THE TAX GAP IN DIVORCE

Every high-net-worth divorce has three professionals and two disclaimers.

The matrimonial litigator runs the case, drafts the agreement, and states — correctly, and usually in writing — that the firm does not provide tax advice. That is not a shortcoming. It is an accurate statement of the engagement and of the lawyer’s competence under the rules of professional conduct.

The forensic accountant traces assets, values the closely held business, and builds the schedule. That professional will also tell you, correctly, that a valuation is not a tax opinion and that characterizing a tax position is not what they were engaged to do.

Both are right. And between two correct disclaimers sits the largest single variable in what each spouse actually walks away with.

WHAT FALLS THROUGH

• Basis. Two assets on the schedule at $1,000,000 are not worth the same if one carries a $200,000 basis and the other a $900,000 basis.
• Recapture. Depreciation taken on a rental property is recaptured on sale, at a rate the schedule does not show.
• Suspended losses. Passive losses suspended under section 469 attach to the activity and to the taxpayer. Who keeps the property determines who keeps them.
• Built-in gain. A closely held entity holding appreciated assets carries a tax liability that is not on any balance sheet.
• Character. Ordinary income and long-term capital gain are not the same dollar, and the difference is often twenty points.
• Timing. An asset that cannot be sold without a tax event is worth less than one that can.

WHEN IT SURFACES

At the end. The schedule is built, offers have been exchanged, the marital settlement agreement is in draft, and someone finally asks the tax question. By then the negotiation has already been conducted on face values.

At that point the options are poor. Reopening a negotiated settlement to correct a tax assumption is expensive, slow, and frequently refused. So the more common outcome is that the party who discovers it simply absorbs it — and never learns how large it was.

THE ALTERNATIVE

Bring tax counsel in when the asset schedule is first assembled, before any offer is exchanged. At that stage every one of the items above is a variable that can be negotiated, traded, or structured around. The cost of looking early is a fraction of the cost of discovering late.

The firm is engaged as special counsel and works alongside the litigator and the forensic accountant. It does not take over the case and does not disturb the existing attorney-client relationship.

ELSEWHERE IN THIS SECTION

• Divorce Special Counsel — the overview, and how the engagement is scoped
• Testing Tax Claims Across the Table — An asserted tax consequence is a legal position, not a fact. It can be verified, and it is frequently wrong.
• After-Tax Value of Marital Assets — Basis, built-in gain, recapture and character — and why dividing the schedule down the middle is rarely an equal division.
• International Assets in a Marital Estate — Foreign trusts, PFICs, offshore holding companies and non-US pensions, where the penalty exposure can exceed the asset.
• Business & Entity Interests — Outside basis, debt allocation, built-in gain, and how the structure of a buyout decides who actually pays the tax.