FAMILY & DIVORCE TAXATION

by

Curtis L. Harrington

HARRINGTON & HARRINGTON

6300 State University Drive, Suite 250

Long Beach, CA 90815

(562) 594-9784, Fax: (562) 594-4414

http:/www.patentax.com E-mail: curt@patentax.com PATENTAX®

A

PATENTAX®

PRESENTATION

Disclaimer: Educational Only: This outline is Educational Only and no part of this presentation can be considered as federal or state tax advice, opinion, or position and is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the internal revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein, nor (iii) constituting guidance on any tax or intellectual property matter.

I.	Selected Married Tax Rules as a starting point.

A.	Property Transfers

1.	Because of the Community Property Presumption (CA Family Code §2581), property transfers are considered to be presumptively within the community property umbrella and are not considered to be a transfer but rather a title change.

2.	The basis of property will be the community basis or the individual basis, as inter-spousal transfers during marriage are not considered transfers and because the Internal Revenue Code causes the taxpayers to be "related"§267 generally, and with other specific provisions §304 (redemption of stock) & §1239 (capital gains) .

3.	Tacking of Ownership. Where a taxpayer transfers property to a spouse or a former spouse, period of ownership of the transferee shall include the period of ownership of the transferor. IRC §121(d)(3)(A). Ownership periods are typically used to qualify for capital gains, but periods of ownership can be used for other purposes.

B.	Separate Property-Joint Property Approaches

1.	Even where spouses remain married, and where tracing can be applied, their separate property remains separate and their community property remains community, with any property not being traceable being presumed to be community property under CA Family Code §2581.

2.	Where separate property is maintained by the community, or where community property is maintained by using separate property assets, two approaches are utilized to determine, on a pre-tax basis. These were

(a)	A "Pereira" approach is to allocate a return on the separate property investment as separate income and to allocate any excess to the community property as arising from that separate property owner spouse's efforts. Pereira v. Pereira (1909) 156 Cal. 1, 7-8 103, 9 Pac. Rptr. 488, 491-492.

(b)	A Van Camp approach is to determine the reasonable value of the separate property owner spouse's services and to allocate that amount as community property, and treat the balance as separate property attributable to the normal earnings of the separate property estate. Van Camp v. Van Camp (1921) 53 Cal.App. 17, 199 Pac.Rptr. 885.

3.	During marriage the income from separate property assets may be allocable to the owner spouse where that owner spouse files "married filing separately". Even where the spouses file jointly (thus pooling their income to make no distinction between separate and community property) spouses should keep separate asset records for community and separate property, including the time and effort and cash spent on each. Other principles turn on the separate v. community character of property, especially where a spouse dies intestate.

C.	General Sale of Residence Rules

1.	Single individuals exclude no more than $250,000 on the sale of their principal residence, while married couples can exclude up to $500,000 (IRC §121) if several tests are met:

(a)	Time Ownership & Use Test: Owned Property and used it as principal residence for two years of the five years immediately preceding the sale. The two year use need not be consecutive use years.

(b)	Frequency of Deduction: The exclusion must not have been utilized within two years prior to the sale in question.

(c)	If one spouse fails in the Time Ownership & Use Test, or the Frequency of Deduction Test: the EXCLUSION will be limited to the sum of the exclusions that each spouse could use if not married.

2.	Special rule allows a surviving spouse to have a $500,000 exclusion instead of the $250,000 exclusion for single taxpayers, IF the surviving spouse sells within 2 years of the death of their former spouse. This is for unmarried persons only, a re-marriage will cost the loss of this deduction, and will revert to the rule in (c) above to yield a single $250,000 exclusion.

3.	Rest Home Occupancy periods count as living at home if the home is occupied at least one year during the five year period prior to sale of the home.

4.	Destruction of the Home: if the taxpayers' insured home is condemned or destroyed, the insurance reimbursement payments are excludable on the same basis that gain would be excluded. Any excess gain may possibly be excluded under the involuntary conversion rules under IRC §1033 generally.

D.	Bankruptcy

1.	Bankruptcy estate can includes all interests of the debtors spouse even where spouse has not filed nor joined the debtor's bankruptcy petition. See 11 U.S.C.§541(a)(2).

2.	Since interest in property is determined at the state level, Domestic Partnership Community Property is included.

3.	Bankruptcy automatic stay under 11 U.S.C. §362 (b)(2) C does not affect interception/seizure of tax refunds to satisfy Domestic Support Orders (and other actions including establishment of paternity, child custody or visitation, domestic violence, etc.)

E.	Child CARE Credits (Not to be confused with Exemptions and Child Credit)

1.	This non-refundable credit is for a maximum $3000 spent per qualifying individual (child under 13 or a dependent which is physically or mentally incapable of caring for themselves-- same residence as taxpayer), up to two qualifying individuals. They lived with you more than 50% of the year.

2.	Qualifying Expenses include (a) dependent care, (b) household services, (c) school costs for nursery/pre-school (d) some special school expenses. Qualifying Expenses are limited to the income of the earned income of the taxpayer or spouse. The payments for care cannot be paid to your spouse, to someone you can claim as your dependent on your return, or to your child who is under age 19, even if he or she is not your dependent. You must identify the care provider on your tax return.

3.	Calculation involves multiplying a decimal which ranges from 0.35 (for AGI under $15,000) to 0.02 (for AGI over $43,000) times the money actually spent on qualifying expenses. Multiplying the maximum decimal 0.35 times the maximum expense limit per child/dependent of $1050.00. Because this credit is non-refundable it is limited to being no more than the tax actually paid.

