After practicing family law for many years, I can verify that all three of these statements are actual possibilities. Taxes represent the only method by which to increase postdivorce income or a marital estate because market value or stated income is what it is, but postdecree tax consequences are not always the same. A divorce lawyer who works with a tax expert to understand tax law can effect the full calculation of the impact.
Family Advocate: Outstanding Financial Experts (Buy Issue)In divorce taxation presentations, David Rooney from Rhode Island advises that tax problems are handled in a divorce in one of three ways: (1) both sides have experts who understand and negotiate the tax issues as part of the divorce resolution; (2) one side understands tax issues; the other does not, and an ambush is set up that—assuming the IRS does get involved—is devastating to the side that does not understand; and (3) neither side understands tax problems until the IRS gets involved, and then both sides realize that they are dealing with a problem that can be very expensive to resolve and that has been created by their lack of understanding.

If you have in your library Frumkes on Divorce Taxation (James Pub., 2006), you have taken a major step toward understanding tax problems in divorce cases. Although the book describes each problem that may be encountered, it is sometimes possible to back into these problems without recognizing that they exist.

The first point Frumkes raises in his book is that divorce counsel is responsible for presenting tax issues. This is especially important because most state court judges who handle divorce matters have little knowledge of taxation. A retired judge recently told me that judges bend over backwards to avoid making decisions that involve a major tax problem, even one that is carefully delineated by well-prepared, articulate experts on each side who present evidence on the problem and how it should be resolved. If courts are reluctant to decide tax issues, family lawyer must understand them and help clients address them. As most divorce cases now are being resolved through negotiation, mediation, or collaboration, understanding and resolving tax issues is increasingly important.


Prior to the Tax Reform Act of 1984, a routine division of property contained a land mine resulting from a decision of the U.S. Supreme Court, U.S. v. Davis, 370 U.S. 75 (1962). The Court sustained the IRS position in ruling that surrendering property for matrimonial rights was not surrender for consideration. A simple example shows what that means. The trial judge told husband that he was not to pay alimony but instead to transfer interest in the marital home to his wife. Initially the husband was quite pleased. However, later he was advised that as a result of Davis his agreement to swap equity in the house in lieu of paying alimony was not good consideration. Thus, the transfer of his half of the equity in the house was considered a sale from him to his wife. Husband now owed capital gains tax on the gain that resulted from the "sale" of his half, whereas his wife received a step-up in basis. Bottom line, wife could sell the house and receive a substantial return that was nontaxable, whereas husband owed taxes as though he had sold the property to his wife, but had no money with which to pay the taxes.

The adoption of Section 1041 of the Internal Revenue Code changed this outcome. Presently, an exchange of property incident to divorce does not give rise to taxable income. Although family law practitioners were under the impression that they did not need to involve tax experts in the transfer of property, unfortunately as cases have proceeded through the court system that has turned out not to be true.

After the Divorce Taxation Reform Act was passed, the Treasury Department issued temporary regulations on August 30, 1984. Despite the fact that the law was modified in 1986 and numerous court decisions have come down both applying and rejecting the terms of the temporary regulations, they remain unaltered. Under new Section 1041 of the Internal Revenue Code, no gain or loss is recognized on the transfer of property incident to a divorce. The spouse who receives property takes it with the tax basis the property had prior to marriage. However, the transfer should take place within six years. All of this appears simple, but is not necessarily.

Shortly after the Act was adopted, one divorce settlement involved a husband who was buying the wife's interest in a business they had started together. He did not have the funds available to pay wife in full. Therefore, while giving wife a substantial amount of cash, husband and wife agreed that he would buy her out in the future when he had the money. Papers were drafted to say that full payment to the wife would be considered incident to divorce, even if it was more than six years in the future. (It is hoped that the IRS would accept that provision.)

Other problems can occur when a property division is ordered and, for example, a judgment is taken against or note given from one spouse to the other. If the note or judgment is not paid and further court action results in execution is the transfer of property incident to divorce? A knowledgeable tax expert must help work through that question.

Curious complexities

Another area that has emerged is the question of interest on a note or judgment. Is the interest "property" under Section 1041 or is it "taxable income to the recipient?" If it is taxable income to the recipient, is it tax deductible to the payor? Will this change if the transfer is an interest in a home that qualifies versus a consumer-type obligation? Some of these questions have been resolved; others are still in process. A tax expert should help resolve those questions. The higher the amount, the more important is the tax assistance.

