Tax Implications of Changing Circumstances - Examples Flashcards
Marriage - Married Filing Separately - Married individuals who choose to file separate returns must use the separate rate schedule. The rates on this schedule are higher than other individual rate schedules. Several disadvantages are associated with the filing of separate returns by married individuals.
For example, a taxpayer may lose all or part of the benefits of the deduction for individual retirement accounts, the childcare credit (a tax credit that offsets your taxes in a direct dollar-to-dollar manner for child and dependent care expenses), and the earned income credit (a tax credit available to low-income taxpayers, which effectively serves as a negative income tax).
Marriage - Surviving Spouse - A widow or widower can file a joint return for the year his or her spouse dies if the widow or widower does not remarry. For the two years after the year of death, the widow or widower can file as a surviving spouse only if he or she meets specific conditions.
For example, Connie and Carl are married and have no dependent children. Carl dies in 20X3. Connie can file a joint return, even though her husband died before the end of the year. Alternatively, Connie can file as a married individual filing a separate return. In 20X4, however, Connie must file as a single taxpayer since she has no dependent children who would qualify her as a surviving spouse or a head of household. Alternatively, if Connie and Carl had dependent children, Connie could file as a surviving spouse for 20X4 and 20X5 and use the joint return rate schedules.
Marriage - Head of Household - A second-rate schedule or tax table is available to a head of household. The head of household rates are higher than those applicable to married taxpayers filing jointly and surviving spouses, but lower than those applicable to other single taxpayers.
For example, Brad and Ellen divorced. Ellen receives custody of their child, and Brad is ordered by the court to pay child support of $6,000 per year. Ellen agrees in writing to allow Brad to claim the dependency exemption for the child. If Ellen maintains the home in which she and her child live, she can claim head-of-household status even though the child is Brad’s dependent.
As noted, the taxpayer must pay over half the cost of maintaining the household. These expenses include property taxes, mortgage interest, rent, utility charges, upkeep and repairs, property insurance, and food consumed on the premises. Such costs do not include clothing, education, medical treatment, vacations, life insurance, transportation, or the value of services provided by the taxpayer.
Marriage - Abandoned Spouse - An abandoned spouse is usually a person in dire financial condition. If no relief were granted, this person would be required to use the married filing separately tax rate schedule, which contains the highest rates. However, Congress has provided relief for taxpayers in this situation if they can meet certain conditions.
For example, in October, Bob and Gail decide to separate. Gail supports their children after the separation and pays the costs of maintaining their home. Gail cannot claim abandoned spouse status because Bob lived with her for over one-half of the year. If she had obtained a divorce before the end of the year, she could have filed as a head of household. In the absence of a divorce, Gail must file a separate return, unless both Bob and Gail agree to file a joint return.
Assume the same facts as in the example above except that Gail continues to support her children and pay household expenses during the next year. She can file as a head of household even if she has not obtained a divorce.
Divorce - Separate Maintenance Payments - Any payment pursuant to a divorce or legal separation must be classified as one of the following for tax purposes:
* Alimony
* Child support, or
* Property settlement.
For example, Helen earned $500,000 and, as a result of her divorce, which was finalized in 2018, she was required to pay William $250,000. If the payment were viewed as a property settlement, Helen could not deduct any of the $250,000 payment and William would not be required to include the payment in his income. However, if the $250,000 were viewed as alimony, Helen could deduct the full amount in computing her adjusted gross income. William would report the $250,000 as alimony income. This demonstrates the significant difference in taxation that can occur when a payment is classified as either alimony or a property settlement.
Divorce - Significance of Alimony Income - Whether payments made in connection with a divorce or separation are classified as alimony is of major tax significance. Such classification results in a deduction for the payor and income to the payee for divorces entered into prior to December 31, 2018. Alimony was actually a way to shift income prior to the enactment of TCJA of 2017.
For example, Tony and his wife were divorced prior to the TCJA. Tony, who has a 35% marginal tax rate, makes payments of $40,000 to his former wife. If it is deductible as alimony, Tony will save $14,000 (0.35 times $40,000) a year in federal income taxes. The amount of tax that the former wife must pay depends on how much other income she has and whether she has deductions that reduce the tax. Her tax might be even higher than her former husband’s or as little as zero.
Divorce - Property Settlement - A division of property does not result in any income to either spouse, nor does either spouse receive a tax deduction. The basis of property received by either spouse as a result of the divorce or separation remains unchanged.
For example, as a result of a divorce, Dawn receives stock that she had purchased with her former husband during their marriage. They had purchased the stock for $12,000. At the time of the divorce, the stock was worth $14,000. Neither Dawn nor her former husband reports income from the transfer of the stock because the stock was acquired as a property settlement. If Dawn subsequently sold the stock for $15,000, she would report a $3,000 gain.
Death - Final Income Tax Return - The rule states that if the deceased individual met any of the filing thresholds for the year that would have required that person to file a tax return if alive, then a final return for the year of death must be filed.
For example, a tax return must be filed for a deceased single person over age 65 if he or she had already received taxable income over $16,550 (2024) for the year.