F.	Child Dependency Exemption & Under Age 17 Child Credit

1.	The Dependency Exemption is $3500. The exemption beginning and endings are: Joint $239,950- $362,450; Head of household $199,950- $322,450; Single $159,950-$282,450 & Married couples filing separately $119,975-$181,225. Maximum savings with an exemption, is $3500 x 35% = $1225.00

2.	The Child Tax Credit (under 17) a maximum of $1000.00 (non-refundable) This credit is phased out by $50 (of or subtracted from the $1000) for every $1000 above a phase out threshold. Simple math indicated that there are 20 such $50 packets within the $1000 credit and thus the range above the phaseout threshold is $20,000 in each case. Beginning phase out is: Joint $110,000; Single Head of Household and Qualifying Widow(er) $75,000; and Married Filing Single $55,000. IRC §24

3.	The child tax credit under IRC §24 is limited by IRC § 24(b)(3)(a) to tax imposed, either regular or AMT tax. Further IRC §26, limits credits under IRC §§ 23 (adoption expenses), 24(child credit above), 25A(I) (Hope and Lifetime Learning Credits), 25B ($2000 elective IRA deferrals), 25D(Residential Energy Efficient Property), 30(Certain Plug-In electric vehicles), 30B(Alternative Motor Vehicle Credit), and 30 (D) (New Qualified Plug-In Electric Drive Motor Vehicles).

Mathematically, the IRS is limiting each category individually, and then all categories individually over regular tax liability in excess of AMT. Thus, even if a taxpayer had $25,000 in regular tax liability and $25,001 as an AMT tax liability, no credits of any kind in §26 would be available.

II.	Alimony

A.	Alimony is distinguished from transfers of property already owned at the time of divorce.

B.	Alimony is deductible by the payor former spouse (on line 31a of form 1040) and included in the income of the payee former spouse (on line 11 of form 1040). See IRC §71(b).

C.	Requirements of Alimony

1.	Payments must be in cash, checks, money orders. Cash payments to 3rd parties are considered alimony is contemplated by the divorce orders.

2.	Payments must be required by degree and need not be under another form of obligation, such as a note.

3.	Instrument must not designate the payment as "not alimony".

4.	Payor and Payee former spouses must NOT be members of the same household if separated by decree or order of separate maintenance.

5.	Payment may not be treated as child support by payee.

6.	Payor's requirement to make this stream of payment must cease upon the death of the recipient/payee former spouse.

7.	The former spouses must not file a joint return.

8.	Non-cash transfers not included.

9.	Payments which are a part of a spouses community property income is not counted as alimony.

10.	Payments for the use of property do not count as alimony.

11.	Payment which is used to maintain payors or payors property is not counted as alimony.

D.	Tax Option to treat alimony as "not alimony"

1.	Where divorce decrees permit it, the former spouses may agree to designate certain payments as "not alimony". Temporary Regulations §1.71-1T(b) Qa8.

2.	Possible purpose for treatment as "not alimony".Requirements of Alimony

(a)	Payor former spouse as no gross income from which to deduct alimony and wishes to save the payee former spouse from having to include it as income.

(b)	Payee former spouse has a significantly higher income tax bracket than payor spouse. (Not normal, but the higher bracket may be due to a temporary windfall, etc.)

(c)	Payor and payee wish to designate a payment to avoid the unexpected possibility of invocation of the alimony recapture rule.

III.	Alimony Recapture

A.	Because Alimony produces such a severe and disparate tax effect the IRS has developed a mechanical test to determine whether there is "excess alimony" payments. If "excess alimony" is found, according to the formula, the transfer is characterized as a "property transfer" (read: inter-spousal gift).

B.	The mathematics of the recapture formula reveal that the "perfect alimony" should be a flat stream of cash passing from the payor to the payee.

1.	Strategies for avoiding recapture- avoid 2nd year payments that exceed 3rd year payments by more than $15,000, and first year payments that exceed second year payments by more than $7500.

2.	Avoid an alimony payment schedule that leaves little or no alimony payable in the third year

3.	Start payments late in the year (November or December).

4.	Even if payments are scheduled to avoid alimony recapture it can still occur because computations are based actual payments rather than scheduled payments alone. As an example of this - spouse paying alimony is also obligated to pay the ex-spouse's attorney's fees and these are then characterized as alimony. Since ALL payments qualifying as alimony during the three year period are subject to recapture, a large attorney's fee deducted as alimony could trigger recapture.

C..	Mechanical"Transferor" must provide basis and holding period of the property to the receiving spouse upon transfer. (No real penalty for failure, except for nagging questions by the transferee when its time to sell the property).

D.	Specifics of the recapture method:

1.	A three year period is necessary to begin the calculation with the first year being the year in which alimony payments are made under a final divorce or written separation agreement. IRC §71(f)(1).

2.	As stated in the statute, Excess Alimony is:

(a)	The amount of alimony during the first post separation year, Over the sum of the average of 2nd year alimony over excess payments for the 2nd alimony year; averaged with (the alimony paid in the 3rd year + $15,000).

(b)	Where the Excess Payments for the 2nd post separation year needed in part (a) is: The amount of the alimony in the 2nd year over the sum of (the amount of alimony in the 3rd year) plus $15,000.

3.	Examples.

(a)	On the next page, the first example is given by the IRS, in which first year alimony is $50,000, second year alimony is $39,000 and third year alimony is $28,000. Now as a strict construct assuming that the third year went on forever, it would be seen that year 1 might have had $22,000 recapture and year 2 might have had $11,000 recapture, but the formula is more forgiving. Out of the potential $33,000 of alimony in years 1 and 2 which was above an assumed constant rate of alimony of $28,000 in year 3, the recapture equations only recaptured $1,500, Seemingly very forgiving. All family law attorneys should keep a pad of this worksheet in order to test alimony payments. So long as the actual amounts reported and paid result in zero recapture, it shouldn't be a problem.

(b)	Re-running the numbers in worksheet 1 at the top of the page with the IRS numbers, and assuming that the $28,000 figure was the "real" flat rate alimony, and with the second year alimony the same as in the example, with a first year alimony rate of $1,500 less than $50,000, or $48,500 would have caused zero recapture.

Alternatively, if the second year alimony rose from $39,000 to between $42,000 and $43,000 the result would have also been zero recapture.

