Post Divorce Planning Articles
- Planning for Divorce - Part I
- Planning for Divorce - Part II
- Partial Checklist of Actions as a Result of Divorce
| Published in WG&L Practical Tax Strategies, December 2002 Copyright, 2002 John J. Scroggin, J.D., LL.M., All Rights Reserved. |
"I guess about the only way to stop divorce is to stop marriage."
Will Rogers
Most divorces are largely unplanned. More often then not, emotion, not reasoned self-interest governs the decision process. Unfortunately, this is also an area of self-inflicted damage by clients and their unwary advisors.
Divorce remains an unfortunate reality for many of our clients. In the fall of 2000 Time Magazine [1] ran a lead article that discussed the impact of divorce in America. The article noted that roughly 49% of all U.S. marriages end in divorce. The highest number of divorces occur in the third year of marriage. On average, divorces in second marriages generally occur by the sixth year, while most divorces in first marriages occur by the eighth year.
These statistics are a demographic fact which is often ignored in the planning process. Every plan needs to address the possibility that the client or an heir will face a future divorce. While the discussion may be awkward for the client and advisors, it is an unpleasant prospect which should be strongly addressed. There have been numerous articles which have discussed the rules governing alimony deductions, property settlements and child support. [2] This article will mainly focus on planning areas which have received less scrutiny. To aid your own research, we have provided information on additional research materials.
Income Taxes and Divorce
The focus of most planning for divorce is on the income tax issues of alimony, child support and property settlements. The rules are generally straightforward.
Alimony . Properly structured, alimony payments are considered gross income to the recipient [3] and are deductible to the payor. [4] To qualify as alimony all of the following must occur: [5]
The payment must be made in cash,
The payment must be made pursuant to a divorce or written separation agreement,
If divorced or legally separated, the couple must live in separate households,
Payments made on behalf of the recipient spouse to a third party must be evidenced by a timely executed document,
The payor's obligation to make the payment terminates at the recipient's death,
The couple do not file a joint return, and
The divorce or separation agreement does not provide that the payments are not considered alimony.
Normally, the payor ex-spouse does not have to withhold taxes on the alimony payments. It is the responsibility of the recipient ex-spouse to make sure sufficient taxes have been withheld or estimated taxes have been paid. If the recipient spouse is a nonresident alien, a withholding tax may be imposed on the alimony payments. [6] However, review any tax treaty between the US and the recipient's country of residence because it could override the requirements for withholding.
While the alimony rules seem fairly straightforward, this is one area where drafting documents without proper tax advice can have disturbing consequences. For example, the Tax Court in Croteau [7] a taxpayer drafted his own settlement agreement using someone else's agreement as a format. Because of improper language, the Court ruled that $34,000 in "alimony" payments were instead a non-deductible property settlement. Not only did the husband lose a $34,000 deduction, the Court also imposed an accuracy related penalty also.
It should also be noted that alimony which remains uncollected at the recipient's death is considered income in respect of a decedent [8] and can result in the imposition of both estate and income taxes at the death of the recipient.
Child Support . Payments designated as child support are not deducible by the payor or taxable to the recipient parent. [9] A payment is deemed for child support if any one of the following occur:
The divorce agreement designates it as child support, or
The payment reduces at times tied to a child's pivotal birthdays (e.g., age 18), or
The payment reduces when an event occurs to the child (e.g., marriage), or
The payment reduces at a time clearly associated with a child related event.
A related issue to child support is deciding which parent receives the dependency exemption for the child. Assuming all of the dependency exemption requirements are meet, [10] the parents can decide among themselves which of them are entitled to the exemption for a minor child. However, once the child reaches majority, the parent claiming the dependency exemption must supply over 50% of the child's support. [11]
While the parent in the higher income tax bracket will normally receive the greater tax benefit for the dependency exemption, the phase-out of the exemption for higher income taxpayers should be taken into account. In addition, in order the claim either the Hope Scholarship Credit or the Lifetime Learning Credit for a child, the taxpayer must be entitled to claim the child as a dependent.[12]
Property Transfers . Most property transfers which are "incident to divorce" are not taxable to either spouse. [13] However, there are some situations in which income taxes will be imposed, including:
A stock redemption as a result of a divorce may be taxable. See the later discussion in this article.
