As we begin the final quarter of 2015, many people are starting the process of year-end tax planning. A married couple’s filing status is one aspect of the tax return that is almost automatic from year-to-year, and critical to determining their final tax liability. For divorcing couples, however, determining the filing status of their tax return is anything but automatic. Until the divorce decree is in-hand, a number of filing statuses allowed by the Internal Revenue Code are a possibility.
An individual’s filing status has a direct impact on his or her tax liability. A given amount of income will yield different tax liabilities depending on the filing status chosen. For example, assume a couple has taxable income of $300,000 ($250,000 attributed to W and $50,000 attributed to H). If this couple filed a married filing joint tax return, the estimated federal tax would be approximately $68,656. Now, if you changed the filing status to married filing separately, the parties combined estimated federal tax would be $76,865. If the parties were able to file as single individuals, the estimated federal tax for W would be approximately $63,459 and $5,819 for H (the combined federal tax would be $69,278). As you can see, changing the filing status could yield a difference in tax liability of approximately $8,000 even though the income remains the same.
Ultimately you want to select a filing status that results in the lowest tax liability for each party, but you need to be able to fit your facts within the rules set forth in the Internal Revenue Code.
Potential Tax Filing Statuses for Divorcing Couples
So what are the various filing statuses available to divorcing couples and rules for qualifying for each? Let’s start with the most common:
Married Filing Jointly
Generally speaking, the married filing jointly filing status (MFJ) will yield the lowest federal tax for married couples, especially in situations where there is a wide disparity of income (as in the example above). From a tax preparation perspective, it is also the easiest. There is no need to go through the exercise of separating out income and deductions, or fighting about who gets dependency exemptions, etc. All of the couples’ pertinent tax information appears on one return.
In order to qualify for MFJ status, you simply need to determine your marital status as of the close of the tax year (typically December 31st). Couples legally separated under a decree of divorce or separate maintenance are not considered married. This is defined by state law. However, the mere fact that spouses have not lived together during the course of the year does not prohibit them from filing a joint return. A couple separated under an interlocutory decree of divorce retains the status of husband and wife until the decree becomes final.
A couple of quick planning items to consider in choosing the MFJ filing status are:
- Some tax attributes (earned income credit, child care credit, etc.) are only available to individuals on a MFJ return. They cannot be claimed if an individual is considered married and he or she files a separate return.
- If you file a MFJ return, you cannot amend your filing status to married filing separately. Make sure you understand and agree with all of the information contained on the tax return. If you file an MFJ return, you and your spouse, jointly and severally, are responsible for the tax liability and any penalties if something is incorrect. The IRS typically isn’t sympathetic to “I didn’t know” arguments.
- Alimony deductions are not permitted on a MFJ return.
Married Filing Separately
If you are deemed married at year-end, couples always have the option to file their tax returns separately. Although this is not normally your best option from a tax liability perspective (especially if there are disparities in income), there are sound reasons why you may want to file separately from your spouse.
One of the biggest reasons for filing separately is to protect yourself against any tax penalties that may arise because of reporting errors committed by your spouse (accidental or intentional). This is especially true if one spouse has his or her own business. Unless you are involved in the day-to-day operations of the business, how do you know if the activity of the business being reported on your joint tax return is accurate? It’s not uncommon during the divorce process for parties to cease communicating. I suspect conversations about your spouse’s business are practically nonexistent, and you don’t want to be responsible for penalties because of inaccurate reporting of the business activity. The way around these penalties going forward (there is nothing you can do if penalties are assessed on prior jointly filed returns) is to file separately, even though it may cost you a few more dollars in tax.
Keep in mind that the separate returns must be filed sort of in-sync. If one party itemized his or her deductions, the other party must itemize as well. This doesn’t always work out to one party’s advantage. Decisions regarding dependency deductions (if any) also need to be considered.
Head of Household
The head of household (HOH) filing status is one that can be beneficial to both divorcing parties under the right circumstances. It combines the tax benefit of the MFJ status with the independent filing advantages of the married filing separately status. However, you need to meet certain criteria in order to take advantage of this filing status. In order to utilize the HOH filing status, you must:
- Be unmarried or considered unmarried on the last day of the year;
- Not be a surviving spouse at the close of the tax year;
- Not be a non-resident alien for any part of the tax year; and
- For more than one-half of the tax year, maintain a household which is the principal place of abode of a qualifying individual who is a member of the household.
For purposes of this filing status, you can be considered “unmarried” if your spouse was not a member of your household for the last six months of the year.
As you can see, the choice of tax filing status for divorcing couples may not be as simple as originally thought. Ultimately, someone needs to “put pencil to paper” and prepare a solid tax projection to see which status, given the facts, works best for the divorcing parties. Your choices get much easier once you have the final divorce decree in-hand.