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  • Constant W. Watson, III, CPA, CTRS

How Life Events Can Lead to Tax Problems

A taxpayer’s problems start in any number of ways, but it is seldom that a tax problem arises

from a taxpayer who intends to defraud the IRS. Most tax problem resolution cases begin with some serious life event that has a tax problem as a side effect.


Divorce

Divorce can result in unexpected tax liabilities. A spouse may start to receive alimony payments without being aware of the fact that this new form of income is taxable. A divorce settlement may involve the liquidation of some material assets that result in taxable gains. A division of property is often facilitated by converting assets to cash, like an insurance policy with the unexpected aspect of a tax liability. A taxpayer may be divorced near year end and find that taxes withheld from wages through the year were based on filing a joint tax return with several exemptions. Because of the new filing status, as a single taxpayer, they find themselves grossly under withheld and facing a large, unexpected balance due. This might happen at the same time the taxpayer is incurring significant expenses trying to get re-established in a new life. These situations can arise in the most amicable of divorces. When a divorce becomes adversarial or even hostile, other issues may further complicate a taxpayer’s ability to file their tax return timely and properly. If enough animosity is present, one spouse may withhold tax documents the other spouse needs to file a return or worse yet, may destroy tax and business records.


Loss of Employment

Loss of one’s job may cause unforeseen tax issues in multiple ways. A taxpayer collects

unemployment benefits after suffering the loss of a job. Because of their reduced income they might forego having tax withheld believing they need every penny to live on. When the year ends, they prepare their tax return only to learn there is a balance due. This starts a cycle of not filing, that often runs for years before the IRS pursues them to the point they have no choice but to try to get back on track. In another job loss scenario, a taxpayer withdraws funds from retirement accounts such as 401K plans or IRA accounts. They are attempting to maintain their old lifestyle while seeking new employment. They think that because of the loss of earnings they will have reduced tax liability and that they need to hold onto as much as possible of their income until the new job is found. Therefore, no taxes are withheld and the next tax return shows an unsurmountable balance due.


Forgiveness of Debt

Another instance where I find tax problems stemming from other events is when a forgiveness of debt occurs. Taxpayers are often shocked to find out that they owe taxes because they have suffered an economic reversal. For example, under the cancellation of debt rules, a problem that ended up in the loss of an asset through abandonment, foreclosure, or repossession can cost them tax dollars. The amount of debt that is cancelled or forgiven in these situations is treated as taxable income by the IRS. Note that there are exceptions to this rule that apply in bankruptcy and insolvency. Further, there is an exception that may apply if the forgiveness is related to a personal residence.


You don't have to navigate your tax problem on your own. Remember, for every tax problem, there is a solution.
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