people do, but maybe.
You’re going to file as single and then you’ve got an issue, which is that the first half of the year you are married and the money you were earning and the money your spouse was earning or the taxes you were prepaying, they’re all community – up until June 30th in that case, since she got divorced July 1st. So what do you do? It’s a problem. Do you have to go back and basically break it into two pieces and cooperate with the person you’ve just divorced, which is probably going to be difficult to figure all of this out. One answer is yes you can, but that’s a really difficult complex thing and it’s such a problem that amazingly there’s an amendment to the Texas constitution which allows you to what’s called partition your income.
It’s really the only kind of example of this that we have in Texas family law. Where you can by agreement say, “Well, we will pretend like we were divorced for tax purposes only back to December 31st, 2021”. So that the entire year, last year of 2022 in this case, you just file your own return single, and you just treat everything the way that it is. And that’s what most people do when they have an agreed divorce, which is 95% of all divorces ultimately are agreed. Well, that solves that particular problem, but then it creates another problem, which is the one you just mentioned. What if somebody during the year was over or under withholding? What if there was an unexpected tax event? What if one of the spouses was living in the house until July 1st and paying the mortgage and then the other person moved in on July 1st, who gets the deductions even though they were paid by somebody else? So, do you have any thoughts about how to deal with those particular issues?
Jake Gilbreath: Well, I guess the first thought is deal with it, it is shocking. I’m sure you have the same experience, Brian. How many lawyers either forget to deal with it or maybe they do remember and they’re silent and it’s a problem for another day or they just deal with it incompetently. I mean, it’s a big issue. It could be, like you said, six figures, it could be a seven-figure issue for some couples. Regardless, it’s money that needs to be addressed. The one I see that’s most common I guess, or the one that you really got to look out for, because most of the time it’s going to be partition. It’s going to be the easiest way to do it. Everybody has a W2 income and they have sort of normal withholding, so there’s really not that big a deal. And maybe we need to figure out who claims the mortgage interest deduction or we split it or what have you on a marital home and stuff like that.
But it’s just going to be so much easier partitioning, even if it was a slight advantage to file it one way or another. It’s just going to be easier just partitioning income, filing as if you’re a single, claiming all your own income deductions. But when you have somebody that’s self-employed, the most common problem I see is there’s going to be a problem if they’re not paying their quarterly. As a reminder for those who are, if you’re self-employed, you need to be sending off quarterly income tax. I mean there’s no paycheck for them to withhold unless you pay yourself a W2 salary. But let’s just say you pay yourself by just taking distributions from your company. And you know what you should do, anytime you take a distribution, if you’re smart, you take it, you move it from your business account to your personal checking account.
And then what I see the best way of doing it, you have your separate savings account, and you move whatever percentage you think you’re going to owe the IRS, call it 40%. You move it to your savings account, that’s not my money, that’s the IRS’s money. And then come quarterly taxes, you send it off so you’re current on your taxes. And there’s a shocking amount of people out there that don’t pay their quarterly taxes and then come tax return time, it’s you owe $200,000 in taxes. And there’s kind of a scramble and borrow from this or push for that, because they haven’t been paying their quarterlies. And so if you’re the business owner or the self-employed person and you don’t pay your quarterlies and so you’re really say $200,000 behind on what you should have been shipping off to the IRS, and then you partition, the community state got the income because like you said, there’s no legal separation in Texas.
So we’re gaining the income during the divorce, but we’re not paying our tax bill. And if it’s my business or I’m the self-employed one, I’m going to be eating the tax liability a hundred percent. And so I see that mistake a lot, with people just not having that quick conversation with the client of like, “Okay, if y’all are W2, do y’all do normal withholdings? Are y’all somebody that doesn’t withhold and then you pay liability at the end?” Which there’s nothing wrong with that, just be aware of that. “Are you current on your quarterlies, or do you have a savings account?” I’ve seen people have that savings account that’s for your quarterly taxes, that’s the IRS’s money. And I’ve seen people put that on the spreadsheet as an asset and then divide the estate forgetting that, that’s really not your money, that’s the IRS’s money.