However note that the difference between year 1 alimony and Year 2 alimony is roughly half of the difference between year 1 alimony and year 3 alimony. The formula is looking to have a smaller difference between year 1 and year 2 than between year 2 and year 3.

4.	Helpful Rule of Thumb? (But always consult the chart to be sure). Because the worksheet makes a separate recapture for the 3rd year versus 2nd year and a separate recapture between 1st year and (average of 3rd year-2nd year), the $30,000 difference needs to be divided with about one third of it between the first and second year and about two thirds between the second and third year. A blank worksheet is provided for your convenience at the bottom of the worksheet page. Remember, if a sum on the worksheet turns out to be less than zero, simply put a zero. A blank copy is provided for your future use.

IV.	Carry Forward Items

When couples divorce and have tax carry forward items, the carry forward items must be allocated between the spouses. Allocation methods:

A.	Capital losses - based upon the separate capital gains and losses of
each spouse. Reg 1.1212-1(c)(iv)

B.	Charitable contribution - ratio of what separate carry forward items would have been id the spouses had filed separate returns for the year the excess contribution arose. Reg. 1.170A-10(d)(4)(I)(b)

C.	Net operating loss (NOL) - ratio of what the separate NOL carry forward items would have been with each spouse separately computing income and deductions. Reg 1.172-7(d)

D.	Suspended passive activity losses - treat as a gift and the suspended PALS of the transferor spouse added to the basis passing to the receiving spouse. IRS MSSP Guide on Passive Activity Losses. IRC 469(j)(6). & IRC 1041(b).

E.	Suspended S corporation losses - Follow the stock in a divorce related transfer to the other spouse. IRC 1366(d)(2).

V.	Child Support

A.	Child support payments are NOT alimony, are not taxable to the receiving spouse and are not deductible by the payer [Temp.Reg.1.71-1T(c)]. Payments are child support for tax purposes if they are either:

1.	designated as child support in the divorce or separation agreement (fixed child support) or

2.	deemed to be child support.

B.	Fixed child support - an amount designated as such, specifically for a child only, in the divorce or separation instrument. The payment may be a fixed amount or a fixed portion ( for example, 50%) of a payment.

C.	Deemed child support - certain payments are not identified in a divorce or settlement agreement as child support are treated as such for tax purposes if the instrument reduces the payment:

1.	due to a child contingency or

2.	at a time that is "clearly associated" with a child contingency.

D.	Calling such a payment 'alimony' in a divorce instrument does not
change this result. Contingencies related to a child include reaching 18,	21 or local age of majority, or the child's death, marriage, completion of
school, leaving the household, reaching a specified income level or
becoming employed. [Temp.Reg.1.71-1T(c)]

E.	Clearly associated with a child contingency - if either of the following tests is met, payments are considered to be clearly associated with a child contingency and therefore deemed child support and not alimony:	[Temp.Reg.1.71-1T(c)]

1.	Payments are reduced within six months before or after a child
attains age 18, 21 or local age of majority.

2.	The payer has more than one child, payments are reduced more	than once, the reductions occur within a year of the same age for each child, and the age is between 18 and 24, inclusive.

3.	The presumption that payments are child support can be rebutted by showing the reduction in payments is not related to a child (Shepherd, TC Memo 2000-174).

4.	The presumption could also be rebutted if, for example, the taxpayer showed the payments lasted for a period customarily used in his jurisdiction for alimony, such a half the length of the marriage. [Temp.Reg.1.71-1T(c)]

F.	Converting Alimony to Child Support.

1.	Normally this is not a result desired, but it may be forced upon the payor by IRS rule. It is presented before the "converting Child Support to Alimony" in G below because it will be easier to understand if introduced first. There are two rules stated in the temporary regulations where alimony "will be treated as support" because the payment are reduced at times associated with the time that a child turns 18, 21, 18-24 or the local age of majority.

(a)	Payments are reduced nor more than six months before or after the child reaches age 18, age 21 or the local age of majority.

(b)	Payments are reduced on two or more occasions that occur not more than one year before or one year after a different child attains a certain age between the ages of 18 and 24.

2.	These rules appear in (Temp. Reg. §1.71-1T(c)Q-A18). It is stated that it is possible to "rebut" the presumption of the rule where a payment is reduced within this period, but it should have heavy substantiation and be reasonable. Reductions occurring outside this period will not receive the presumption and may not need much substantiation.

G.	Converting Child Support to Alimony- any reduction of an otherwise qualifying alimony payment that is tied to a child contingency will be deemed to be child support from inception. As a result, a desire to structure an agreement whereby child support is treated as alimony has limited opportunities.

1.	Renegotiate the alimony level ab initio well before a 6 month birth date or do it during child contingency which occurs outside that range - the couple can execute a further divorce settlement agreement that recite support payments that are not allocated between alimony and child support and that contain no reduction provisions (Lawton, TC Memo 1999-243)

2.	The agreement can provide that the amount of future alimony payments will be renegotiated upon the happening of specified contingencies related to the child. (Since no reduction amounts are specified in the instrument, the theory is that an amount of deemed child support cannot be determined, and a re- negotiation also contemplates an alimony increase). This approach may yield favorable tax results - alimony- at least until the first reduction actually takes place.

3.	Dangers of taking the re-negotiation position.

(a)	the IRS may take the position that all prior payments were partially child support and deny deductions claimed for all prior open tax years.

(b)	A requirement to periodically renegotiate the amount of payments with an adversary may foreclose the ability to effectively re-negotiate.

(c)	Make adjustment on specified dates not related to a child, such as when the child turns 21, or 18, etc. The parties may write the reduction clauses with specific reduction dates that do not violate any of the "clearly associated" factors previously discussed. The dates that children turn age 18, 21 or the local age of majority are known and easily avoided. It is fairly easy to estimate when each child will reach these dates and to time any re-negotiation well clear of these dates.