Although this may appear simple, additional complexities occur in some very strange ways. For example, if one or both spouses works for an employer who grants stock options, does Section 1041 apply to the division? Is an option property or deferred income considered part of an income stream? The IRS, after an advisory opinion by a field officer created a storm of controversy and numerous years of doubt, issued Revenue Ruling 2002-22, which made division of options taxable when they are exercised rather than when they are divided in the divorce. However, very few companies have modified their options plans to effect this Revenue Ruling.

A tax accountant or attorney should be involved whenever options are at issue to avoid inadvertent or unnecessary taxation. If not properly worded, the option exercise will require the earner to be responsible for all taxes.

Another emerging concern is what is called the Arnes problem. This involves division of stock in closely held corporations. If the spouse who is going to remain in control of the corporation is awarded stock and uses it to pay the other spouse funds in lieu of his or her interest in the stock, that is a 1041 transaction. However, the spouse who remains in control of the corporation receives no step-up in basis. In addition, that spouse may not have funds with which to buy the stock, but the corporation may have the funds to repurchase it.

In Arnes v. United States, 981 F.2d 456 (9th Cir. 1992), the tax court ruled that because the company's redemption of stock owned by Mrs. Arnes was done on behalf of Mr. Arnes, Mrs. Arnes did not recognize gain or loss. In another circuit, where the tax court was not bound to the 9th Circuit, in Blatt v. Commissioner, 102 T.C. 77 (T.C. 1994), a similar transaction was deemed taxable. The difference is in how the divorce documents were drafted.

If a transfer of Series E or EE Savings Bonds to a spouse or former spouse is incident to the divorce, the accrued but unpaid interest is taxable income in the year of transfer

While these cases were proceeding, the IRS looked to collect from John Arnes, saying that the company had issued a constructive dividend to buy JoAnn's stock for him since it was done on his behalf. The tax court determined that since John did not have a primary obligation to purchase JoAnn's stock, the corporate redemption did not result in a dividend to him. Arnes v. Commissioner, 102 T.C. 522 (T.C. 1994). Several additional cases followed with courts reaching inconsistent results based on the wording of divorce documents, which demonstrated either the involvement of counsel or appropriate tax experts, blind luck, or ambushes.

On January 13, 2003, the Treasury Department issued a regulation codified in 26 C.F.R. § 1.1041-2, which requires parties dealing with Arnes-type problems to determine the tax treatment to be effected, that is, a redemption (generally capital gains) or constructive dividend (ordinary income). These apply to redemptions made on or after January 13, 2003. This might appear simple, leaving a lawyer to ask why a tax expert is required. The answer, however, is not only to help you compute the taxes to work through the problem, but as Marjorie O'Connell in her treatise Divorce Taxation cautions, the regulation, by its terms, applies only to redemption of "C" or "S" corporate stock. It does not apply to LLCs, LLPs, or partnerships. These are the other pass-through entities, which means that when dealing with these types of entities Arnes and other problems continue to exist.

U.S. Savings Bonds

If you are not yet convinced that you need a tax expert in what initially looks like a simple divorce, be aware of the problem associated with transfers of United States Savings Bonds. If a transfer of Series E or EE Savings Bonds to a spouse or former spouse is incident to the divorce, the accrued but unpaid interest is considered to be the transfer, which is taxable income in the year of transfer. Rev. Rul. 87-112.

Most divorces involve disposition of a principal residence. Prior to August 5, 1997, a gain on the sale of a principal residence could be deferred unless it was a ?nal sale. 26 U.S.C.A. § 1034, repealed by 312(b) Pub. L. 105-34. This was changed by Section 121 (26 U.S.C.A. § 121 (West 2006)), which excludes $250,000 of gain for a single filer and $500,000 for joint filers. This can be applied every two years. However, there are problems with tacking of time periods, divorce and remarriage, and who is entitled to what and when. Whenever you are dealing with the sale of the residence, prior to, during, or after the divorce, a tax professional should help you work through the precise amount to be sheltered. In fact, this is a valuation consideration that should be included in the division of assets. Sometimes the delay of a month or two can result in a huge tax saving or major tax loss.

