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It’s That Time Again: How to Handle Filing 2020 Tax Returns (Part Two)

by | Apr 22, 2021 | Firm News |

While 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 decision on how to file business and personal income tax returns is fraught with a number of considerations, not the least of which is the potential of being exposed to IRS tax liability as a result of inaccurate or incomplete tax filings. For  W-2 wages earners the potential for an inaccurate return is not as great as there can be no mis-statement of income. A party’s income is clearly set forth on the W-2 wage and tax statement. Mis-statements or inaccuracies may occur in the listing of deductions on Schedule B or the inaccurate reporting of income from real estate rental if such exists on Schedule E of the tax return. A careful review of the tax return to be filed is required by each spouse before filing.

As we previously discussed, 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 or under 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. A party agreeing to file such a return is not only exposing themselves to potential tax liability, but may also be held by a court to have acknowledged the non-existence of the other party’s cash income as judicial decisions in New York have held that a party cannot take a position in litigation concerning income different that what they declared on the filing of an income tax return.

This issue is further complicated when a business owned by one party is paying substantial personal or family expenses from the business income and deducting the same as business expenses thereby decreasing the net business income on which income taxes are assessed.  Oftentimes a family business is operated during the marriage as a Sub-Chapter S Corporation whose income is passed through to the parties’ individual (joint) tax return. The non-business owner may not be aware of the failure of the business owner to report all income or improperly taking deductions from the income that are not genuine business related deductions. The risk to the non-business owner in agreeing to file their returns jointly is considerable as the Internal Revenue Service will not discriminate as to which party is liable for any tax indebtedness  which may arise if the returns are audited. Further, a court, while acknowledging that the non-business owner may not have been privy to the business tax return filed by the owner, may nevertheless take a dim view of the fact that the non-business owner agreed to file the joint return and has acknowledged the accuracy (or better yet the inaccuracy) of the income  reported. Thus 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.

An “Income Tax Indemnification Agreement” is often prepared and used in those matters that involve a request by a party to file joint income tax returns where there is a doubt that the business owner may have failed to report all of their income or  a doubt exists as to the accuracy of the business expenses deducted from the gross income of the business, although not yet proven. One may ask, why would one consent to the filing of a joint tax return under these circumstances. It’s complicated and not subject to an easy answer here. The filing of a tax return under the heading of married filing separate will expose the non-business owner of the most unfavorable tax treatment with increased taxes due the tax authorities. This requires a thorough review and discussion with your attorney and a qualified accountant who will assist in arriving at a solution best suited for the spouse and family.  The “Income Tax Indemnification Agreement” can give 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 signor 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.

In all respects, a careful analysis must be conducted by the divorce attorney and accountant to determine how best to protect the non-business owner spouse while at the same time preserving assets for equitable distribution and shielding the non-business owner from potential liabilities down the road. These are, to say the least,  complicated issues that not only require consideration for the filing of 2020 tax returns with all of the Covid-19 pandemic issues involved, but are considerations for potential 2021 taxes as well.  It is best to begin now to consider how to approach the 2021 tax filings, as well, 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.