VI.	Property Transfers incident to Divorce

A.	Under IRC §1041(a) property passing between the spouses generates no gain or loss.

1.	Includes transfers under a trust for their benefit.

2.	Technically treated as a gift (§1041(b)) which will not even have a gift tax effect since spouses have an unlimited gift & estate tax exemption.

3.	The basis in the property is the transferor's basis. Thus it covers both the other spouses separate property with a basis acquired before or during marriage, as well as property having a basis by acquisition within the Community.

4.	Transfer timing: The transfer must be either within one year of the divorce OR the transfer must be shown to be related to the divorce proceeding. (Definition of "incident to divorce)

5.	Transfers more than six years after marriage are PRESUMED to be unrelated to the divorce proceeding /termination action of the marriage.

6.	"Transferor" must provide basis and holding period of the property to the receiving spouse upon transfer. (No real penalty for failure, except for nagging questions by the transferee when its time to sell the property).

7.	Cash "buy-outs" are included in the exception. A cash payment for property is essentially a gift of the property by the property donor spouse to the property donee spouse, followed by a gift of cash from the cash donor spouse to the cash donee spouse.

B.	Exceptions to tax free treatment under IRC §1041(a):

1.	Loans to bring in a time payment element where the asset retained is a non-
business asset that one former spouse is paying off to the other.

2.	Property is transferred to a non-resident alien.

3.	Property subject to liabilities in excess of basis is transferred to a spouses trust (rule against liability stripping).

VII.	Closely Held Businesses

1.	Where a business asset has a low basis, and it is sold to the other spouse at a price above that basis, the buying spouse takes over both bases, and the other spouse has no gain on the sale. An example is a closely held corporation where husband's basis is $500 and wife's basis is $500, and where husband buys out wife for $100,000. Wife has no gain on the transaction, and husband's new basis in the business is $1000.00

2.	Stock redemption can be tricky. Say that H & W each have 100 shares in Corp. X, and that H & W have no money, its all inside the corp. X. Lets say W and H have a basis in their shares of $50,000 each. H wants to cash out, so the corporation redeems his stock to the corporation for $100,000, corporation X takes his shares and retires them. W now owns 100% of the corporation with her remaining 100 shares. The possibilities are (1) treatment as if corp issued a dividend to both, followed by W buying H's stock (bad tax result), (2) gain to H in excess of the $100,000 over H's $50,000 basis, (3) if possible a reduction in W's basis to zero, even though she didn't receive H's stock directly, with H walking away with no tax.

Because IRC §1041 only deals with transactions solely between former spouses, the result may depend upon who gets to Tax Court first. There have been "whipsaw" results in which H walks away tax free and the corporation will have paid out cash without declaring a dividend. If one former spouse makes their case, the other former spouse may not be a part of the case. Treasury regulations section 1.1041-2 (a) attempts to approach this problem but without clear direction. Subsection (a) states that if redemption occurs without triggering a "distribution" from the corporation under state law, then the transferor spouse walks away tax free. However Subsection (2) of Treasury regulations section 1.1041-2 (a) states that generally a redemption (in our example by H) is treated as if first, H gave his stock to W, second, W took the stock and handed it to the corporation creating a redemption, and third, that any property received by H due to the redemption (H is the non-redeeming spouse, mind you) is deemed to have been distributed to W. This means that W pays the tax due to H's redemption.

VIII.	Stock Options.

A.	Since Under IRC §1041(a) property passing between the spouses generates no gain or loss and because basis in the property is the transferor's basis, a former spouse who takes an option and who subsequently exercises that option is treated as having the same tax treatment as would have been experienced had the option been exercised during marriage.

B.	The result will depend upon whether an 83b election had been made and other circumstances. It may even result in employment income to such non-employee former spouse. See Revenue Ruling 2002-22.

IX.	Community Property

A.	Community Property is a system of property division which divides equally all property - no matter in whose name it is held - acquired during the term of the marriage, excluding inheritances and gifts in some jurisdictions.

B.	There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin (quasi-community property). In these jurisdictions property acquired prior to the marriage stays with the party who acquired it. Certain jurisdictions exclude property that comes into the marriage by gift and inheritance.

C.	Some community property states allow equitable distribution where justice is served. These rules vary state to state and are fraught with exceptions. For example, the rule in Texas in 1983 was that any division of community property didn't need justification unless it tilted excessively far in one spouses favor, and then justification needed to be given. The California rule at that time was the opposite, namely that the division had to be equal unless reasons for deviating from 100% equal were articulated.

X.	Child Related Tax Breaks Available to Both Former Spouses

A.	Child's Itemized medical expenses.

B.	Employer provided health care or accident plan for a child.

C.	Medical Savings Account or Health Savings Account distributions from Either former spouse for a child or children.

XI.	Dependent's Tax (Child CARE Credits, Exemptions, & Child Credits

(Also see this outline Roman numeral I, subsections E & F above.)

A.	Optimizing the Tax Benefits

1.	Because (1) dependent credits have such a low resultant dollar amount, and (2) because each of the Child CARE, Exemptions, & Child Credits the Under Age 17 Child Credit are computed differently and with different phase outs, and (3) because the inclusive income profiles of the former spouses undergoing is rarely addressed, there is not much written on trying to optimize the now separated spouses' tax dollars.

2.	The total tax savings (or maximum government tax loss) will depend upon (a) the incomes of the now divorced spouses (b) the amount of alimony which now affects those incomes, and (c) the shifting of the dependency exemption.

3.	However, the Internal Revenue Code has in the past allowed the dependency exemption and child tax credit to be shifted as a single unit to the noncustodial parent when a child receives over one-half of the child's support during the calendar year from the child's parents who are either (I) divorced, (ii) legally separated, (iii) separated under a written separation agreement, or (iv) living apart at all times during the last six months of the calendar year. (See IRS form 8332) A child must be in the custody of one or both of the parents for more than 50% of the calendar year. Where the "special rule doesn't enable joinder of the dependency exemption and child tax credit, the form 8332 will be effective to shift the dependency exemption alone.

