James Nolletti is a New York attorney who provides his clients peace of mind. Assertive and client-centered, Mr. Nolletti and his team of professionals are dedicated to providing prompt, efficient, and exceptional legal services. In this podcast, James explains many of the tax implications of getting a divorce in New York, and explains what can happen if one spouse is under-reporting their income and how his firm selects business valuators and tax experts to assist in your divorce case.
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Hosted by: Diana Shepherd, Editorial Director, Divorce Magazine
Guest speaker: James Nolletti is a White Plains divorce lawyer and founder of Nolletti Law Group. James has over 30 years of experience in providing excellent service to individuals going through divorce who have complex divorce issues and significant assets.
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Read the Transcript of this Podcast Below.
New York Tax Implications of Divorce
Diana Shepherd: If the stay-at-home spouse filed joint tax returns during the marriage, and it turned out that the moneyed spouse was under-reporting income or making fraudulent claims, can the innocent spouse be protected from prosecution?
James Nolletti: There are two issues: one is criminal prosecution and the other is prosecution with respect to the taxes owed.
Many married taxpayers file joint tax returns because of the financial advantages this filing status allows them. However, when married taxpayers file jointly, both taxpayers are jointly as well as individually responsible for the taxes and any interest or penalty due on the joint return – even if they later divorce. This is true even if a divorce decree or judgment states that one of the spouses will be responsible for any amounts due on the previously filed income tax returns. One spouse may be held responsible for all the taxes, interest, and penalties even if all the income was earned by the other spouse.
Therefore, filing a joint return during the marriage or after separation presents spouses with risks that they must consider and protect themselves against. The internal revenue code offers possible remedies for spouses who find themselves in the position of defending an improper or erroneous tax return, which is referred to as innocent spouse relief. By requesting innocent spouse relief, a joint taxpayer could be relieved of the responsibility for paying tax, interest, and penalties if their spouse has improperly reported items or omitted items on their joint tax return.
Generally, the tax, interest, and penalties that qualify for relief can only be collected from the spouse or former spouse for misreporting. To qualify for innocent spouse relief, a taxpayer must meet certain fairly strict requirements under the internal revenue code. If they do meet the requirements, they can qualify for that status and not be responsible to the government to pay those taxes, penalties, and interest.
Let’s talk about businesses partnerships. Should you tax-affect the earnings of pass-through entities like general partnerships, limited partnerships, or limited liability companies in the case of divorce?
Tax-affecting the earnings of past entities can have a profound effect upon valuation of the entities. As you can imagine, taxes play an important role in valuing a business for any purpose – including divorce – because taxes can reduce the value by as much as 40%.
To understand the role of taxes in a business valuation, one needs to step back and review the technical part of valuation. Most valuations have three moving parts: one, a future cash flow stream; two, expected future growth of those cash flows; and three, a required rate of return to attract an investor to the risks associated with the future cash flows and growth.
A sound valuation has to match apples with apples: when applying the required rate of return to the cash flows – whether in the form of a multiplier or discount rate or capitalization rate – both the cash flows and the risk factor must treat taxes the same way, otherwise one will likely misvalue the entity.
On a more granular level, valuation analysis build up a required rate of return, and they do that by including – among other factors – the yield that an investor would receive when investing in, for example, publicly-traded stock. That yield is generally net of taxes – or as we say, tax affected – and thus it can only be applied to tax-affected cash flow streams.
Even if a pass-through entity does not pay entry-level taxes, the normalization process burns those cash flows with a hypothetical tax expense so that the tax-affected risk factor – whether a multiplier, discount rate, or capitalization rate – is apples-to-apples.
Jim, I’ve got to admit my head is spinning a little bit listening to your explanation! I know that you probably can’t simplify it any more, so let me ask you another question. Do you always work with business valuators and tax experts, and how you go about selecting those professionals if you do?
I think one of the most important things for any experienced lawyer is to know your limitations. You can’t be an expert in everything. And when you have high-asset or high-net-worth clients, it is extremely, extremely important to have a team of qualified tax lawyers, forensic accountants doing your tax and valuation work. We have many of the top such experts in the New York area, and I’ve been fortunate to have worked with many of them and I’ve learned quite a bit from them over the years. But yes: they are a necessity in many of these cases?
But I also sense that you have a very keen interest in the subject matter as well and you’ve done your own studying to make sure you’re up-to-date on the latest information to help your clients.
Well, yes. That’s why becoming involved in the academy of certified financial litigants or litigators, we spend time and effort educating ourselves and others on some of these concepts but it still doesn’t make us a forensic accountant or tax lawyer.