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Tax Returns in Divorce


Before reading this understand that I, Eric Roy, write these articles for my own benefit as I am interested in the subject material. I am an attorney and not a CPA. If you wish to really have a thorough understanding of the material I suggest you purchase one of the numerous books written on the subject as they will be much more exhaustive. That being said, this article discusses the importance of understanding tax returns and understanding their significance in the divorce process.

As divorce counsel you need to get used to reading tax returns. You should be aware of the various schedules and the significance of the different schedules. Of course, if you have a CPA working your case with you then you should also have your CPA look over the returns. CPAs will typically be able to perform this review faster and more thoroughly than you can. Additionally keep in mind that even if you do understand what you are looking at you as counsel are not allowed to testify as a witness in trial. Your client can testify but often times won't have the sophistication to speak intelligently on the subject on the stand. When you review tax returns you need to be using your marital balance sheet as a reference. Anything found in the returns not included in your balance sheet needs to be added to your balance sheet. You may have fodder for a fraudulently omitted asset on this point if disclosures and discovery have been conducted without any mention of an asset which you independently find on the tax return.

Often times a spouse will sell one or more valuable assets in anticipation of divorce. The spouse will sell the asset for cash thinking that if there is no paper trial in the checking accounts that he or she will not be found out. Use the tax return to uncover these fraudulent transactions. Both the seller and the purchaser of a significant asset are required by federal law to declare such asset for tax purposes. Thus the seller spouse may not disclose in his or her divorce financials that the asset ever existed or was sold but still may declare the sale in his taxes so as to avoid federal tax fraud. If the seller is bold enough to not disclose the previously sold asset on his return don't fret as the buyer likely will. If the buyer reports the transaction on the tax return the IRS will likely cross reference the reported purchaser's transaction with a corresponding sale by the seller. When the IRS discovers that the seller didn't report the transaction it can institute sanctions. If you find that the other spouse didn't report an item to the IRS use this as leverage in pushing for a favorable settlement. The seller spouse will lose credibility with your judge instantaneously if the judge learns of the omission. Punish the omitting spouse on cross examination if he or she wishes to go to trial.

When collecting tax returns you need to get ahold of all federal returns including the most common form which is the 1040 personal income return, the 1120 which is a corporate income tax return, and the 1165 which is the partnership return. Nevada is one of the few states which does not have a state income tax. Be sure to obtain both original and amended returns. You also want to get your hands on state excise tax returns as well sales tax and personal property tax returns. First of all you need to request these tax returns from your client. If your client doesn't have access to them then tell your client to get the return from the marital couple's CPA. If the CPA is a personal friend of the adverse spouse then think about sending a subpoena early on in the case to keep the CPA honest. If these sources don't work then think about making the request directly from the IRS. There are a couple of forms that the IRS provides, Form 4506 and Form 4506-T, which you can fill out and submit to the IRS along with a check payable to the treasury. The first form, Form 4506, will provide you with the entire return but this can take a couple months to receive so act early on this one. If you need the information faster then submit the 4506-T which is a simply a request for the tax return transcript.

Keep an eye out for an adverse party who files married filing separately and then overpays into future years. The reason for doing this is so that the individual gets this marital asset to him or herself post-divorce without having to divide the marital property. Divorce counsel simply needs to compare the amount owed on the return in conjunction with overpayments which are listed on the next line. In the same area of the return there is a line item describing the amount applied to future estimated tax consequences. This overpayment is community property of course.

Along with the return, if the spouse is an employee look at the W-2. The W-2 will tell you whether the employee is receiving income by way of 401(k) or pension benefits. If line 1 of the W-2 is different than line 2 of the w-2 then you know that there is a retirement income. Line 2 describes Medicare wages which don't factor in retirement income. On the 1040 form there is a line item specifically for IRA contribution deductions. Always request tax returns for several, usually five, years back. In this way if the adverse spouse didn't contribute to his or her IRA in the most recent year you can still catch the IRA by observing the contribution on prior returns. The adverse spouse may not contribute to the IRA in the divorce year simply in an effort to hide the asset's existence. You can also find another line item for SEP, Simple and qualified plans. Look to line 30 to see if there are any "penalties on early withdraws".

In Las Vegas you need to remember that money can be kept on the books at the local casinos. If the adverse party is a gambler then you need to get the W2Gs which record significant winnings. To see if a local casino has money on the books for a particular employee submit a subpoena. Of course if you are seeing ATM withdraws at the casinos then this is good evidence that the adverse spouse is gambling at the casinos.

Within the return you need to get familiar with the various schedules and understand how each schedule can assist you. Schedule A lists all of the itemized deductions if the taxpayer choses to use the itemized deductions instead of the standard deduction. Review these deductions. Any interest deductions which are listed on the schedule indicate that there is a mortgage on property. Analogously any real estate taxes will be itemized here on schedule A. Look to make sure that the interest and real estate taxes listed on discovered documentation reflects the amount on the schedule. If the deductions on the schedule are greater than those listed in your documentation then you can assume that there is more real estate out there that you disclosed by the opposing party.

Look to Schedule B to find interest and dividend income. If you see that interest or dividends were paid out then you know you have investment accounts to look for. Financial institutions report dividends paid out to the IRS on a 1099 – DIV Form and Interest is reported by these institutions to the IRS on the 1099 – INT Form. Get your hands on these documents to see what the various investments are. If the adverse party is smart they may omit a newly acquired investment from the return. Once the IRS receives the 1099 –INT and 1099 – DIV forms form the IRS the IRS will notice the discrepancy and assess additional taxes and penalties upon the omitting spouse. In the spouses mind this may be a fair trade off given he or she doesn't have to split the omitted asset in the divorce. As counsel, you can follow up by requesting the parties' transcript from the IRS to see if there were any post-filing adjustment and amendments. You will catch the omitted asset here on the post filing amendment.

If the adverse party owns a business then you need to look to Schedule C. Schedule C will list any business income. Of course if the business is owned by a separate legal entity such as a corporation then such business will not be listed in Schedule C because it is not considered to be owned by the individual taxpayer. Schedule C can be a good starting point for business valuation. When you look at accounts receivable know whether the business operates on an accrual basis or a cash basis. If the business operates on a cash basis then these accounts receivable will not yet be recorded. Cash basis accounting only accounts for the cash once it is actually received or relatively certain to be received at a designated time.

As counsel you need to have an understanding of capital gains. Capital gains or losses occur when property or investments are sold resulting in a gain or loss from initial investment price. This initial investment price is more accurately called the basis. The capital gain is thus the difference in sale price of the capital asset and the asset's basis. There are both short and long term capital gains and losses. The significance of the distinction lies in the tax treatment afforded. These capital gains and losses are recorded on Schedule D. This schedule will tell you when the asset was acquired and for how much as well as when the asset was sold and for how much it was sold for. This of course is useful information when determining community and separate property valuation. Schedule D will list gains and losses attributable to partnerships and S corporations as well.

Schedule E of the tax return is going to tell you about any income received by individual taxpayers based on incomes and losses to a particular employee of a partnership, LLC, S corporation, estate and the like. This information is also reported on a K-1 by the business itself reporting the individual's income or losses. Thus the IRS compares the information in the K-1 delivered by the business to the information provided by the individual's personal return. If there are differences the IRS will make adjustments. K-1s can be complicated and thus you may want your forensic accountant to look it over for you.

For more information on this subject I direct you to Miles Mason, Sr.'s work. He is a JD and a CPA and has written thoroughly on these subjects. Most of my learning, such as the information provided above, comes from his mastery and writing on the subject matter.

Categories: Family Law