U.S. Individual Income Tax Returns (Form 1040)
Individual tax returns can provide a general picture of the parties’ financial standing and provide a road map to additional discovery. At the outset of the case, request copies of individual income returns and amended returns, if any, for the past five (5) years, including all supporting schedules and underlying documentation (W-2s, 1099s, K-1s). Also, ask if the client’s returns have been audited by the IRS and, if so, request a copy of the final audit report.
1040 Page 1
Filing Status Most married taxpayers file joint tax returns. If your client has consistently elected married filing separately status, inquire as to the reason. In some situations, it may be advantageous to file this way. However, in other situations it may indicate a desire on the part of one of the parties to keep financial information from the other.
Wages, Salaries, Tips A close look at a W-2 can provide a wealth of information above and beyond taxable wages.
- By comparing Box 1 (taxable wages) with Box 5 (Medicare wages), you can determine if there is income in excess of that reported as wages on the 1040.
- Income from nonqualified plans is reported in Box 11. This may indicate that one of the parties participates in a deferred compensation plan the balance of which would presumably be a marital asset.
- Box 12 provides valuable information about elective deferrals, specific types of income, and certain employer-provided benefits. The nature of the item is indicated by a letter next to the amount. Some of the more common entries in Box 12 are as follows:
C – Taxable cost of group-term life insurance over $50,000. Employer-provided life insurance is often used to secure child support and spousal support obligations.
D – Elective deferrals to a section 401(k) cash or deferred arrangement. Also includes deferrals under a SIMPLE retirement account that is part of a section 401(k) arrangement. You will want to request a copy of the most recent statement for the 401(k).
G – Elective deferrals and employer contributions (including non-elective deferrals) to a section 457(b)- deferred compensation plan indicating that there is a deferred compensation account to be considered in the division of assets.
V – Income from exercise of non-statutory stock options. If there is an amount in this box, you should request information concerning any other unexercised stock options including the date the options were granted, the date on which the options vest, the number of shares granted, the exercise price for each of the grants, and the expiration of each option.
W – Employer contributions (including amounts the employee elected to contribute using a section 125 (cafeteria plan) to your health savings account. Health savings plans are qualified plans and, as such, can be divided by qualified domestic relations orders.
AA and BB – Designated Roth contributions under section 401(k) 402(b) plans, respectively. Again, request the most recent statement showing the balance in the plan.
DD – Cost of employer-sponsored health coverage.
Taxable Refunds, Credits, Offsets for State and Local Income Taxes These are tax refunds from the State or City from the prior year. Two different things could have happened to this money. They were either (1) applied to the current tax year, or (2) they were refunded. If applied to the current year, the taxpayers can agree how to allocate to their separate tax returns. Be sure to address this in negotiations; it is a marital asset.
Other Income Miscellaneous income such as directors fees and consulting fees may be reported here and indicate business relationships that warrant further discovery. Gambling winnings are also reported on this line. If you see gambling winnings consistently, or suspect that a spouse may be a high roller, you may also wish to inquire about any “house accounts” held at local casinos. Individual records can be subpoenaed directly from the casino.
1040 Page 2
Payments Taxes withheld from wages are reported on page 2. Verify the amount of taxes withheld for the current year to date to determine if the taxpayer(s) have made significant changes in the historical level of withholding. Over-withholding of taxes can give rise to a significant refund, which may inure to the benefit of only one of the clients. This is a marital asset that should be considered in the settlement.
Estimated tax payments made during the year and amounts applied from the previous year’s return are also reported here. For those taxpayers required to make estimates, the payments are due quarterly on April 15, June 15, September 15, and January 15 of the following year. Be sure to inquire as to the amount of estimated taxes paid to date for the current year. As with overwithholding, excess estimated payments can give rise to an overlooked marital asst. Also, if the taxpayers are going to be divorced by the end of the year and thus filing separate returns, address how the estimated payments made during the year are going to be divided. If you don’t address it, the IRS will.
Refunds Overpayments of tax can either be refunded or applied to the next year’s return. If the refund is applied to the next year’s tax, the parties can allocate the refund against their respective tax liabilities as they deem appropriate. Again, if the parties do not agree, the IRS will determine how the refund is to be allocated
If an overpayment was refunded, make sure that it is accounted for either in a marital account or used for living expenses. Also, check to see if the refund was direct deposited in a known bank account.
Preparer’s Signature All paid preparers are required to sign individual income tax returns. Ask your client to authorize you to speak with the preparer regarding the returns and other financial issues. Frequent changes in preparers may be a red flag as to the accuracy of the returns.
Schedule A – Itemized Deductions
Interest Home mortgage interest is the most common interest deduction. A quick review of the deducted amount should indicate whether the expense is reasonable in relation to the known mortgage balance. If the deduction has increased from one year to the next, it may indicate that the principal residence has been further encumbered by a home equity loan or the parties may have acquired a second residence. Interest may be deducted on the taxpayers’ principal residence and one other home. Mortgage interest paid is reported on Form 1098.