4.	Clearly due to its higher limits, the dependency exemption is worth more to a spouse in a higher tax bracket. In what is referred to as a typical divorce in which alimony is present, the child dependency exemption was surrendered to the parent with the greatest tax savings and alimony might or some other part of the settlement was adjusted to try to increase overall after tax cash flow to both parties (assuming that the level of contentiousness was not so high as to inhibit such considerations).

Table I

Top Bracket Breakdown of Value of Exemptions and Credits

Federal	Max Dependency Fed	Total

Tax Bracket	Tax Saved at top of Bracket	Child Credit	Value

15%(to $43,650)	to $525	$1000	$1525

25%(to $112,650)	to $ 875	$1000@$75k	$1875-- to

phased out @ $95k	-- $875

28%(to $182,400)	to $980	$0(phased out)	$980

33%(to $357,700)	$1155 to total phase out	$0 (phased out)	$1155 to 0

35%( over $357,700)	$0 Phased out	$0 (phased out)	$0

5.	What Table I very roughly shows is that as between a non-custodial parent with high income and a low income custodial parent, that the differences between the value of the Value of Exemptions and Credits is not huge. The difference in awarding the exemptions and credits to one parent over the other amounts to a tax savings maximum of $1875, HOWEVER it can't necessarily be said that exemptions and credits in the hands of a lower income custodial spouse are insignificant. In other words, having exemptions and credits is worth more than not having them, BUT the value of exemptions and credits in the hands of the higher earning spouse is not that much MORE valuable than remaining in the hands of the lower earning spouse. The driving force of the tax bracket driven exemption value is offset by the much higher value of the child credit for much lower income taxpayers.

6.	More bluntly, the maximum combined benefit above occurs with the exemptions and credits in the hands of a $75,000 wage earner at $1875. Even where the other spouse earns only $20,000; the combined exemptions and credits are worth $1525 in the hands of such lower earning spouse. This is a difference of $350. But considering the higher marginal utility value of money for a custodial low wage earner, the change in the rules governing surrender of the exemptions and credits (below) could have been predicted.

B.	Revocation of the Shifting of Exemptions and Credits to the Non-custodial spouse

(New Rules)

1.	Revocation of release of claim to an exemption. During May 2009, the IRS created a new rule and altered form 8332 to allow the custodial parent to REVOKE any previously made Release of Claim to of Exemption (and Credit where Credit flowed with it). Since the changes to the rule occurred in 2009, and since revocation is effective no earlier than the tax year beginning in the calendar year following the calendar year in which the custodial parent provides, or makes reasonable efforts to provide, the noncustodial parent with written notice of the revocation, and since the form heading is entitled "Revocation of Release of Claim to Exemption for FUTURE YEARS, a revocation filed in 2009 would only apply to a shift the exemption for tax year 2010 and later.

2.	Post-1984 decree or agreement. If the divorce decree or separation agreement went into effect after 1984 and before 2009, the noncustodial parent can still attach certain pages from the decree or agreement instead of Form 8332. For any decree or agreement executed after 2008, Form 8332 or similar form must be used.

3.	Given that revocation can be executed and filed unilaterally, there may be a large number to be processed between summer 2009 and the end of the year. The form makes it clear that the rights to the exemptions and credits are for the sole determination of the custodial parent. There is not and will not believed to be any method of contesting this unlimited right, unless the surrender of the exemption and credits was part of the divorce decree.

4.	Practice Pointers

(a)	Keep in mind that exemption claims are federal and preemptive. Custodial spouses can be controlled to maintain the release of exemptions and credits only through the state court decree.

(b)	The possibility of revocation should be either taken as a fact that it will occur, or a contingency placed in the decree to offset the effect. However, the effect has been shown to have a maximum value if lost of not more than about $1875 and a differential value in one former spouses hands over the other spouses hands of about $350. Thus the spouse "bargaining" to obtain the exemptions and credits should not ascribe much value to it.

(c)	Heuristically, the differential value makes most sense when the custodial parent is a very low marginal earner, and where the noncustodial parent has AGI of LESS than $75,000 so as to be eligible for the child tax credit. Most of the other cases will diminish an already small exemption/credit.

XII.	Estimated Payments/Withholdings

A.	If a couple divorces after making joint estimated tax payments and then later files separate returns, estimated tax payments may be claimed in full by either spouse or divided between them however they agree.

B.	If, however, they are unable to agree, the payments are allocated between based on the allocable shares of their combined income and Self-Employment (SE) tax for the year. [Reg. 1.6654-2(e)(5)]

C.	Then each spouse claims estimated tax payments equal to the total estimated tax times the tax paid on their separate return for the year, divided by the total of the tax shown on both former spouse's separate returns.

D.	Overpayment from prior return - when overpayment from a prior joint return is applied to the following year's tax, and the couple divorces during that year, the overpayment credit from the joint return is treated like a jointly made estimated tax payment (CCA 200130036). The spouses can agree to divide the overpayment in proportion to each spouse's separate tax liability in the current year.

Example: Yoshihiro and Keiko filed a joint return for 2008 with joint estimated tax payments of $18000. Their total tax for 2008 was $16000 and they applied the $2000 overpayment to their 2009 tax liability. They divorce in January 2009. Yoshihiro and Keiko can divide the $2000 overpayment in any way they agree. If no agreement can be reached, they must allocate in proportion to their separate tax liabilities for 2009.

XIII.	Divorce Related Sale of Residence

A.	Under §121(d)(3)(A) as applied to real property, the length of ownership test is met by a transferee spouses use of the transferor spouses time of ownership test.

B.	Under impending divorce rules, a taxpayer is using the property as a principal residence during the time that a spouse or former spouse is granted the use of the property under (a) a divorce or (b) separation instrument. Therefore, absent other considerations, where the home is going to be sold (and in particular under today's market conditions with longer sale periods) it is preferable that the divorce decree state emphatically that both spouses have the right to live at the residence.

