Use of Escrow Accounts: Divorce

How May Escrow Accounts Be Used In a Divorce Context?

An escrow agreement in conjunction with your divorce settlement can be a useful tool to guard against unknown tax contingencies. An escrow arrangement is the temporary holding of money (or other assets) by a third party in an interest-bearing account (usually) until all contingencies of a contract are satisfied. If you're going to use an escrow arrangement, you should be aware of both the legal and tax consequences.

When Is an Escrow Arrangement Warranted?

Escrow arrangements are especially useful when the tax consequences of a divorce-related transaction are unknown at the time of the divorce (e.g., rollover of gain on an involuntary conversion whereby the proceeds must be reinvested in another residence within two years to avoid gain recognition). Escrow arrangements are also useful to ensure that a particular spouse will pay the IRS for any unpaid taxes due on a joint return after a divorce has been finalized. Either party of the joint return can be held liable for any tax deficiency (in the eyes of the IRS).

Example(s):  Assume John and Mary have always filed joint returns. John owns his own business, while Mary is a homemaker.  Mary does not want to be held liable by the IRS for questionable business deductions or unreported business income attributable to John. Consequently, John agrees to deposit $5,000 into an interest-bearing escrow account to be held for a period of three years. The money will be applied to any tax deficiencies, interest, and penalties due as a result of John's federal income tax errors and omissions regarding the joint tax returns. At the end of three years, the money (plus interest) will be returned to John.

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What Are The Legal And Tax Ramifications of Escrow Arrangements?

When an escrow arrangement is established pursuant to a separation or divorce agreement, it constitutes a legal contract recognized by state courts as a means of enforcing obligations between the spouses. However, such a contract can't prevent the IRS from collecting the entire joint tax return deficiency from either spouse. A joint tax return generally obligates you to be held individually responsible for the accuracy of the return, even if your spouse earned all of the income and made financial decisions without your knowledge. (Although in certain circumstances, you may be eligible for innocent spouse relief.) For this reason, an escrow agreement can prove invaluable--it ensures that funds will be available to pay the IRS if a problem arises. If you draw up an escrow agreement, you should decide how interest accruing on the account should be divided. In most cases, interest will be assigned to the spouse who deposited the money into the account.

Tip:  It's sometimes difficult to come up with a reasonable sum of money to deposit into the escrow account. If the tax bill were known ahead of time, it probably would have been paid.

Are There Any Other Ways to Avoid Paying Another Spouse's Tax After A Divorce?

Ideally, your property settlement agreement should describe each spouse's responsibility for unpaid taxes attributable to the years covered by joint returns. Instead of using escrow arrangements, you might consider inserting an indemnification clause in the divorce agreement whereby your spouse agrees to reimburse you for all tax liabilities related to his or her failure to report and pay tax due on the joint returns. However, this will work only if you are able to collect the money from your spouse. And again, although the clause constitutes a legal agreement, it doesn't affect the IRS's ability to seek payment from either spouse.

Tip:  In terms of collecting money from your former spouse, you should also consider that property settlement notes (or IOUs) are dangerous. A property settlement note can be discharged in bankruptcy, whereas alimony and child support payments cannot.