A deduction for investment interest expense frequently indicates the existence of a margin loan in a brokerage account.
Taxes Paid Are the property taxes deducted appropriate for the known real property holdings of the parties? If none are deducted and the parties own the marital home, it may indicate a significant marital debt. Conversely, if the tax deduction is high in relation to the value of the home and local tax rates, it may indicate that the parties own additional real property.
Automobile license fees based on the value of the vehicle are deductible as ad valorem property taxes that should be commensurate with the value of the parties’ vehicles.
Miscellaneous Deductions If the parties have a safe deposit box, the annual fee will be reported here. You should inquire as to the contents and make sure that both parties are aware of its existence.
Schedule B – Dividends and Interest
This schedule is extremely useful in identifying bank accounts, brokerage accounts, and interest-bearing and/or dividend-paying investments. Reviewing the entries on Schedule B can assist in identifying bank accounts, money market accounts, bonds, and brokerage accounts at both the personal and the entity level (for pass-through entities).
If interest from a business owned by one of the parties is reported here, it probably means that there is a shareholder loan that should be taken into account as a marital asset.
Schedule C – Business Income
Schedule C is used to report the annual financial performance of sole proprietorships. The owner of the business, the nature of the business, and the accounting method used by the business are all reported on this schedule.
Schedule C businesses are great places for people to claim everyday life expenses (e.g., auto expenses, travel expenses, entertainment, office expense, etc.) as business expenses. If the claimed expenses appear to be inappropriate for the nature of the business, you may wish to challenge such expenses and attribute them back to the individual’s income.
If the expenses seem excessive in relation to the reported receipts, it may indicate that not all income has been reported. Many sole proprietorships have a significant number of cash transactions that can “fly under the IRS radar.”
Further investigation may be warranted if either the income or expenses seem questionable. You can then attempt to verify the amounts by requesting copies of checkbooks, electronic accounting systems, and receipts. Or, you may want to engage the services of a forensic accountant.
Schedule D and Form 8949 - Capital Gains and Losses
Any capital asset sold during the year is reported on Form 8949 and the total of all sales is carried to Schedule D. For each sale, the nature of asset (e.g., 100 shares IBM), the date and cost of the original purchase, and the date of sale and proceeds received is required to be reported. The proceeds may have been reinvested in other capital assets or converted to cash. If converted to cash, you may want to inquire as to the disposition of the proceeds.
A capital loss carryforward can be a valuable asset. Because taxpayers are limited to a $3,000 deduction annually, there may be significant losses that can be carried forward to future years. If the losses were generated jointly (e.g., from a joint brokerage account), the loss carryforward can be divided evenly between the parties. Under IRS regulations, the capital losses belong to the party who generated them. If only one of the parties is going to benefit from the carryforwards in the future, you may want to attribute value by using an assumed tax rate and an assumed period in which the losses will be used.
Schedule E – Rental Real Estate, Royalties, Partnerships, S Corporations, Trusts
Income from rents and royalties is reported on Page 1 of Schedule E. Significant information is provided regarding rental properties including, but not limited to:
- The address of the property
- Gross rents received
- Interest expense, which indicates there is an underlying debt on the property
- Depreciation expense, a non-cash expense which may be available to the owner as additional cash flow
- Potential personal expenses of the owner such as excess travel or vehicle expense
Royalties reported on Schedule E are often associated with publications, inventions, and oil and gas investments. The existence of royalties may indicate the existence of a valuable asset requiring further investigation.
Income or loss from partnerships, LLCs, and S corporations is reported on Page 2 of Schedule E. The IRS requires that all partners/shareholders be provided a K-1 from any entity in which they have an ownership interest. Information to be gleaned from a K-1 includes:
- Percentage ownership interests at the beginning of the year and the end of the year. Note any changes and determine the impact on the marital estate.
- Guaranteed payments to partners may indicate the existence of partnership agreements, which can be subpoenaed from the entity.
- Distributions and withdrawals, which may be either more or less than the income required to be included in the taxpayer’s income. This can be a critical factor in determining the actual amount of income available to pay support.
- Repayment of shareholder loans may indicate the existence of another marital asset. Request verification of the current balance of any shareholder loans.
- Capital contributions made during the year.
Income from trusts and estates reported on Page 2 of Schedule E can indicate the existence of significant inheritances. While the beneficiary may claim the interest as separate rather than marital property, this may provide an additional source of income available to pay child and/or spousal support.
Be sure to request copies of the tax returns for any entity reported on Schedule E!
If you have reason to believe the returns you have been provided may not be the actual returns filed, you can request tax returns (and amended returns) directly from the IRS using Form 4506 or 4506 T (for transcripts only). A power of attorney can be signed to enable consultants to contact the IRS directly to ask questions about historical taxes actually owed and paid versus taxes reportedly owed and paid.