Then there is a decree of separate maintenance, which is not a divorce. It can be a tax-exempt transfer of property between spouses or not. Unmarried couples must use tax experts or proceed at great risk. Finally, in dividing retirement funds, a Quali?ed Domestic Relations Order (QDRO) must be used to avoid or trigger taxes ( e.g., take some funds to pay debts, etc.), as is best for the clients.

As a final note, all of these property divisions have tax consequences as noted. All are based on valuation of the property. Although valuations can be based on the opinion of the owner(s), it is advisable to secure expert valuation evidence on which to base tax planning. Few family lawyers are qualified valuation experts.


Under Section 71 of the Internal Revenue Code (26 U.S.C.A. § 71 (West 2006)), payments that qualify are tax deductible to the payor and taxable to the payee. Payments that do not qualify are not tax deductible to the payor or tax deductible to the payee. The prior two sentences trigger in many a lawyer's mind state law terms such as "alimony" and "child support." However, these terms are not material to the issue of whether they are tax deductible/recognizable. The provisions of Section 71 govern. To be tax deductible to the payor and taxable to the payee, payments must meet all seven tests of Section 71. These were first articulated by Marjorie O'Connell and have since become part of the language of family lawyers.

The seven D's are carefully explained by Mel Frumkes in Chapter 3 of his treatise. In summary, they are:

1. Dollars (cash received by or on behalf of the spouse);
2. Documents (written agreement or court order);
3. Designation (not stated to not be tax deductible or includable);
4. Distance (you cannot live in the same house if status of marriage changes); 5. Death (the liability to the payee must end on the payee's death); 6. Dependents (not fixed as child support);
7. Dual (separate returns, rather than joint returns, must be ?led).

When are payments deductible?

Each of these seems straightforward, but numerous tax court decisions determine whether payments made on behalf of a spouse qualify. If someone makes the house payment, for example, a percentage is mortgage, a percentage is interest, and a percentage is property tax. The liability is joint. The amount that can be deducted will depend on whether the obligations are joint. If the payment is labeled as alimony and paid fully to the payee, can all of it be deducted? These are questions that can be decided in different ways, depending on the situation and language used. A tax expert should be employed to help determine what you want to accomplish, which language is best suited, and how to minimize the tax impact on everyone. Remember, in a divorce we are taking income that supported one household and stretching it to support two. To the extent that taxes can be eliminated, there are extra dollars for each party. For an example of these principles, see Maher v. Commissioner, T.C.M. 2003-85, 2003 WL 1562152 (T.C. Mar. 25 2003).

The documents problem rears its ugly head whenever we have a client who has separated from a spouse and support payments have been arranged. We do not want to make feelings worse or exacerbate problems by telling the parties there must be a court order or it must be in writing to be tax effected. Without either, no portion of payments will be deductible to the payor or includable as income by the payee. Retroactive "fixes" have been found to be ineffective. We must get it right the first time.

Designation can be an excellent tax-planning tool, and a tax expert can help. For example, the payor may have substantial tax-exempt income that can be taxable to the payee as alimony, as defined by Section 71.

It seems simple that payments ending on death will qualify for deductibility, and many states provide that alimony will end on the death of the payee. The problem arises when there is an undifferentiated payment for the support of spouse and children. Even U.S. courts of appeal have not agreed on resolving that question. Kean v. Commissioner, 407 F.3d 186, 190-91 (3rd Cir. 2005), specifically rejected the contrary authority and held that all payments were taxable, whereas the United States Court of Appeals for the Tenth Circuit in Lovejoy v. Commissioner, 293 F.3d 1208, 1211-12 (10th Cir. 2002), ruled that payments failed to end on death because, though alimony might end, child support did not and, therefore, an unallocated payment would not be tax deductible to the payor or taxable to the payee.

Although this reasoning may appear simplistic, changes effected in Section 71 in 1984 and 1986 were in part an effort by the Treasury to make unallocated payments nondeductible and thus to eliminate use of unallocated payments as a tax-planning tool. Such use had been created by Commissioner v. Lester, 366 U.S. 299 (1961), in which the court had held that an appropriately drafted unallocated support order would be considered tax deductible to the payor and taxable to the payee.

The Kean decision recreates that tax-planning tool for the Third Circuit, whereas the Lovejoy decision eliminates it in the Tenth Circuit. If you are considering such use in other circuits, be aware of an unpublished decision by the U.S. Court of Appeals for the Sixth Circuit, Freyre v. U.S., No. 04-5580, 2005 WL 1515099,**3-4 (6th Cir. June 28, 2005), that is in accord with the Kean decision. This, of course, means that in the other eight circuits no controlling authority currently exists. Although the Sixth Circuit is not controlling, it would certainly be persuasive.

