Tax Implications in a High Net Worth Divorce

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Filing taxes can be a complex and overwhelming task even without having gone through a divorce. However, after a divorce, particularly a high net worth one, this ordeal becomes even more challenging.

The spouses have to first and foremost decide whether they will file taxes jointly or separately.

To file taxes jointly, which will ease the burden of the process to a great extent, you must have been married on the last day of the year you got divorced.

This is the requirement you must meet if you want to continue filing a joint return with your ex-spouse.

You might have a lower total tax bill if you file jointly than separately. This is because some tax deductions, credits, and other benefits are unavailable or limited when you file separately. Nevertheless, a former couple might pay less by filing separately in special cases. This is likely to be true if one ex-partner has deductions that are restricted by a percentage of their income, such as high medical expenses.

Lastly, some couples in the midst of a divorce might be reluctant to file taxes jointly regardless of the consequences because they fear their spouse is dishonest about their Internal Revenue Service.

Determining Whether You Are Married or Single Upon Filing Your Taxes

When it comes to tax filing, a rule applies everywhere across the country to spouses on the brink of divorce. More specifically, if you are in the process of getting a divorce and will not be legally separated on December 31, you usually must file jointly.

Nonetheless, if you will be divorced by the last day of the year, you are considered single for the entire year by law. It is paramount to know that, to file as Head of Household, you might be seen as unmarried even if you were not legally separated by the last day of the year.

Typically, you will pay fewer taxes by filing as Head of Household, but you have to meet the following requirements:

  • pay more than half the cost of maintaining your house for the tax year
  • not live in a home with your ex-partner during the last six months of the year
  • maintain the primary home for over half the year for your dependent child
  • file a separate tax return from your ex-wife or ex-husband

Taxes Regarding Children, Retirement Accounts, and Property

Child Custody and Taxes

Firstly, if you have a child and they have lived with you for a longer period than with your spouse during the year of the divorce, you can keep claiming them as dependent on your tax return. If this happens, you will be the custodial parent of the child.

However, the non-custodial parent can claim a dependent child if you sign a waiver pledging that you will not claim them.

Only one spouse can be the custodial parent of the child for:

  • having the head of household filing status
  • the child tax credit
  • the credit for other dependents
  • the dependent care credit
  • exclusion for dependent care benefits
  • the Earned Income Tax Credit

As a general rule, the parent who legitimately files as Head of Household is eligible for the child tax credit benefit if their income is under $112,500. However, this is not the case with high net worth spouses. For this reason, it will be necessary for a lawyer to advise a divorcing high net worth couple regarding how to work out a satisfactory arrangement.

If the wealthy parent claims the child, this will produce additional tax savings in most cases. Nevertheless, this arrangement might be detrimental to the child's wellbeing in some cases, so each and every factor will have to be considered before making a final decision.

Retirement Accounts and Taxes

When it comes to retirement accounts, if you have a highly advantageous retirement savings account, such as a 401(k) or IRA, you will have to be very careful when dividing the proceeds during the divorce. The last thing you wish to do is face early withdrawal penalties.

A lawyer with decades of experience in high net worth divorces will be able to help you set up a qualified domestic relations order, which allows you to divide retirement holdings without incurring tax penalties.

Property and Assets Liquidation and Taxes

Another noteworthy thing is that, oftentimes, high net worth divorcing couples liquidate property and assets. When doing this, the wealthy spouse has to be careful. The liquidation of assets might trigger capital gains tax liability.

Luckily, there are options available to limit the impact of capital gains taxes in some cases. It is recommended not to sell the family home without speaking to a high net worth divorce lawyer first.

Spousal Support and Business Taxes

Spousal Support and Taxes

Unfortunately, spousal support, also known as alimony, is frequently a big issue during a high net worth divorce, as the wealthy partner might be ordered to pay this benefit to their ex-spouse. The aim of spousal support is to help the less wealthy partner live a comfortable life either until they become employed and start having a higher income or permanently.

Because the formula used to calculate the spousal support payment does not apply to high net worth couples when they are getting a divorce, it is usually the judge who decides what the sum of money will be. However, with the guidance of a specialized attorney, the spouses can agree on a reasonable payment themselves, without the judge's subjective decision interfering.

When negotiating the payment that will represent the spousal support, it is crucial to consider the tax implications of this financial benefit. It is essential to be aware that the Tax Cuts and Jobs Act changed how spousal support is taxed. These payments are not tax-deductible for the payor anymore, and they are neither reportable income for the receiver.

Businesses and Taxes

Usually, spouses can divide most assets during a high net worth divorce, including the ownership interests in a business, without any federal income or gift tax consequences. When assets fall under the tax-free transfer rule, the partner who receives the asset takes over the existing tax basis for tax gain or loss purposes and the existing holding period for short-term or long-term holding period purposes.

To comprehend how the process works, let us imagine that, under the terms of a divorce agreement, one spouse gives their primary residence to their ex-spouse in exchange for keeping all the stock in their business.

This asset switch will be tax-free. The basis and holding periods for the home and the stock will carry over to the person who receives them. Tax-free business transfers can occur before the divorce or when it becomes final. This treatment applies to post-divorce business transfers, too, as long as they are made incident to divorce.

Transfers incident to divorce are those that occur within one of these periods:

  • a year after the day the marriage ends
  • six years after the date the divorce is finalized if the transfers are made following the divorce agreement

Over recent years, the Internal Revenue Service has extended the beneficial tax-free transfer rule to ordinary-income assets, not just to capital-gain assets. For instance, if one transfers a business to their ex-spouse in divorce, these types of ordinary-income assets can also be transferred tax-free. When the asset is later sold, the person who owns it at that time must recognize the income and pay a tax liability.

If You Are Going Through a High Net Worth Divorce, Sean M. Cleary Can Offer You Quality Legal Assistance

Divorce is bound to take a heavy toll on your time, finances, emotions, and well-being in general, as it usually involves a complex process you have to navigate.

If you are a high net worth individual, things are typically even more convoluted, and you will most likely struggle a lot to finalize your divorce without the assistance of a specialized lawyer.

With over 25 years of legal practice, Sean M. Cleary can offer you the legal assistance you need to ease the burden of your high net worth divorce and attend to the most challenging aspects of the process on your behalf, as he has helped numerous persons in your situation.

Disclaimer: Please note that the information provided on this site is not formal legal advice, also the site does not allow you to form an attorney-client relationship.