It seems like many of us just filed our 2019 income tax returns and here we are discussing the filing of our 2020 tax returns in 2021. For sure the Covid pandemic brought delays and uncertainties with respect the timing of filing our personal and business income tax returns for 2019. Decisions on how and when to file the 2020 returns, especially in the midst of a divorce action remain as complex as ever with the consequences long lasting.
With the rising number of two income families the most frequent question asked of divorce attorneys at tax time is whether to file personal income tax returns as “joint” or as “married filing separate”. With two W-2 wages earners and no other complications, the answer is relatively simple. The filing of a joint income return would in most instances yield the most beneficial tax treatment either reducing the ultimate tax due the IRS and NYS and/or significantly increasing any refunds due for overpayment of income taxes throughout the year. The payment of taxes due must be addressed and in the case of the refund the sharing of same must be addressed. One party’s decision to file married filing separately in this circumstance may be motivated more by not wanting to share the refund which may ultimately be due. That of course could be short sighted as electing a married filing separately designation results in the most unfavorable tax treatment which also may result in increased taxes due or a significantly reduced refund. This decision to file in this manner may be likened to cutting off your nose to spite your face and could also result in a claim by the damaged spouse for reimbursement.
A genuine complication on whether to file “joint” or “married filing separate” arises when one party’s income is paid in cash or other bartering and where no W-2 or 1099 form is issued by the employer and that party has decided not report the cash income. In this instance, where the other spouse is asked to sign a personal income tax return by the spouse whose income is not being reported to the tax authority, the distinct possibility of tax liability arises as well as scrutiny of these tax returns by a Court in any divorce proceeding or possible trial.
Another issue arises when one party owns and operates a business which may be paying some or all of that party’s or the family’s personal expenses. If those expenses are being deducted from the business income and not being reported as personal income, it creates an issue. Under these circumstances, a careful analysis is required to ascertain the other spouse’s liability(ies) to the IRS or the NYS taxing authorities if the returns are subsequently audited and such tax liability is found to exist along with interest and penalties and possibly criminal liability as well. The decision as to whether to file “joint” or “Married filing separate” is complicated and requires the assistance of your divorce attorney as well as a qualified accountant who can provide tax advice.
In some instances, where the filing of personal income tax returns with the above complications may result in severe hardship to the family’s finances, the possibility exists of the parties entering into an agreement commonly referred to as an “Income Tax Indemnification Agreement” which agreement could permit the filing of a “joint” income tax return while at the same time giving some level of protection to the non-business owner of liability should any tax authority audit the filed tax returns and find tax liabilities with interest and penalties. While no tax authority will recognize this agreement as shielding a joint signer from liability, it may give some level of protection to the non-owner spouse from the business owner. This indemnification agreement might also be effectively used to prevent one spouse from claiming that the other is bound by the income as reflected on the jointly filed return.
We will continue this discussion in greater detail in our quarterly publications as tax time approaches. It is best to begin now to consider how to approach the 2020 tax filings so that these important decisions are not made the night before the tax filing deadline. Consulting with your divorce attorney now on these matters will save a lot of anguish in the months ahead.