C.	Destruction of the Home: result is the same for Divorcing Taxpayers as Destruction of the home for married taxpayers.

XIV.	Separate Property

A.	The California Rule - income from separate remains separate property, while other states hold that income from separate property is community property. This will affect apportionment of taxation from income produced during the year of divorce, both before and after physical separation.

B.	Division of Community Income is generally taxed equally to each spouse.

1.	However, IRC §66 provides that if all four of the following are met, that the separateness of such community property will be governed by IRC §879(a). Note that IRC §879(a) relates to non-resident aliens and does not seem natural for use with IRC §66. The four numbered "treatments" under subsection (a) of IRC §879 are simply "read into" IRC §66, presumably to save paper. This is sometimes known as the "living apart" rule. The requirement are:

(a)	The two individuals are married at any time during the year;

(b)	Live apart and did not file a joint return for that year;

(c)	Community income was earned during that year; and

(d)	No portion of such income was transferred between the two before the close of that year.

2.	The four numbered "treatments" under subsection (a) of IRC §879 are:

(a)	Income other than trade or business income or partnership income, shall be treated as income of the spouse who rendered personal services.

(b)	Trade or Business income, and a partner's distributive share of partnership income, shall be treated as provided in IRC §1402(a)(5). IRC §1402(a)(5)(A) states that a community business income and deductions belong to the spouse carrying on the business, but if both spouses carry it on, the apportionment is in accord with their respective share of gross income. IRC §1402(a)(5)(B) states that if its a partnership business, that all of that partner's share is used to determine the partner's net earnings, and that none of it is to be taken to account in computing the net earnings from self employment of the spouse of such partner.

(c)	Community income from separate property will be treated as the separate property holder's property.

(d)	All other community income will be treated as provided under applicable community property law.

3.	IRS can "deny the benefits of any community property law" to a taxpayer who acts as if he or she is solely entitled to such community income and failed to notify that person's spouse before the due date for filing an income tax return. IRC §66(b).

4.	IRS can relieve a spouse from tax liability of another spouse, including IRC §66(c) innocent spouse, Injured spouse [IRC § 6402; 31 CFR 285.2(f) & (g); IRM 25.15.1.2.5], or IRC §6015 innocent spouse.

XV.	Retirement Accounts Division & QDROs

A.	Employer Retirement Plans - subject to Qualified Domestic Relations Orders (QDRO). It relates to the rights of someone other than a participant to receive benefits from a qualified retirement plan (such as most profit-sharing and pension plans) or a tax sheltered annuity.

B.	Qualified Domestic Relations Order (QDRO) Requirements. A QDRO is a judgment, decree or court order (including an approved property settlement agreement) issued under a domestic relations law [IRC 414(p)] which contains the following:

1.	Name and last address of participant(s) (employee) and alternate payee (former spouse diverting portions of the plan's assets).

2.	Identity of the retirement plan of employer or employer's retirement account to which the QDRO is directed.

3.	Percentages of each benefit type to be paid to the alternate payee.

4.	Time period and payment amounts to be diverted.

C.	Effect: In some cases it can "split the plan"into two plans which are separately operable, but not always. In some cases, the alternate payee can be made to wait until some pre-determined event, in order to begin enjoying cash and benefits.

D.	The IRS has issued a notice (Notice 97-11) to assist domestic relations lawyers, qualified plan participants and plan administrators if drafting and reviewing qualified domestic relations orders (QDROS) The notice consists of two parts, the first covers the issues that should be considered in drafting a QDRO and the second part provides examples of language that should be included in the QDRO.

E.	ERISA limits how a QDRO can affect a qualified retirement plan.

1.	A QDRO may make no provision to cause the plan to increase its benefits.

2.	Another QDRO can't be overridden by a subsequent QDRO.

3.	Different benefits or options not provided for in the plan cannot be required. (The QDRO must be consistent with the terms of the retirement plan to which the QDRO applies.)

F.	QDRO Tax Effects

1.	Amounts paid to child or dependent of plan participant are
treated as having been paid to the participant.

2.	Spouses or former spouses must include in income any amounts which are paid out.

3.	Early distribution penalty of 10% does not apply to divisions and distributions made pursuant to a valid QDRO which is consistent with the plan.

4.	To qualify as a QDRO the funds must be distributed to the spouse directly from the plan, not via the employee accruing benefits under the plan.

5.	Example: Wait for the QDRO. In the Karem case - [Karem, 100 TC 521(1993)] a taxpayer awaiting division of community property following a divorce, received lump-sum distribution from a retirement plan and deposited the funds into a trust account pending the court's division of community property. Year later- court issues a QDRO authorizing division of the funds. IRS held & the Tax Court agreed: payment was fully taxable to the original participant, as it was not made under a QDRO order.

6.	Rollovers - tax-free distributions of cash or other assets from one retirement program to another. A distribution received by a plan participant's spouse or former spouse under a QDRO can very likely be rolled over tax-free into an IRA, a qualified employer retirement plan or a qualified annuity plan. Rollover rules apply to the spouse as if she were an employee.

7.	20%withholding rule may make direct transfer a preferred option to a rollover - when rolling over from an employer's plan to an IRA. IRC §3405(c)(1)- Employers must withhold 20%of an eligible rollover distribution -if over $200-made from the qualified plans to the employee

8..	Alternatively, if the balance is rolled over to an IRA, an under age 59 ½ participant can receive the balance in the IRA as a	series of substantially equal payments and avoid the 10% early withdrawal penalty.

9.	Basis is allocated - if the alternate payee is the former spouse of the plan participant, any basis the participant has in the plan is allocated on a pro rata basis between the present value of the alternate payee's interest and the total present value of all the benefits payable with respect to the plan participant.[IRC 72(m)(10)]

XVI.	Individual Retirement Accounts Transfer

A.	Individual Retirement Accounts are not subject to Qualified Domestic
Relations Orders.

B. Tax Effects of Transfer

1.	If divorce decree or separation agreement requires a transfer to a spouse or former spouse, such transfer is not considered a taxable event (decree should state that the transfer is intended to be tax-free under the provisions of Section 408(d)(6).