That’s a long way of saying the biggest problem I see. And the one that I see flubbed most by people is when you have someone self-employed that’s not current on their quarterlies. Of course, you can have the reverse, where somebody’s purposely overpaid their quarterlies to sort of almost escrow money with the IRS, but you had W2 employees, there’s issues that can come up. Like I said, that story, that guy was a W2 employee and he just super over withheld purposefully. So he could play that game. But usually you have W2 employees, everything’s going to be kind of straightforward and simple trust but verify.
But when you have self-employed, then that’s where you need to ask the follow-up questions as the lawyer and maybe bring in a CPA. But a lot of people don’t even ask those follow-up questions and then you’re getting a phone call five years later from somebody saying, “Well, how did this happen to me?” And it’s because it wasn’t addressed in the divorce degree. Or say it’s not a divorce and let’s say you have the non-self-employed spouse and you don’t partition and you say, we just file it for the internal revenues code and then you owe $300,000. And the spouse that wasn’t self-employed wasn’t planning on that, I mean, it’s owed, but I wasn’t planning on it, so I wasn’t actually getting the deal that I thought I was getting. It’s a bad conversation both ways.
Brian Walters: Yeah, absolutely. And again, on this one that I kept referring to, there was a combination of things. They went to trial and the court made certain rulings and we’ve talked about the court kind of has limited power about that. And then they went and settled the rest, thought was the rest of their case in mediation post trial, but the lawyers in that case didn’t think it through and they basically didn’t think of high six figure tax liability was going to be dropped on their head years later. But it happens. And you’ve got to address all of that. And obviously, I’m cleaning up the mess from these prior lawyers and the court, honestly. And so it is what it is. And by the way, one other thing about the underpayment for the self-employed, which of course usually means business owners, a lot of times it’s not even purposeful.
There’s two things going on that kind of drive it. Number one, it’s expensive to get divorced, two households to pay for, two electric bills, two cable bills, number one. And two sets of lawyers, maybe some experts on top of it. So you’re tempted to dig into that savings that you put aside to send to the IRS and say, “Oh, I’ll take care of it next time.” And then also you see frequently businesses that suddenly aren’t doing as well as they historically have when they’re getting into a divorce. And maybe that’s purposeful again, to drive down the value of the business. Maybe that’s because they’re distracted because of its very stressful and difficult to go through a divorce. Maybe it’s just the business is cyclical, but all of those things can happen. So maybe the business is kicking off less cash that was used for distributions to pay taxes.
And of course, distributions aren’t taxable, but that’s how you pay your taxes usually. So anyway, it is a lot going on and lawyers really need to be aware of it. And I’m like you, I’m continually amazed at even courts, but especially lawyers that don’t understand that. So, a couple other quick questions that come up frequently. Who gets to claim the kids on taxes after a divorce? And this is a classic case of the court can’t tell you that. I get that all the time, “Well, I want to deduct the kids on my decree and if I’m going to pay child support, I should be able to get the tax deduction. I want that in my decree.” Bad news, you can’t have that in your decree. You want to tell them why, Jake? I always use the, I guess the Joe Biden one’s more like, “Who has F15s or not?” Or I guess the older one is, “Who has nuclear weapons and who doesn’t.”
Jake Gilbreath: Well, as far as kids, yeah, it’s like you said, the IRS rules control whoever has more time with the kids, but you can claim them. I have a lot of people that pay child support that say, “Well, why can’t I claim the kids, I’m paying child support?” And that’s not the IRS rule, but you can agree that the other side can claim the child tax credit or head of household or what have you. And so that’s something that can be done in a divorce.
But then the other issue as far as child support and spousal maintenance I think is kind of a related topic. Child support is not income. So I’m not claiming my child support. If I receive child support, I’m not claiming it on my tax return and I’m not deducting it. If I’m paying it and then spousal maintenance or contractual alimony is the same. I don’t claim it as income and I don’t deduct it for my taxes if I’m paying it, which used to not always be the case. I forget, Brian, you’ll probably remember the year it changes, three years ago or two years ago, maybe four?
