The Importance of Disclosure and Financial Consistency in Divorce and Tax
For most of their lives, individuals guide their financial decisions with two primary goals: Goal number one: to make as much money as possible. Once an individual has had a taste of success with this first goal, then goal number two becomes very clear: to pay as little of this income as possible toward taxes. Successful individuals spend years creating structures to allow for maximum benefit with minimum tax.
Suddenly, however, for many of these successful individuals, a new goal comes immediately to the forefront. How are they going to retain as much value as possible through a marital dissolution? Many divorcing parties are simply looking for a fair and equitable resolution of their property division. There is nothing inherently wrong with the goal of retaining value through the divorce process. The goal itself is not unreasonable for a person confronting the most expensive individual event of their lives. The problem arises when the singular goal of maximizing their side of the divorce ledger may conflict with the other priorities of income and taxes.
On my first day of preparing tax returns in a CPA firm, my boss posed to me the following question: would I like to pay more or less in taxes? The correct answer is that we should want to pay more in taxes, because it is a primary indicator that we made more money that year. It’s not a lesson against tax planning, but rather a reminder that one should always keep priorities in line. Less tax should not be the primary metric by which one evaluates the financial year
The same concept can apply even more drastically during a marital dissolution. It can take years for individuals to effectively optimize the income/tax equation. Often, divorcing parties have had little to no time to plan for divorce. The sudden prospect of loss can become so overwhelming that an otherwise prudent decision maker may operate from a position of uncharacteristic panic. This can lead to poor and short-sighted decisions which can create unplanned negative consequences, hindering all financial priorities.
One of our first professional responsibilities as litigation consultants and experts is to inform clients of the rules of family law. Family law is often not intuitive, and parties are shocked to learn the legal consequences which they have unwittingly created by prior actions. Prior efforts to maximize profits and minimize taxes may suddenly become useful tools against them. One of only three key elements of the fraud triangle is rationalization and it is a normal psychological response for an individual hearing this news to search for all ways to mitigate what they foresee as an unfair loss they are about to incur. We should make sure as professionals that when we advise clients of family law rules, we should also inform them of how a singular focus on minimizing their perception of loss in divorce may actually lead to increased cost both in the divorce and to the taxing authorities.
A critical first lesson is that the IRS generally does not care what you agree to in your divorce if it conflicts with the facts or conflicts with the Internal Revenue Code. For example, a party may stipulate to an order that the high-earner spouse will claim head of household status for all future years. However, if that individual does not meet all IRS rules to claim this status, then the IRS can reject the claim. Similarly, when a party purchases a home from their spouse, the payment cannot be added to tax basis. No matter of legal drafting will convince the IRS to deviate from the code.
The second lesson is consistency. In life, one prioritizes maximum benefit with minimum tax. In divorce, one may prioritize presentation of less benefit and more tax. These conflicting motivations can lead to trouble. For example, a party may delay or under-report disclosure of their income in the divorce because they fear they may have to share in the divorce. This sometimes leads them to delay tax filings as well. The combination of time and the divorce process has a way of bringing this information to light, eventually, whether by eventual filing or by investigation. On the divorce side, delayed or errant reporting could subject a party to sanctions, a loss of credibility and extension of the legal process with increase in legal costs. This behavior can also lead to tax penalties which the court may reasonably add to the increasing tally of costs accruing to the obfuscating party. The tax code dictates that community income should generally be reported 50% by each party. If both parties are not coordinated and knowledgeable about the facts, then it is likely that one or both parties are going to incorrectly report on their taxes.
We have similar responsibilities to inform the “out-spouse” (the less advantaged spouse) of the risk of creating imbalance between their tax and legal motivations. For example, during the legal process the out-spouse may claim habitual underreporting and/or large community income owed to them from their soon-to-be ex-spouse. That same party may plan to file separate tax returns reporting little to no income. These individuals need to be aware that one of the tests that the IRS will implement when determining either the innocent spouse claims made during marriage or whether the community property should be reported unequally after separation is (1) whether the “out-spouse” expects to receive any direct or indirect benefit from the transaction AND (2) whether they “didn’t know of, and had no reason to know of, that community income.” It is easy to see how such conflict between legal claims and tax reporting could lead to tax trouble for all involved.
We cannot control our clients’ financial decisions or their proper disclosure of assets. What we can do is make sure that when we explain family law rules to clients, we also make sure to remind them that this process does not supersede tax obligations and to counsel them why providing clear, timely and consistent disclosure is the best choice.