2.	An early distribution penalty of 10% may apply to the recipient spouse who makes a withdrawal before the age of 59 ½.

C. Transfer Methods

1.	Change the name on the IRA

2.	Direct trustee-to-trustee transfer of IRA assets. Caveat divorceur: If funds are not directly transferred to the other spouse's IRA the 10% penalty may be imposed. Note the Bunney case [Bunney, 114 TC 259(2000)] - husband ordered by divorce court to evenly divide his IRA with his spouse. Rather than directly transferring the interest in the IRA to the spouse, he withdrew the money and gave it to the spouse. Tax court holding: husband owed tax plus the 10% early withdrawal penalty on the distribution, despite taking the distribution to comply with his divorce decree.

XVII.	Registered Domestic Partners

A.	Domestic Partner Rights and Responsibilities Act (DPRRA), Family Code (F.C.). § 297, was passed in 1999. F.C. § 297.5, added in 2003, became effective January 1, 2005. The amendment extended to registered domestic partners (RDPs) most of the rights and obligations of married persons, including rights with regard to community property assets and liabilities Domestic Partner Rights. Therefore, commencing with the date of their registration, RDPs acquire community property like spouses, and their creditors have recourse to both RDPs interests in such property to the same extent as creditors of married persons.

B.	Defense of Marriage Act ("DOMA"). For purposes of federal law, "spouse" refers

only to a person of the opposite sex who is a husband or wife, and marriage is limited to opposite-sex couples. 1 U.S.C. § 7. See also 28 U.S.C. § 1738C.

C.	Comment. The non-consistent treatment of domestic partners under the federal law versus California Law causes a number of problems.

1.	Domestic Partners, two people, have to collectively draft five tax returns, including (a) a joint California FTB tax return, (b) a pair of theoretical California FTB tax returns which are prepared as if the two people in question were single, even though these two returns are never filed, and (c) the two have to prepare and file federal tax returns based upon or consistent with the a pair of theoretical California FTB tax returns, for a total of five returns.

2.	The domestic partnership very likely is a partnership relationship which will generally force attribution under IRC §267 and §318(a) despite exception of the word "spouse".

3.	Inheritance, and Estate and gift planning remains a creative exercise as the spousal exclusion is not available, gift splitting is not available, etc.

XVIII.	Innocent Spouse Relief from Joint Tax Liability

A.	Requirements: for IRC §66(c)

1.	Joint return was NOT filed for any taxable year.

2.	Such individual does not include in gross income for such taxable year an item of community income properly includible therein which, in accordance with the rules contained in section 879(a), would be treated as the income of the other spouse.

3.	The individual (seeking relief) establishes that he or she did not know of, and had no reason to know of, such item of community income, and

4.	taking all of the facts and circumstances it would be inequitable to hold such item of community income in such individual's gross income.

5.	If (a) - (d) are met, the item of income is included in the gross income of the other spouse,

6.	FURTHER, under procedures prescribed by the Secretary, if , taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either) attributable to any item for which relief is not available under the preceding sentence, the Secretary may relieve such individual of such liability.

B.	Requirements: for IRC §6015(b)

1.	Joint return was filed for the applicable tax year.

2.	There exists the understatement of tax which is attributable to an erroneous item (understated income or overstated deduction - usually) of the other spouse.

3.	The taxpayer applying for innocent spouse status neither knew nor should have known about the understatement of tax.

4.	taking all of the facts and circumstances it would be inequitable to hold the innocent spouse liable for the understatement.

5.	Extent of relief from tax will occur to the extent the tax deficiency is apportionable to the non-innocent spouse. §6015 (b)(2)

6.	Benefits of the subsection must be elected not later than 2 years from the time that collection activities have begun.

C.	Requirements: (for IRC §6015(c) Separation of Liability

1.	Joint return was filed for the applicable tax year.

2.	Understatement of tax is apportioned between the innocent spouse and the non-innocent spouse. The burden of proof of each item is upon the innocent spouse.

3.	innocent taxpayer must (be not married or legally separated) or ( must or not have been living together for the past 12 months).

4.	Extent of relief from tax will occur to the extent the tax deficiency is apportionable to the non-innocent spouse. §6015 (c)(2) and burden is on the innocent spouse applicant.

5.	The taxpayer applying for innocent spouse status must have had no actual knowledge of each item from which relief is sought

6.	Benefits of the subsection must be elected not later than 2 years from the time that collection activities have begun.

7.	No credit or refund under section (c).

D.	Requirements: (for IRC §6015(f) Separation of Liability

1.	The innocent spouse is not eligible for innocent spouse relief under IRC §6015(b) or IRC §6015(c).

2.	It would be inequitable to hold the innocent spouse applicant liable for any unpaid tax or deficiency (or any portion of either). Comment: This implies a heightened threshold, in that the innocent spouse should show a level of righteousness (or clean hands) to the extent that the facts should show no shades of entitlement or degrees of liability, unlike the earlier sections. In effect, this section is a "catch all" section which purports to grant relief over the relief denied in the earlier sections (expected due to technical difficulties).

3.	As before, but even more so in this section, there must be no trace of fraud or illicit transference of assets.

4.	If you meet this exception, the IRS will consider granting equitable relief, although, the underpayment may be attributable in part or in full to your item, and only to the extent the funds intended for payment were taken by your spouse, or former spouse.

5.	The array of facts which can assist qualification under this section are many, and might for example, include being a victim of abuse, or not being allowed into a business, or where the spouses had separate businesses, and the like. Anything which forms a barrier to the innocent spouse's ability to see into the business of the non-innocent spouse, should be emphasized.

