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Tax Fraud During Marriage Creates Big Problems in a Divorce

Many people who are self-employed will indulge in a culture of trying to pay Uncle Sam as little as possible, often dishonestly, by misrepresenting their business expenses so they are reporting very little income. The end result of this practice can have grave effects on both parties.

This scenario repeats itself over and over: parties with a small business who are doing well enough, after several (or many) years in business, who have new, paid off cars, a house or two that are nearly paid off, who have reported income as $15,000 per year for husband (wife reports no income, though she’s kept the books or manned the phones), and think they are doing well because the IRS hasn’t caught them yet.

Then, one of them decides on a divorce. Maybe Husband had an affair; maybe Wife feels neglected. What happens next?

That’s when the “in spouse” – who had, say, the license for the construction business, or Wife, who had the license for the accounting business, and who is going to end up with the business – will swear that the business only produced $15,000 a year. The “out spouse” will insist that the business made a couple hundred thousand a year, and wants the business valued and support ordered on that basis.

The “in spouse” provides the Court with tax returns, signed under penalty of perjury, as evidence supporting his position. The “out spouse” wants to subpoena years and years’ worth of banking records to present to the Court as evidence supporting her position… Hopefully, her attorney, at that point, tells her she’ll be providing evidence to the court that the parties have filed fraudulent tax returns for many years.

The “out spouse” then has two options:

 Lodge the bank records with the court as evidence, and risk the IRS catching wind of this and doing an audit. In the event of that audit, both parties will be assessed with substantial tax penalties and, perhaps, lose the houses, cars, and likely the business. Both parties should note that the tax authorities are taking an increasing interest in divorce proceedings, for precisely this reason.

  1. Accept support orders based on the actual reported income (which will be very little), accept a business valuation based on nearly no income from the business (which will be very little), take half the proceeds from the sale of the real property, and hope that she can find work that will pay above minimum wage.

Long term consequences for the “out spouse” if she does not present the records are poor indeed:

  1. Because her only job reference is her husband, she’s unlikely to be able to get a well-paying job which will meet her needs. As a result, each month she’s going to dip into the proceeds from the sale of the family residence until eventually it’s gone.
  2. She’s spent decades of her working life not contributing to social security, and so her social security benefit will be minimal (so will his benefits, but he got the business for nearly free, remember?) leading to a life in old age at the poverty level. Keep in mind that, even if she does not remarry before age 55, her derivative social security benefits from her ex-husband’s reported income will also be extremely minimal, because of those minimized tax returns.

Skilled and experienced counsel can, sometimes, thread this needle and get to a more equitable outcome – but not nearly as equitable an outcome as one in which we don’t have to worry about protecting our clients from the consequences of long-term tax fraud.

If you and/or your husband is self-employed, I strongly suggest you consider the following:

  1. Incorporate your business, and make sure you, and your husband, are receiving W-2 income from the business. Don’t take draws: take bonuses and pay taxes as you go.
  2. Report all of your income.
  3. Do not get greedy with your deductions.

Not only does this put you in a position of “rendering to Caesar that which is Caesar’s,” which means that even if you’re audited you need not fear the outcome; but it also protects you in the event of the fraying or loss of your marriage. That’s particularly true for the “out spouse,” but even if you are the “in spouse,” you need to keep in mind that a vengeful ex can potentially cause you to lose absolutely everything by going to the IRS. [1]

 

 

 


FN[1] Don’t let someone tell you that Innocent Spouse Relief under the Internal Revenue Service Code will solve all your problems.  If you’ve benefitted financially from the tax evasion, a) your assets are still at risk, and b) Innocent Spouse Relief is not a sure thing.