June 07, 2017 Articles

Best Practices for Reading a Personal Tax Return

By David L. Gresen

You’re a lawyer, not an accountant, and attempting to navigate, understand, and cull pertinent information contained in a personal income tax return for your matrimonial matter may seem like a daunting exercise. Thus, the goal of this article is to provide you with a road map of the Form 1040 to (a) understand the form; (b) identify pertinent financial information; and (c) enable you to ask targeted questions and prepare a proper, detailed information request.

Initial Request
To obtain a preliminary understanding of the parties’ reported income, generally three to five years of the parties’ personal income tax returns should be obtained. Upon receipt of a copy of a personal income tax return, it may behoove you to obtain an official copy from the Internal Revenue Service (IRS) to ensure you have been provided with a copy of the tax return filed with the government. To obtain and review any amended tax returns directly from the IRS, use Form 4506—Request for Copy of Tax Return. You can also obtain a transcript, which lists summary information and takes less time to obtain, by using Form 4506-T. Only one party needs to sign the IRS authorization for joint tax returns, but you will need both Social Security numbers.

Personal Tax Return: Form 1040, Pages 1 and 2
The first two pages of the personal tax return contain information on the person or persons filing the return and their dependents, and it lists the types of income earned during the year as well as what deductions are being claimed. The following is a list of the pertinent information to be reviewed on the first two pages of Form 1040:

  • First, check the filing status (lines 1–5): what status did the person select—married filing joint return, married filing separately, or single? Ensure that the proper box is checked so that your client (a) is aware if he or she needs to file his or her own return and (b) to ensure the proper tax rates are being applied. Also, note the Social Security numbers (top right of page 1 and box 6c)—this information is useful for bank and credit card account authorizations—and identify the number of dependents and their ages (box 6c). This information is useful for child support purposes, if applicable.
  • Second, who works and in what capacity? Line 7 contains information on wages earned. This is the taxable component of wages; it will not include tax-deferred income (e.g., 401(k) contributions). When examining this section, check to see if there are any W-2 forms attached. If not, request them. W-2s indicate the existence of deferred compensation plans as well as other forms of compensation (e.g., stock options).
  • Lines 8 and 9 concern the taxable and nontaxable interest and dividend income. When comparing tax returns year by year, pay attention to changes in sources of such income, which may reveal previously undisclosed accounts. (See the discussion of Schedule B below.) Identify any tax-exempt interest (included or omitted). This is useful to identify retirement accounts and assist in identifying sources of cash flow. Just because income is not taxable does not mean it is not available for maintenance and support.

Other sources of income on page 1 of the 1040 can be found in the following areas:

  • Line 12 (business income): Amounts shown on this line indicate that there is income from an unincorporated business. (See the discussion of Schedule C below.)
  • Line 13 (capital gains): Amounts shown on this line represent income from sales of stock or other assets. (See the discussion of Schedule D below.) When reviewing line 13, determine where the distribution came from—a retirement or pension account? If yes, there will be amounts reported on lines 15 and 16.
  • Line 17 (rental and pass-through entities): Amounts shown on this line indicate that there is an ownership interest in a rental property, “S” corporation, partnership, or limited liability company. This type of income and the entities associated with it are known as “pass-through entities.” (See the discussion of Schedule E below.)
  • Line 21 (could include income items such as gambling): Any gambling winnings or losses should be reported on the personal income tax return. If there are amounts listed on this line, you may want to request the Form 1099 issued by casinos, and follow up with a subpoena to quantify the total moneys used for gambling if this is an issue in your case. In fact, you should get copies of all 1099s, as they indicate sources of income and can be useful in identifying undisclosed accounts and undisclosed sources of income.
  • Line 25: Is there a health savings account? If so, is your client due a portion of the moneys being kept in the account?
  • Line 28: Identify all self-employed retirement plans.
  • Line 40: Are there any itemized deductions? If so, see the discussion of Schedule A below.
  • Line 49: Did the person claim a child care tax credit? Will this be an issue in the divorce? Was the person allowed to do so under a prior order? Who is the person claiming the credit on?
  • Line 52: Did the person claim a child tax credit? Will this be an issue in the divorce? Was the person allowed to do so under a prior order? Who is the person claiming the credit on?
  • Lines 64 and 65 (withholding and estimated tax payments): Did a business owner spouse fail to make estimated payments or the converse? Did the business owner spouse withhold too much so that there may be a refund due after the divorce is over?
  • Line 75: Is there a refund due? How will it be paid? (Also see if an amount is reported on line 10.) Be sure to check the routing and account number where the refund is directed for deposit—has the account been disclosed? What is the nature of economic activity that generated the tax refund or liability? Will this activity be recurring or nonrecurring? Consider whether the asset or liability represents a pre-filing or post-filing item or must be allocated between the two parties.

Schedule A—Itemized Deductions
Schedule A is where the taxpayers list their deductions such as medical expenses, state taxes, real estate taxes, mortgage interest, charitable deductions, and business expenses.

Lines 5–9 report real property deductions. It is important to determine the following: What properties have they paid real estate taxes on? Have the properties all been disclosed? Are there any separate property claims? Anything sold or purchased during the year? Check returns for prior years to see if there are any significant changes in this section. Also, check to see if any state or local taxes have been paid to other states, as this could indicate additional sources of income (i.e., have all income sources been disclosed?).

Lines 10–15 report mortgage and investment interest expense information. Make sure to reconcile the amounts to mortgage statements. Request all loan applications, which are a great source of information because they show what is being reported to lending and credit institutions as income and assets. When comparing mortgage interest with investment interest, obtain all statements to ensure all debt is disclosed and uses of loan proceeds are properly accounted for.