Joint returns

When confronting whether to file a joint return, an accountant should definitely be involved. The problem facing the payee spouse (generally the wife) is that her support has been set without considering whether it is taxable. Accordingly, she will not have made quarterly estimated tax payments during the year and suddenly must come up with a substantial sum if she files separately. This can be minimized if the client is expeditiously referred to an accountant.

If the client has concerns about a spouse's tax practices, he or she could lose innocent spouse status by signing a joint return with knowledge that either he or she personally has gained from examination of the financial affairs or has been advised that such practices exist as part of advice received from counsel or a tax expert (assuming that you follow the advice in this article). If the client is to delay filing to provide maximum protection, accounting assistance is necessary to treat and finance the whole operation.

Tax dependents

If the income of either party is less than $125,000, the child tax credit makes a dependency deduction valuable. The ability to file as head of household versus either married ?ling single or joint is important. Experts can help you work through what must be determined. While this may seem simplistic, it is not. In a dispute before the IRS, one spouse's accountant improperly ?led for the client as single rather than married filing separately during one of the disputed years. This error, it is believed, has already placed that spouse's tax return in play and more serious issues, which were not negotiated between the parties, have now arisen. The accountant must have believed this would help the client. It did not. The moral of the story is to have a knowledgeable and competent tax expert involved. See Dail v. Commissioner, T.C.M. 2003-211, 2003 WL 2660133 (Jul. 16, 2003).

To qualify the tax dependency of a child, counsel must follow Section 152(e) of the Internal Revenue Code. Even the term "custody" must be as determined under Internal Revenue Code 26 C.F.R. § 1.152-4(b) (West 2006), as opposed to state law. When the Tax Code was amended in 1984, one goal of the Treasury and Internal Revenue Service was to remove from dispute which parent was entitled to dependency deductions. It was to be the custodial parent. However, though an order may say that a child is the tax dependent of the person who is awarded custody, it does not always work out that way in practice.

A couple of years ago, the Utah legislature amended provisions of the support statutes to provide that child support moves with the child. This came about because children frequently move back and forth between parents, and the state, trying to collect child support, was confronted with orders that directed payment to one parent while the child was residing with the other. The obligor objected to paying twice, once for the child living with him or her and once to the other parent.

In addition, the questions of who could claim head of household and dependency deductions (child tax credit) arose. There is also the nonmarital situation (paternity) and the requirement of signing a Form 8332. In Chapter 5 of his book, Frumkes carefully lays out some of the variations of this problem. A recent case involved a nonmarital partner who had signed Forms 8332 for all years in the future, but did not receive the ordered child support and could not during the years in question claim the children as dependents, even though very limited or no support had been paid. The decision does make clear, however, that the parent could request revocation of the 8332 for future years. King v. Commissioner, 121 T.C. 245 (T.C. Sept. 26, 2003).

Where parties separate and/or divorce after having paid estimated taxes or withholding taxes or have a refund due, who owns the funds? An excellent article "Who Gets the Tax Refund?" by Joanne Ross Wilder appeared in The Matrimonial Strategist, Nov. 2004. A tax expert is vital to handling and resolving this question.


What appears to be an equal division of income may not be. For example, wife owns a company run by husband. Husband is paid a salary, and wife receives a comparable amount in dividends from company profits. However, husband has had taxes withheld. Wife, who has been "covered" by husband's withholding of taxes, now must pay quarterly estimated taxes and may not realize it. If she has been living off the dividends, taxes will come as a shock-along with the rest of the divorce. This and similar problems require expert help—unless the family lawyer computes as well as identifies tax problems.

Though an order may say that a child is the tax dependent of the person who is awarded custody, it does not always work out that way in practice

In Ali v. Commissioner, T.C.M. 2004-285, 2004 WL 2980210 (T.C. Dec. 27, 2004), both a nunc pro tunc order and community property arguments were rejected and payments made before the order were ruled nondeductible to the payor, even though they effected a division of income.

