When Does a Divorce Call for an Escrow Account?

An escrow account holds money with a neutral third party, usually in an interest-bearing account, until specific conditions are met. It is a private arrangement between the spouses. In a divorce, spouses sometimes set one up when the tax outcome of a joint return is not yet settled. The IRS might still be auditing a prior year, a position taken on an old return could be challenged, or neither spouse knows yet whether a joint business deduction will hold up.

A divorce decree does not change who the IRS can collect from. Both spouses who signed a joint return stay responsible for the tax, interest, and penalties tied to that return, even after the marriage ends. An escrow account gives one spouse a fund to draw on if the other spouse's share of a later tax bill goes unpaid.

What Does Joint and Several Liability Actually Mean?

Under the tax code, when a married couple files a joint return, the tax is figured on their combined income, and each spouse is responsible for the full amount, not a prorated share. This is called joint and several liability. It applies whether or not the couple later divorces, and whether or not a divorce decree assigns the taxes to only one spouse.

An escrow agreement is a contract between the spouses, enforceable in state court. It is not a contract with the IRS, so it cannot change the IRS's right to collect the full joint liability from either former spouse.

What If One Spouse Did Not Know About the Other's Tax Problem?

Three kinds of relief exist under the tax code for a spouse who signed a joint return but should not have to answer for part of it. Innocent spouse relief, under section 6015(b), can relieve a spouse of tax tied to the other spouse's unreported income or improper deductions if the requesting spouse did not know, and had no reason to know, about the error. Separation of liability, under section 6015(c), is open to spouses who are divorced, separated, or have not lived together for the past 12 months, and it divides an understated joint tax bill based on which spouse the items belonged to.

A third option, equitable relief under section 6015(f), covers situations that do not fit the first two, such as tax that was reported correctly on a joint return but left unpaid. All three types of relief are requested on the same form, Form 8857, and the IRS decides which type fits once it reviews the request.

The filing window is not open-ended. For innocent spouse relief and separation of liability, the deadline is 2 years after the date the IRS first begins a collection action against the spouse asking for relief. Equitable relief runs on a different clock. A request tied to tax that is still unpaid must be filed before the IRS's collection period for that tax expires. A request tied to tax that has already been paid must instead be filed within the window for claiming a refund of that payment.

Who Pays Tax on the Escrow Account's Interest?

Who reports the interest earned on the account generally follows who owns the escrowed funds, so the escrow agreement should spell that out. Divorcing spouses often assign that interest to whichever spouse deposited the money. Because the answer can depend on how the account and the underlying deposit are structured, a tax professional can look at the specific agreement before either spouse reports the interest.

Can an Indemnification Clause or Property Settlement Keep the IRS Away From One Spouse?

A divorce settlement can include an indemnification clause, where one spouse agrees to reimburse the other for tax liabilities tied to the first spouse's reporting. A property settlement agreement can likewise spell out which spouse answers for taxes owed on past joint returns. Both are legal agreements between the spouses, and one spouse can sue the other to enforce them.

Neither one limits the IRS's ability to collect the full joint liability from either spouse; that only changes through relief granted under section 6015 or through the IRS's own collection decisions.

What Are the Current Tax Rules for Property Divided in a Divorce?

Transfers of property between spouses, or between former spouses when the transfer is related to the divorce, generally trigger no taxable gain or loss. The spouse who receives the property takes over the giving spouse's cost basis, and the tax code counts the transfer as a gift, not a sale.

A later sale of a home carries its own rules. A single filer who meets the ownership and use tests can generally keep up to $250,000 of gain from selling a main home out of taxable income, and a married couple filing jointly can keep up to $500,000. A spouse who moved out under a divorce or separation agreement, while a former spouse stayed in the home and used it as a main residence, can generally still count that time toward the use test. An older rule had required reinvesting sale proceeds into a new home within two years to defer the gain; that rollover rule was repealed and does not apply to a home sale today.

How Is Alimony Taxed Now?

For a divorce or separation instrument signed after December 31, 2018, alimony is not deductible by the spouse who pays it and is not counted as income to the spouse who receives it. Instruments signed before 2019 generally keep the older treatment, deductible to the payer and income to the recipient, unless later modified to adopt the newer rule. Child support and noncash property settlements do not count as alimony for tax purposes, regardless of when the instrument was signed.

Can a Bankruptcy Filing Wipe Out These Debts?

A note from a property settlement behaves differently in bankruptcy depending on which chapter is filed. Since a 2005 change to the bankruptcy code, a debt owed to a spouse or former spouse from a divorce property settlement, if it is not a domestic support obligation, generally survives a Chapter 7 case. The debtor stays on the hook for it after the case closes.

A completed Chapter 13 plan works differently. The discharge a debtor gets after finishing all payments under a Chapter 13 plan does reach this kind of property-settlement debt. That discharge statute excepts only a specific list of paragraphs from section 523(a), and the property-settlement paragraph is not on that list.

One category stays owed in both chapters. A domestic support obligation, meaning amounts in the nature of alimony, maintenance, or child support, is excepted from both the Chapter 7 discharge and the Chapter 13 completion discharge.

A Hypothetical Example

Consider a hypothetical. John and Mary had filed joint tax returns every year of their marriage. John ran his own business. Mary did not. At the divorce, Mary worried about tax deficiencies that might surface later from John's business deductions, items she had no part in and no way to check. John agreed to deposit $5,000 into an interest-bearing escrow account for three years. If the IRS later assessed tax, interest, or penalties tied to his business reporting, the escrow would cover it, and whatever remained would go back to John at the end of the three years.

The escrow gave Mary a means to collect from John if a problem surfaced, but it did not change the IRS's underlying right to pursue either of them for the full joint liability. If Mary wanted a legal basis to be relieved of that liability, instead of a fund to draw from, she would need to look at innocent spouse relief or one of the other options under section 6015.