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Tax Implications of Special Circumstances

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

Most tax matters are routine for individuals from year to year, but circumstances that can significantly impact someone's taxes may come up occasionally. Let's take a look at situations where a person might have major changes in his or her taxes.

Special Circumstances and Taxes

Bob is a financial planner who often advises clients who have experienced recent or ongoing special circumstances in their finances. Every year, we all file tax returns on our income, but, once in a while, we encounter some kind of major life event with which we don't have much experience. These unusual situations often involve tax considerations. Let's see what kind of guidance Bob gives to clients in these circumstances.

Audits and Fraud

Perhaps one of the biggest fears of Bob's clients is an audit of their taxes by the Internal Revenue Service (IRS). An audit is a detailed review of the records used to create a tax return and may occur randomly or because of specific triggers. Outright fraud as an attempt to illegally reduce the amount of taxes owed can be met with criminal penalties. Those with patterns of unusual financial activity or association with business partners who have unusual patterns or who are guilty of fraud may also be targeted for audits. If the taxpayer owes more money than was paid, the tax bill plus penalties will become due. An audit does not always result in a tax bill or penalty.

Bankruptcy

Occasionally, one of Bob's clients considers bankruptcy as a way to relieve the burden of crushing financial debts. Unfortunately, he must advise them that any taxes owed to the IRS typically cannot be discharged, or forgiven, in bankruptcy. If the IRS has placed a lien against a client's property, that problem will not be resolved with a bankruptcy filing.

It is possible under some circumstances to discharge back taxes, but a number of rules must be met to qualify. To do so, the taxes must be income taxes and the client must have filed a tax return. Other taxes like the self-employment tax or Social Security payroll withholdings cannot be discharged. There must be no fraud involved, and the taxes must be more than three years old. Finally, the IRS must have assessed the taxes at least 240 days before the client files for bankruptcy.

Death, Disability, and Divorce

Let's say that one of Bob's clients is a woman, Mary, whose husband, Bill, has just died. She needs to be aware of two potential tax issues at stake: filing status and the estate tax. Mary can still file her taxes jointly for the year her husband died. After that, she can file as a qualified widow for the next two years if she still has minor children and hasn't remarried.

For couples with a high net worth, the estate tax is another concern. If the husband's half of their net worth was more than $5.43 million in 2015, for example, the IRS would assess a tax on the amount of the estate above that number. Mary and Bill aren't near this limit, but if Bob's other clients are close to reaching the limit established by the IRS, he can suggest they reduce or eliminate an estate tax bill by giving away or spending money before death.

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