Q&A Topic: Tax Implications of Divorce in New York
James J. Nolletti, Esq.,
Q. If a stay at home spouse signed joint tax returns during the marriage and it turned out that the moneyed spouse was under-reporting income or making fraudulent claims, can the innocent spouse be protected from prosecution?
A. There are two issues: One is criminal prosecution and one would be civil prosecution with respect to the taxes owed. Many married taxpayers file joint tax returns because of the financial advantages this filing status allows them. However, when married taxpayers file jointly, both taxpayers are jointly, as well as individually, responsible for the tax and any interest or penalty due on a joint return, even if they later divorce. This is true even if a divorce decree or judgment states that one of the spouses will be responsible for any amounts due on the previously filed income tax returns. One spouse may be held responsible for all the tax, even if all the income was earned by the other spouse. Thus, filing a joint return during a marriage and after separation presents spouses with risks that they must consider and protect themselves against.
The Internal Revenue Code offers possible remedies for spouses who find themselves in the position of defending an improper or erroneous joint tax return. It’s collectively referred to as Innocent Spouse Relief.
By requesting Innocent Spouse Relief, a joint taxpayer can be relieved of responsibility for paying tax, interest and penalties where their spouse or former spouse has improperly reported items or omitted items on their joint tax return. Generally, the tax, interest and penalties that qualify for relief can only be collected from the spouse or former spouse who misreported. To qualify for this Innocent Spouse Relief, a taxpayer must meet certain fairly strict requirements set forth in the Internal Revenue Code, but if they do meet them, they can get that status and therefore not be responsible to the government to pay those taxes, penalties and interest.
Q. Let’s talk a little bit about business partnerships. Should you tax affect earnings that pass-through entities like general partnerships, limited partnerships or limited liability companies in the case of divorce?
A. Yes, tax affecting the earnings of pass-through entities can have a profound effect on the valuation of the entities. Taxes play an important role in valuing a business for any purpose, including divorce, as taxes can reduce the value by as much as 40%.
To understand the role of taxes in valuation, one needs to step back and review the technical part of valuation. Most valuations have three moving parts: Future cash flow streams, expected future growth of those cash flows, and a required rate of return to attract an investor to the risks associated with the future cash flows and growth. A sound valuation has to match apples with apples. That is, when applying the required rate of return to the cash flows, whether in the form of a multiplier or a “discount rate” or a “capitalization rate,” both the cash flows and the risk factor must treat taxes the same way. Otherwise, one will likely misvalue the entity.
On a more granular level, valuation analysts build up a required rate of return by including, among other factors, the yield that an investor would receive on an investment, for example, in publicly traded stock. That yield is generally net of taxes, or as we say “tax-impacted,” and thus, it can only be applied to tax-impacted cash flow streams. So even if a pass-through entity does not pay entity level taxes, the normalization process burdens those cash flows with a hypothetical tax expense so that the tax-impacted risk factor—whether a multiplier, discount rate or capitalization rate—is “apples to apples.”
Q. Do you always work with business valuators and tax experts, and how do you go about selecting those professionals if you do?
A. I think one of the most important things any experienced lawyer must know is their limitations. You can’t be an expert in everything. When you have high asset or high net worth clients, it is extremely important to have a team of qualified tax lawyers and forensic accountants doing your valuations and tax work. Over the years, I’ve been fortunate to work with many of the top such experts in the New York area, and I’ve learned quite a bit. But yes, they are a necessity in many of these cases.
Q. You seem to have a very keen interest in this subject matter. What have you done—beyond consulting with your team of experts—to stay abreast of the latest tax information and help your clients?
A. Yes, I do have a very deep interest in this area, and it’s why I am a founding member of the New York Chapter of the American Academy of Certified Financial Litigators. We spend time and effort educating ourselves, and others, on some of these concepts, but that still doesn’t make us a forensic accountant or a tax lawyer.
About Nolletti Law Group
James Nolletti is an accomplished negotiator and litigator with almost four decades of wide-ranging experience in matrimonial and family law cases. He is the founder of Nolletti Law Group, a firm focused exclusively on the unique needs of its divorce and family law clients. Formerly, Mr. Nolletti was the supervising partner of the family law and matrimonial litigation practice at the White Plains firm of Collier, Halpern, Newberg & Nolletti. James Nolletti began his career as a criminal trial prosecutor in the Westchester County District Attorney’s Office and has since represented clients in numerous and notable cases at both the trial and appellate court levels.
A Fellow of The American Academy of Matrimonial Lawyers and the International Academy of Family Lawyers, he has earned board certification as a family law trial advocate from the National Board of Trial Advocacy (NBTA) and has maintained the highest Martindale-Hubbell peer review rating for ethical standards and legal ability. Mr. Nolletti is included among those selected on the list of Super Lawyers published in The New York Times, and he has also been selected by peers for inclusion in successive editions of Best Lawyers in America, Family Law Practice Area. He is a founding member of the New York Chapter of the American Academy of Certified Financial Litigators (AACFL), a group of divorce litigators dedicated to professional development and effective advocacy in cases involving complex financial matters. He has served as a member of the Board of Managers of the New York Chapter of the American Academy of Matrimonial Lawyers, as well as the Board of Editors for the Journal of the American Academy of Matrimonial Lawyers (JAAML). Mr. Nolletti has also served on the Executive Committee of the Westchester County Bar Association Family Law Section, and is the author of “Exploring Decisions and Developments that Impact the Practice Today and Tomorrow Inside the Minds,” which appeared in the 2010 edition of Strategies for Family Law in New York, and co-author of “Preparing Clients for Custody Evaluation: A Call for Critical Examination,” which appeared in Volume 27, 2015 of The Journal of the American Academy of Matrimonial Lawyers, with Jonathan W. Gould, Ph. D, ABPP. James Nolletti received his J.D. from Fordham Law School upon achieving a B.A. at Villanova University.
James J. Nolletti, Esq.
Nolletti Law Group PLLC
1 North Lexington Avenue, 15th Floor, White Plains, NY 10601