Brian Walters: 2017 I think, or maybe ’18 is when it kicked in. It was somewhere around that timeframe was when it kicked in, correct.
Jake Gilbreath: It was basically the Trump tax code, because it used to be that spousal maintenance or contractual alimony was an above the line deduction for the person’s paying it and the person receiving it would claim it on his or her taxes. And the family lawyers, the smart ones and the smart litigants would figure out a way, again, everybody, even if you don’t like each other, we dislike the IRS more. And we’d sort of figure out a way to sort of play games with property division because let’s say husband’s got the income earner, wife stays at home, he owns a business. So, let’s say his tax bracket is 38% and let’s say because he’s getting the business, he owes wife as part of the property division. Let’s say it’s a two-year marriage, she doesn’t qualify for spousal maintenance but as part of the overall property division he probably owes her $200,000.
Well rather than just say, I have a $200,000 note to you that I owe you and I’m going to make payments over time with interest secured by the business you can say, I’m going to pay you the $200,000 but I’m going to pay it as contractual alimony. That way I’m paying the $200,000, but I’m deducting it on my taxes so it’s 38% off for me, the person paying it because that’s my tax bracket. And then wife, you’re going to have to claim it on your taxes, but it may not even bump you into a taxable income bracket. Or if it bumps you into a bracket, it’s 15%. So let’s negotiate and find a happy medium on that $200,000, somewhere between a 38% discount and 15% to where we’re all happy, we all make money. And so, maybe the wife gets a little bit more money than otherwise she’d be entitled to under a note.
But husband’s willing to do that because he’ll pay 15% more than he would’ve paid on it because he’s really getting 38% off whenever he pays it. That’s a long way of saying you’ll see older divorce decrees have more contractual alimony for that reason. Which can be frustrating sometimes when somebody comes in and you’re explaining to him or her that you don’t qualify for spousal maintenance in the state of Texas based on your facts. And they go, “Well, my best friend’s neighbors girlfriend’s daughter-in-law got spousal maintenance or contractual alimony on a three-year marriage, why can’t you get me that?” And a lot of times if you dig into it, it’s because of that game that we used to be able to play, but we can’t do that anymore. They got rid of that. So, there may be a reason why you do something as contractual alimony or even spousal maintenance just for enforceability reasons. But generally speaking, there’s not going to be a reason for contractual alimony, and you can’t deduct it on your taxes and the person receiving it doesn’t have to claim it on his or her taxes like they used to.
Brian Walters: Yeah, exactly. I mean the IRS, the federal government figured out smart divorce lawyers were conducting tax arbitrage, and I mean, it was a big number. I remember when it was something like $50 billion or $70 billion a year with the B, the IRS was losing. If you consider the money you earn, the IRS’s to begin with. And so they just like, “Hey, we need money, so here’s one way we’re going to get it.” And I don’t think there was a lot of political sympathy for alimony payers or spousal maintenance payers. So it was a pretty low hanging fruit to get, and I doubt we’ll go back the other way on it. The reference to F15s and atomic bombs was simply that the Texas Divorce Court cannot say in a decree, “Hey, you dad, get to deduct the kids on your federal income tax.”
Why? Because that’s federal law. And that’s kind of the joke. They have an atomic weapons. The state of Texas does not. Therefore, the IRS, the federal government gets to make that decision. But you are right, you can agree. It’s like a number of other things we’ve talked about. There’s certainly a lot more flexibility if you agree on things, but if you go to court the court’s hands are somewhat tied with that. So anyway, that’s probably maybe more information on taxes than you need. But if you have more questions, let us know. That’s all we have for today. If you like what you’ve heard today, do us a favor and leave us a review. We appreciate all the feedback, especially when it helps us better the podcast. If you have any follow-up questions to this episode or would like to talk with one of us directly about your situation, reach out to us at podcast.waltersgilbreath.com or you can contact directly through our website, waltersgilbreath.com. I’m Brian Walters with Jake Gilbreath, and thank you for listening.
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