E.	Action under for IRC §6015 generally.

1.	Relief for innocent spouse may be raised at any level before the IRS, but more importantly may be raised in Tax Court under IRC §6015(e).

2.	Even where a court or agency finding on tax liability has become final for a given tax year, the request for innocent spouse relief can still be made so long as a request for innocent spouse relief was not made in that proceeding (unless the innocent spouse applicant meaningfully participated in such prior proceeding.

3.	Not only may the innocent spouse petition the Tax Court for Review, but the non-innocent (other ) spouse can answer and participate. Participation may include: a filing for a request for innocent spouse (by the other spouse), or the promulgation of facts and evidence so that the court will deny the original innocent spouse filing.

4.	Tax Court Jurisdiction is limited to:

(a)	a time after the IRS (Secretary) has mailed, by certified or registered mail, a final determination (denying) relief under innocent spouse.

(b)	a time which is 6 months after the date the request for innocent spouse relief is filed.

(c)	but not later than 90 days after the IRS (Secretary) has mailed, by certified or registered mail, a final determination (denying) relief under innocent spouse.

(d)	Innocent spouse is limited to income taxes. Other types of taxes may be required to be reported on the joint return for which joint liability attaches but for which innocent spouse relief is unavailable.

5.	Separate Liability Election using Form 8857- Injured Spouse. This is similar to Innocent Spouse (and can be made in addition to the innocent spouse election). This election protects the electing spouse from unpaid tax liability resulting from "understatement" of income. Requires:

1.	Joint return was filed.

2.	Not married or legally separated from joint filer at the time the election was filed.

3.	Not a member of same household as the other joint filer during the past 12 months (at the time of filing).

4.	IRS can properly deny the relief if collusion between the spouses is discovered.

XVIX.	Deductibility of Attorney's Fees

A.	Divorce Attorney's fees are generally not deductible, regardless of which party must pay them (such as where one party is ordered to pay the other party's attorney fees). Only if they are properly classifiable as "alimony" will the party paying the other parties divorce attorney's fees be deductible.

B.	Tax Attorney's fees are deductible "below the floor" subject to the 2% of Adjusted Gross Income Floor (meaning that the deductible portion of the fees is that portion above an amount which is 2% of the Taxpayers' adjusted Gross Income.) Tax Attorney fees which are deductible are those related to general tax advice, divorce tax advice, estate tax consequences of the divorce, appraisers paid to determine tax or to pursue alimony.

C.	Other non deductible costs include costs and fees relating to child custody, child support, and property settlement. Costs and fees related to property are normally added to the basis of the property.

D.	Practice Pointer: This section points out how very important it is to have a complete breakdown of the fees charged by divorce attorneys. Fees for determining alimony (like hunting for hidden assets and determining prior standard of living levels), advice given for tax results (explaining the tax ramifications of different types of property settlement), and fees for property division, especially if they may be either actually allocated to each asset or even allocated based upon some reasonable basis like total value - can save future tax dollars where the property is sold -- due to the increased basis causing a lesser profit.

Curtis L. Harrington

Office:	Harrington & Harrington; 6300 State University Drive, Suite 250, Long Beach,
CA 90815; Tel. (562) 594-9784; Fax (562) 594-4414

curt@patentax.com PATENTAX®	http://www.patentax.com

Specialty:	High Technology Patent / Trademark / Intellectual Property Law & Taxation

Education:	B.S. Chemistry - Auburn University (1974)

M. S. Electrical Engineering - California State University Long Beach (1990)

M.S. Chemical Engineering - Georgia Institute of Technology (1977)

J.D. - University of Houston School of Law (1983)

M.B.A. - University of Oklahoma (1985)

LL.M. Taxation - University of San Diego School of Law (1997)

Admitted	Supreme Courts of California, Arizona, Texas, & Nevada

to Practice: U.S. Supreme Court;	U.S. District Court, Central District of California

Internal Revenue Service	U.S. Patent and Trademark Office

U.S. Court of Appeals for the Federal, Fifth & Ninth Circuits

California Department of Real Estate - Broker

Los Angeles County California EMT-Basic

U.S. Tax Court	FCC-Commercial & Amateur Extra

Certified by The State Bar of California Board of Legal Specialization: Taxation

Languages	Japanese Language Proficiency Examination, Approved by Japan Foundation, Level 4; Kanji Proficiency Exam of the Japan Kanji Aptitude Testing Foundation, passed Level 7, recognized by the Japan Ministry of Education, mastery of 640 kanji; some technical Russian reading ability.

Patents	Prepared and prosecuted more than 100 patents, in the electrical and

Prepared	chemical technologies; specialty areas include optics, fiber optics, cryogenics electromagnetics, natural gas processing and computers, & trademark and copyright preparation and prosecution. Patents include: Chemical: 4,957,634; 4,851,077; Electrical: 4,876,892; 4,833,351; 4,837,525; Mechanical: 4,879,895; 4,906,199; and Optical: 4,919,512; 4,898,468.

Litigation	Associate counsel in patent matters, trade secret litigation; Judge pro tem, Long Beach Municipal Court; Superior Court Mediation program, Long Beach; Attorney- Client fee Dispute Arbitrator, Long Beach Bar Association; Patent Panel, American Arbitration Association.

Teaching	Adjunct Law Professor, Golden Gate University School of Law, LL.M. Taxation Program; Georgia Institute of Technology - previously taught heat and mass transfer laboratories, and analog and digital computer laboratory.

Member:	State bars of California, Arizona, Texas and Nevada; Long Beach Bar Association

(Board of Governors, 1994-95); Orange County Bar Association, Taxation Section, (Co-Chair Technology Law Section 1996); Past Member, Orange County Chapter of California Society of Enrolled Agents - President 2003-2004; Fellow, National Tax Practice Institute; California Bar Association: CEB committee (1999-2000); Income & Other Tax subcommittee (Chair 2000-2002); Taxation Section Executive Committee (2002-2005); Cal Bar Taxation Advisory Committee (2006-2011).