How Big Losses Can Get You Big Gains In Your Divorce Settlement
One of the less scandalous election news topics in the past week was the New York Times article exposing portions of Donald Trump’s 1995 income tax returns and concluding that his $918 million loss declared in that year could have allowed him to avoid paying federal income taxes for the next 18 years. What then followed was a week of cable television talking heads from all sides debating the political, moral, ethical implications of such a maneuver. Tangentially, there was some, but not much, discussion explaining the underlying applicable Internal Revenue Service code sections.
As a family law attorney concentrating in complex and high net worth divorce litigation, my first thought was of Trump’s second wife Marla and their 1999 divorce, and whether Marla’s divorce attorney recognized the value of these future tax benefits. Also, did Marla share or at least benefit from them as part of their 1999 divorce settlement?
In a divorce, tax benefits are often allocated just like other tangible assets such as real estate and bank accounts. The most common of these tax benefits are child dependency exemptions. The dependency exemptions are usually allocated equally or alternated each year depending on the number of qualifying children. Simple enough, but, as referenced in the New York Times revelations, there are also some other potentially much more valuable future tax benefits known as loss carryovers. In other words, if your ex spouse claims a big loss and thereby does not have to pay income taxes for a year or more, that benefit could be part of a divorce settlement.
Loss carryovers are an accounting technique and tax policy that allow investment and business losses incurred in one year to be carried forward (or backward in some instances) to offset future profits or gains thereby lowering a taxpayers future income tax liabilities. The two common examples dealt with in divorce cases are net operating loss (NOL) and capital loss carryforward. Other types of loss carryovers include suspended passive activity loss carryover and suspended loss carryover relating to Subchapter S Corporations. These are sometimes complicated tax areas but ones which divorce lawyers and their clients must be aware of due to the value of these carryforwards in the form of future income tax savings.
For example, a net operating loss from the operation of a business may be carried over to the following 20 years as a net operating loss deduction. If divorcing spouses filed a joint tax return for each year involved in figuring and reporting the NOL carryforwards, the NOL is treated as a joint NOL. Each spouse may then carryover to his or her separate return their share of the joint NOL creating future tax savings for each party assuming they each have business income that can be offset by the NOL deductions.
Capital loss carryovers are similar and much more common in that they result from losses on the sale of a capital asset, such as stocks or real estate, as opposed to the operation of a business. Capital losses are allowed to offset the gains from the sale of other capital assets plus up to $3,000 of ordinary income per year. Capital losses not deductible due to this limit may be deducted in subsequent years until fully utilized. When post divorce separate returns are filed after a net loss was reported on a joint return, the carryover is allocated to each party based on their individual losses from the proceeding years. If the losses were incurred from a joint asset, the losses are split equally and each spouse may carry forward his or her half of the loss to their post divorce income.
Ultimately, even if the loss carryovers cannot be divided between the parties, equally or otherwise, they provide a tangible economic benefit for the spouse receiving them. That benefit must be analyzed and, where possible, quantified when examining the post divorce economic circumstances of each spouse and each spouses’ opportunity for the future acquisition of capital assets and income.
In closing, tax benefits, specifically big losses could prove to be an asset to litigants during a divorce. Unlike Trump, those in divorce litigation are required to show their tax returns at some point during the process. The key is to make sure your attorney is versed on the tax laws that pertain to divorce, and that he or she takes full advantage of these taxbenefits that could make a significant difference in your settlement. To ignore them, as Trump would say, would be a disaster.
David C. Ainley is a Partner at Katz & Stefani.