Another tax trap for the unwary is the doctrine of assignment of income. If an income-producing asset ( e.g., Citicorp stock) is transferred from one spouse to another incident to the divorce, it is governed by 26 U.S.C.A. § 1041 (West 2006), and there is no tax problem. However, if a spouse is entitled to receive income ( e.g., interest or payment for personal services) and transfers that to the other spouse incident to a divorce, there is a tax problem. The transferor will, for tax purposes, be deemed to have received income, and the transferee will receive it tax-free. This means the transferor will owe taxes on money he or she does not have.

While this seems straightforward, it is deceptive. Get an expert to assist in analyzing the problem. For example, in Kenfield v. U.S., 783 F.2d 966 (10th Cir. 1986), Mrs. Kenfield was held liable for income earned and retained by a partnership in which she had been awarded an interest under a decree of divorce. As a result, Mrs. Kenfield paid taxes on funds she had not received. On the other hand, in Meisner v. U.S., 133 F.3d 654 (8th Cir. 1998), where royalties were assigned to the wife in the decree of divorce, the court ruled she was liable for taxes because the right to receive income had been transferred to her.

Attorney's Fees

Attorney's fees may be deducted as a Section 212, Internal Revenue Code, Miscellaneous Expense, incurred in securing advice as to taxes and taxable income, if appropriately supported by the family law attorney. Occasionally, payment of fees by one spouse for the other may be negotiated. If done as attorney's fees, these expenses are not tax deductible to the payor or taxable to the payee. In essence, they are governed by Section 1041.

If, however, you negotiate payment of attorney's fees as a Section 71 alimony payment, such fees can be tax deductible to the payor and taxable to the payee as long as they do not violate the rule against front-end loading and meet all tax-deductible quali?cations. In this regard, if you are talking about a substantial payment, either of early alimony that will decrease over the initial three years or higher payments to cover attorney's fees in the ?rst three years, get a tax expert involved. Alimony can be recomputed under Section 71(f). Recomputation produces a recapture of the deduction taken for alimony payments, which can be extraordinarily painful.

The primary difference between doctors and lawyers is in how they performed in math classes. The recomputation rule involves substantial math, and my recommendation is that whenever the possibility of recomputation is encountered, secure expert help. Recomputation mandates recapture of income reduced by deduction as to payments made during the first three years post-decree. This is set out in Internal Revenue Code Section 71(f). The first post-separation year means the first calendar year in which the payor spouse paid to the payee spouse alimony or separate maintenance to which Section 71 applies. The second and third years are the immediate succeeding years.

The recomputation applies only in the third year of the three-year period. Two calculations are necessary. The first compares the second-year payment to the third-year payment and, if the amount paid in the third year plus $15,000 is less than the amount paid in the second year, the excess amount will be recaptured. Thus, it is added back into payor's income. The payor will owe taxes as the deduction has been disallowed. The second calculation compares the first year to the adjusted average of the second and third years. If this average plus $15,000 is less than payments made in the first year, the excess will be recaptured.

When income fluctuates

The recomputation rule does not apply in situations involving the death of either party or a remarriage of the payee. A possible method of avoiding this problem is to use a fixed percentage of income, which can be used when income fluctuates. The alimony payment will fluctuate, but even here the calculations (tax brackets) require expert skill.

Back to the subject that led to this digression: payment of attorney's fees. A rather unfair but common result is when alimony qualifies under Section 71 as taxable income to the payee. The payee can deduct the amount of the attorney's fees incurred for securing taxable income. The payor who is making those payments cannot deduct anything beyond payments made for tax advice. Under the recomputation rule, because of the three years, if payments will start late in the first year, there is some room to include a higher amount as alimony for that year, which will not be disruptive for years two or three. This payment would be tax deductible to the payor and taxable income to the payee, who may deduct these as expenses incurred in securing the income.

In addition, if there are children, by reason of the category of head of household and child tax credits, along with certain other deductions, such as mortgage interest, the payee may be able to deduct enough to make the whole proceeding tax-neutral and assist everyone. An accountant or tax lawyer should calculate the dollars and taxes of this methodology.


Virtually every divorce involving more than minimal property or income will trigger tax or valuation issues. A tax advisor can use the tax law creatively to help both sides. At minimum, a tax professional should be included on your team to avoid making a mistake that will hurt your client. FA

David S. Dolowitz practices family law with Cohne, Rappaport & Segal, P.C. in Salt Lake City, Utah. He is chair of the Taxation Committee of the American Academy of Matrimonial Lawyers.

Published in Family Advocate, Volume 29, No. 4, Spring 2007. © 2007 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.