Line 20 reports any casualty or theft losses. If any are reported, determine what happened to the disposition of insurance proceeds.

Lines 21–28 report other deductions and will contain information on investment expenses (it’s important to identify all investments), safe deposit boxes (where is it? what’s in it?), and legal or estate planning fees (another good source of information to determine assets––what is being reported to any estate attorneys?).

Schedule B—Interest and Ordinary Dividends Schedule B lists each source (e.g., financial institution or account) of interest and dividend income. You should request all Form 1099s because it is common for tax preparers to group accounts from any one financial institution on one line. For example, there may be multiple CitiBank accounts but only one entry for interest income from CitiBank on the tax return. Think about the following when reviewing Schedule B:

  • Is there interest income from an individual? If so, what is the purpose of this income—perhaps a loan that should be disclosed?
  • Match interest and dividends to bank and brokerage statements to ensure all accounts are disclosed.
  • Part III—Foreign Accounts and Trusts (used to report income from foreign sources): There is a requirement to report foreign income and foreign assets of more than $10,000, referred to as the Foreign Bank and Financial Accounts Report (FBAR). An entry on this line may be the only clue as to the existence of what is called a foreign asset protection trust.

Schedule D—Capital Gains and Losses
Schedule D is used to report gains and losses on items such as sales of stock, sales of business property, and losses from casualties and thefts. When reviewing Schedule D, you should consider the following:

  • The magnitude and consistency of gains (losses)—both short and long term.
  • What has happened to any proceeds?
  • The sale of investments such as stocks and bonds, which could indicate the existence of additional accounts and may include pass-through gains and losses from an interest in a business.
  • Capital loss carryover: Losses from the sale of capital losses can offset gains from the sale of capital assets or, if there is a net loss from such sales, deductible against ordinary income to a maximum of $3,000. Any capital losses not deductible due to the $3,000 maximum may be deducted in subsequent years until fully utilized. If separate returns are filed after a net capital loss was reported on a joint return, the carryover is allocated to each taxpayer based on his or her net losses for the preceding taxable year. If the losses were incurred jointly, the losses are divided equally. Thus, each party may carry his or her half of the loss to the following year. Tax losses and gains that are incurred during the marriage but deferred to the future affect value today. Be careful when asset swapping.

Schedule C—Profit or Loss from Business
Schedule C is used to report revenues and expenses from an unincorporated business. When reviewing this schedule, keep the following in mind:

  • It is important to remember that sole proprietorships’ and DBAs’ names are synonymous.
  • This schedule can also be used for reporting on single-member limited liability corporations and small businesses, like a one-person consulting or professional practice. You will frequently find commingling of business and personal deposits and expenses in the same (multipurpose) bank account. Accordingly, an assessment of actual income derived from the business may be necessary.
  • The schedule may not represent real business operation (subject to valuation) but may be a tax device to deduct mostly personal expenses.
  • Self-employed taxpayers generally do not receive a W-2 form.
  • The wage expense on line 26 does not include the owner but may include other family members.
  • Retirement plan contributions and health insurance premiums for the owner are not deducted within Schedule C; instead, they are found on page 1 of the 1040 in lines 28 and 29 as an adjustment to gross income.
  • Request a fixed asset schedule (Schedule 4562)—there may be a detailed schedule of assets/depreciation not necessarily attached to the return.
  • Line 9 (car and truck expenses): Are any personal deductions being taken? Are all vehicles disclosed?
  • Line 16: Obtain all loan applications and documents associated with this deduction.
  • Line 17 (professional fees): Does this include payments to the taxpayer’s divorce attorney?
  • Lines 18 (office) and 22 (supplies) are commonly abused categories.
  • Line 24 (travel, meals, and entertainment): The owner is allowed deduct only half of the expense. Make sure to request credit card statements to determine the nature and validity of these business expenses.
  • Part III—Cost of Goods Sold: Obtain copies of all inventory sheets and request detail on the cost of labor, which may include family members or paramours.
  • Part V—Other Expenses: This section can be substantial and may require further scrutiny.
  • Schedule E—Supplemental Income and Loss
    Schedule E is used to report income from rental real estate as well as income from ownership in entities such as S corporations, partnerships, and limited liability corporations.

    Information from Schedule E may lead to further inquiries; thus, be sure to obtain information on the following:

  • The source of all rental income and expenses. Are all properties disclosed?
  • Is the proper rental revenue being reported? Request leases.
  • Question the existence of any related-party rental arrangements.
  • For entities such as S corporations, partnerships, and limited liability corporations, obtain all supporting K-1s—these are not usually attached to the returns provided in discovery, and they contain information not reflected in the 1040, such as the percentage owned and distributions.
  • Pass-through income versus distributions: Remember losses do not always mean zero cash flow. The reverse is also true—income may not mean any cash flow (“phantom income”).
  • Part 1—Rental Activities: Will appraisals be needed? Are expenses reasonable; additional income for support?
  • Part II—Pass-Through Entities: Obtain tax returns and financial statements for all entities. It is important to identify business entities early in the case.
  • Part III—Trusts: You will need to obtain copies and information of all trust documents to identify all beneficiaries, trustees, and separate property issues.
  • Conclusion
    In summary, the personal income tax return can be a treasure trove of information if you know how to read it. This article was written to take you through a high-level guided tour of the information a taxpayer has reported to the IRS and how you can use that information in your discovery process.

    Copyright © 2018, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).