Best Practices for Reading a Personal Tax Return

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:

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:

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.