September 1, 2014
The tax return is a valuable tool in divorce. It contains a variety of information that helps us find or verify financial data. Here aresome examples of how to mine the federal tax return:
1. Schedule A: this form lists many different deductions. One often-overlooked item is on line 23, where you can deduct the expense of a safe-deposit box. If you see such a deduction be sure to ask about the contents of the box.
2. Schedule B: this form lists interest and dividends earned from taxable investment accounts. Match each account listed to your list of the party’s assets to make sure you’ve captured all accounts (note: not all taxable accounts earn interest and dividends, but this is one way to find an account the party may have overlooked on the Financial Affidavit.) Ideally you should compare Schedule B for 3 years to look for accounts that show up one year but not the next – what happened to that account? Now look at Form 1040 line 8b which shows non-taxable interest. Just as with taxable interest, this figure should tie into an account listed in the party’s assets. In addition to investment accounts you might find income from a partnership, real estate investment trust or other “K-1” type assets.
3. Schedule C: if the person is a self-employed sole proprietor they will list their business income and expenses on this form. Pay close attention to the deductions: is the party taking a deduction for personal expenses (such as a cell phone or utilities)? If so these should be added back to the net income to get a better idea of the true income of the business owner. Also make sure these same items are not showing up as expenses on the Financial Affidavit (since they are paid from the business.) Likewise any depreciation and other non-cash expense (such as a home office expense deduction) should be added back to net income to get a better idea of the discretionary income of the owner.
4. Schedule D: do you see a capital gain or loss? This denotes the existence of an investment account or other capital asset that was sold. What happened to the proceeds? They should be accounted for. Also look for losses that are being carried forward to next year – these are considered an asset and may possibly be divided between the spouses.
5. Schedule E: This form is used to show the income and expenses of a partnership or trust. The value of that partnership or trust should be included as a marital asset.
6. Passive losses: Some activities (such as owning rental real estate) are considered “passive” and losses generated by the activity cannot be deducted and instead are carried forward until the asset is sold. This is an important consideration when valuing the asset.
7. W2: A copy of the W2 must accompany the tax return. This form will show deductions for tax-deferred company accounts such as a 401(k), 403(b) or Deferred Compensation Plan: accounts which should be on the asset list. Speaking of tax deferred accounts, look on Form 1040 Line 15 and 16 for withdrawals from IRAs or other tax-deferred accounts, and make sure you know where that money went.
It is useful to compare the tax return to a recent loan application (within the past 5 years.) Most people want to look good financially when taking out a loan and will include every asset on the application. You might find assets here that don’t show up on the tax return.
This is a short and incomplete list of how to “read” a tax return. The information it contains is vast, and should not be overlooked. Have an accountant or financial planner review this, especially if you feel some assets may have been overlooked.
