Divorce is a Taxable Event

Divorce, better known as the instant wealth reduction plan, hits about half of all first marriages and more than 60% of second marriages. Few things will stir emotions more in the settling of a dissolution case than the issues surrounding child custody and support.

Over the years, courts and families alike have become more civilized and sensitized to these issues, as dissolution agreements have attempted to craft solutions that seem fair and equitable to all. Unfortunately, fair and equitable sometimes doesn’t always work when money is involved.

A dissolution agreement that awards joint, physical custody and support responsibilities to both parents can work against the children when it comes to obtaining financial aid for college. If both parents share these responsibilities, typically, the joint incomes and assets of two separate households will be counted when the colleges compute the Family Expected Contribution amount. This effectively reduces the amount of aid available.

For example, assume a situation where the non-custodial parent has a much higher income than the custodial parent. Assume the divorce agreement specifically excludes the higher income parent from any responsibility for college support. As a result, the two children would qualify for financial aid based upon the much lower income of the custodial parent. This would result in more financial aid than would otherwise be available if both incomes were used to calculate aid eligibility.

In a recent tax court case, a divorced couple shared support and custody of their one child. The IRS challenged their respective tax returns on the basis that both parents claimed an exemption for the child, claiming that each supplied one half of the support.

The IRS denied the dependency exemption for both parents because neither could prove that the child had spent the greater portion of the calendar year with either. The divorce agreement provided for joint custody of their child, with physical custody split equally between the parents on a weekly basis.

The code allows an individual taxpayer to deduct an exemption amount for a “dependent” (i.e., an individual over half of whose support was received from the taxpayer during the calendar year). If a child’s parents are divorced, the child is in the custody of one or both for the year, and the parents provide over one-half of the child’s support, the custodial parent is treated as having provided over half of the child’s support for the year and he/she may claim the exemption for the year. However, in the case of “split custody,” custody is treated as being with the parent who, as between both parents, has physical custody of the child for the greater portion of the calendar year.

In this case, neither parent could prove to the court’s satisfaction that that parent had provided more than one half of the physical custody. Their documentation and testimony was not convincing enough. In an understatement of confusion, the court noted it would be “sheer unguided guesswork” for the court to find otherwise. As a result, the exemption was denied.

This loss of taxable benefit could have been avoided if the parents had agreed to a specific number of days, even to the extent of alternating years taking the dependency exemptions. Another viable alternative would be for the parties to bargain for a more generous settlement that allows the other to claim the exemption every year.