Episode 447: Partition Agreements and IRS Tax Filing Status

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It is important for taxpayers to understand how partition agreements and an IRS tax filing status are linked. The connection between the two can impact how a married couple files their tax returns and how it could potentially affect the non-debtor spouse.

In the case of married couples, partition agreements are legal documents that define the terms and conditions of the division of property between the two of them. Property can include real estate, bank accounts, and other valuable goods. Examples of partition agreements are prenuptial and postnuptial agreements. Partition agreements are essentially an agreement between the spouses on how to divide ownership and rights to their property. In Texas, any property that is earned or received, with some exceptions like inheritance, is considered community property, meaning both spouses have ownership rights over the whole. A partition agreement is typically used as a way for the spouses to state that they do not want Texas law to dictate ownership of the property, and they want to decide who owns what.

Today, it is not unusual to see couples entering partition agreements after they have married. The reasoning behind this movement is that it can allow the two individuals to have a say in how their property is divided up instead of letting default Texas community property laws decide. Certain pieces of property are defined as separate. This keeps property as “yours and mine” and eliminates the default “ours” factor.

Entering into a Partition Agreement

One of the most common questions we get about partition agreements is why someone would want to enter into one. The short answer is that there are a number of valid reasons, including:

1. People with a second marriage (who have children from a first marriage) may be worried about the consequences upon death (or the incapacitation) of one of the married partners, such that they want some of their money to go to their children. This may or may not occur if it is community property.

1. Married partners that no longer live together but do not wish to legally divorce.

1. In connection where partners are divorced and perhaps there is a reconciliation where the couple decides to reconcile but wants to have boundaries as to what each owns.

1. Estate planning purposes.

1. For creditor protection purposes so that the debts of a debtor-spouse do not attach to the non-debtor spouse, or the assets of a non-debtor’s spouse are not subject to claims from the creditors of a debtor-spouse. This can work fairly well when you partition them, if at the time you partition them there is no real debt problem. It works best if the spouses enter into a partition agreement prospectively so as to avoid the argument that this was done to defraud creditors.

It is worth noting that it can be hard for a creditor to set a partition aside unless the person already has a judgement against them or the partition agreement was signed well after the debt entered into collection actions.

Entering into Partition Agreement Before Marriage and Its Impact on Filing Taxes

If a partition agreement has already been signed, it is important to decide how to file your federal income taxes, especially if one spouse makes significantly more than the other.

If two spouses enter into a partition agreement that they have signed, executed and notarized, it usually does affect how we would advise them to file their tax returns. For example, if a couple has nothing but community property, community income and few debts, there is little reason not to file jointly. But there are financial complications which may need to be considered.

If you have a married couple with a diverse income in which one spouse makes one million dollars annually and the other spouse makes ten thousand dollars, they can still decide to share the income and it will be reported accordingly. This means they can still file a joint return and pay taxes on the whole amount. The benefit to this is typically money saving. Filing jointly often results in paying less tax than if filing separately. Yet it doesn’t have to be done this way. There may be important reasons for a couple to file separately.

 

Reasons for Changing Filing Status to “Married and Filing Separately” After Signing a Partition Agreement

There are some reasons for a couple to change their filing status to “married and filing separately” when a partition agreement comes into play, including:

• One spouse has a judgement against them that does not include the other spouse

• One spouse files bankruptcy

• One spouse is obligated into making financial disclosures to a government entity or creditor

• If a lesser earning spouse has aggressive creditors pursuing them

The goal is to prevent the debtor-spouse’s creditors from getting to the assets of the non-debtor spouse, especially in a case where the non-debtor spouse earns significantly more than the debtor-spouse. Filing jointly would be unwise in this case as it would give the creditors of the debtor-spouse access to financial information about the non-debtor spouse.

Why is this an issue? When creditors know how much the higher earning spouse makes, they could become much more aggressive in making the lesser earning spouse’s life miserable by threatening to take an annual deposition, demanding they respond to requests for production, or by garnishing what is in known bank accounts that the debtor-spouse may enjoy the benefits of. An aggressive creditor could put extreme pressure on the debtor-spouse to come up with money from somewhere, hoping they will dip into the higher earning spouse’s funds to appease the creditor.

If the creditor is the IRS, it can be a very good idea to file separately, because if the spouses file jointly, the IRS can keep any refund that the couple might have received and apply it towards the debt of the debtor-spouse. This means that any refund the non-debtor spouse would have received for money they alone contributed could be lost and the non-debtor spouse would lose out on the option to receive rightful refunds. By keeping property and debts separate, it can be possible to keep the IRS from withholding or garnishing any funds belonging to the non-debtor spouse.

 

Partition agreements and an IRS tax filing status are interconnected and can have far reaching implications. The best way to ensure your rights and your assets are protected is by enlisting the help of a trusted and reputable tax attorney before it is too late.

By Harold "Hap" May, P.C. on September 20, 2024   /   The Legal Play Podcast   /   Leave a comment