There are three types of tax debt that may be addressed in a divorce: tax debt that was paid off during the marriage, tax debt existing at the time of divorce, and tax debt that may exist in the future. Let’s examine each of those types of divorce-related tax debt one by one.
For tax liabilities in existence at the time of divorce, the court is called on to determine whether the liability is separate or marital in nature.
The issue of tax debt paid off during the marriage might come up where the tax debt itself was a separate debt of one of the spouses, from prior to the marriage or related to a separate asset of that spouse. Perhaps the spouse came into the marriage with a tax liability, or perhaps they owned land prior to the marriage that they sold and owed taxes on during the marriage.
In either case, where a separate tax debt was paid off during the marriage, it could have been paid off in three ways: from the separate property of the debtor spouse, from the separate property of the non-debtor spouse, or from marital property (or income). In the latter two cases, the non-debtor spouse may want a credit back for his or her share of marital property—or for his or her separate property—that was used to pay off the other spouse’s separate (pre-marital) tax liability.
Another type of debt paid off during the marriage that may raise issues in a divorce is where a marital tax debt was paid off with one spouse’s separate property. Say that at the end of the calendar year, the spouses owed taxes on their income that they didn’t have the funds to pay. One spouse pulled from a separate (pre-marital) savings account to pay off the marital tax liability. In that situation, as well, the spouse who used his or her separate property to pay off a marital debt may be looking for compensation.
As with student loans, spouses looking for compensation or recoupment of debts paid during the marriage are best served by explaining the unique facts of their situation to an attorney. Whether recoupment is possible is a highly contextual and fact-specific inquiry.
For tax liabilities in existence at the time of divorce, the court is called on to determine whether the liability is separate or marital in nature. Separate tax liabilities are typically those that were either incurred prior to the marriage, or that arose out of the separate property of one of the spouses. (As offered above, an example would be the spouse who owned land prior to the marriage [separate property], sold the land during the marriage, kept all sale proceeds in a separate account that was not used for marital benefit, and owed capital gains tax on the sale. That tax liability would most likely be deemed the separate debt of the land-owning spouse.)
Marital tax liabilities are divided equitably between the spouses. Equitably does not mean equally, but equal division is certainly the most common way to divide marital debt.
We often anticipate and speak to potential future tax liabilities in a negotiated divorce settlement. Specifically, we address how responsibility for a future tax liability (related to tax returns filed during the couple’s marriage) would be distributed between the spouses. Similarly, we address how a tax refund would be distributed between spouses. Some couples choose to share any potential tax liabilities or refunds equally, while others choose to assign responsibility pro rata, based on each person’s income for the tax year in question. Where one spouse earns substantially more than the other spouse, they may commit to 100% responsibility for any future liabilities (and entitlement to future refunds). Most often, the percentages of responsibility for tax liabilities will mirror the percentages of entitlement to tax refunds.
Liabilities arising out of one spouse’s tax fraud are their own unique brand of liability to be addressed in divorce. Where one spouse was clearly a bad actor, their actions are likely to impact the court’s assessment of what distribution seems equitable (fair) between the couple. However, many couples have a shared awareness of and complicity in not fully reporting their income. If you have or anticipate having a tax liability arising out of tax fraud (e.g., under-reporting of income), speak to a matrimonial (and tax!) attorney about your situation as soon as possible.