If a property settlement is made with a non-resident alien, section 1041 does not apply and the transfer may be a taxable event. [14]
A direct transfer of property to a divorcing spouse is not taxable even when the liabilities secured by the property exceed the transferor's basis in the property. However, if the transfer of the same property is made to a trust for the benefit of the divorcing spouse, the difference between the secured liability and the basis in the property may be taxable to the transferor. [15]
Accrued interest on Series E and EE US Savings Bonds must be recognized by the transferor of the bonds, even when the transfer is a part of the divorce. [16]
Many divorcing spouses make settlement payments over a number of years. Any interest on an installment obligation will be taxable to the recipient spouse. [17]
In a recent ruling [18] , the IRS ruled that the transfer of non-qualified stock options and deferred compensation to a spouse incidental to a divorce did not result in any taxable income to the employed spouse who made the transfer. In addition, the transferee spouse was taxable on the options and deferred compensation only when benefits were received.
Redemptions in Contemplation of Divorce . In many cases, a couple have either owned a business interest together, or part of the business interest is transferred as a result of the divorce. Having an ex-spouse as a partner is not usually a good idea and often the spouse most active in the business wants to buy out the interest of the ex-spouse. If the active business owner has a legal obligation to acquire the business interest of the ex-spouse, but has the business redeem the interest, the business owner, not the ex-spouse may be taxable on the redemption. In Arnes v. U.S., [19] the Ninth Circuit Court of Appeals ruled that a stock redemption as a part of a divorce was taxable to the business owner, not the ex-spouse whose stock was redeemed, because, under the terms of the divorce decree, the business owner had a obligation to redeem the stock interest. [20]
The IRS has issued proposed regulations [21] which address the issue of income taxation resulting from stock redemptions which are created by a divorce. Effectively the proposed regulations provide that if a business owner has an obligation to purchase the stock transferred to a divorcing spouse and the stock is redeemed by the corporation, the business owner will be treated as the seller of the stock.
In general, the treatment of a stock redemption as a sale by the business owner is highly disadvantageous to the business owner:
If the business is a C corporation, the business owner will generally continue to hold significant interests in the corporation after the redemption, making it extremely hard to qualify for capital gain treatment under IRC section 302 or 303. The resulting treatment of the distribution as a constructive dividend means the business owner may be taxed at ordinary federal income tax rates (as high as 38.6% in 2002), while the ex-spouse might have received capital gain treatment at a rate as low as 10%.
The business owner may be taxed on 100% of the redemption cost, while the ex-spouse receives 100% of the funds. Thus, the business owner must pay the tax cost of the redemption with other funds.
In many cases, the business cannot afford to redeem the ex-spouse's stock in one cash payment and will use the installment method to pay redemption cost over time. The recipient spouse is taxed as the funds are received. However, if the transaction is treated as a deemed distribution to the business owner, the installment method may be lost, because the transaction may be treated as a taxable dividend. [22]
What is the answer? Careful drafting is critical, including:
The parties should first evaluate the best after tax result by comparing the relative tax costs to each of them upon divorce.
The agreement should clearly state how the parties intend to treat any redemption for income tax purposes.
The agreement should provide that if the couple's approach is not recognized by the IRS, the party who is not taxed has an obligation of assuming part or all of the tax cost.
Under no condition should the business owner have any personal obligation to buy the stock or guaranty the company's obligation to purchase the stock.
Many state statues provide that a redemption of stock cannot be made if they would result in the corporation being insolvent. [23] Before entering into an agreement, counsel for both parties should evaluate the impact of a redemption on the business's financial statement.
If the business operates as a C Corporation and intends to distribute an appreciated asset, the redemption could result in a taxable cost to the corporation. [24]
If the business operates as a C Corporation the parties should be careful to make sure the transaction is treated as capital gain transaction under IRC section 302 or 303. If the redemption fails to meet the these rules, sales proceeds could be treated as ordinary income (i.e., a dividend) to the deemed seller.
Basis on Divorce Assets . The basis of assets transferred as a result of divorce should be an important past of the negotiating process. The following general rules apply:
In general, lifetime, non-taxable divorce-driven property transfers between spouses result in the recipient spouse receiving the basis of the transferor. [25]
If the property transferred directly to an ex-spouse has a liability in excess of its basis, no recognition occurs on the transfer and the recipient spouse takes the transferor spouse's basis. [26]
If the property is passive activity property, any suspended passive activity losses for the property are added to the basis of the property. [27]
Finally, although the basis in most gifts transfers is the lesser of the asset's fair market value or its basis, this limitation is not applicable to divorce or separation transfers. [28]
The holding period of the transferor also carries over to the transferee spouse. [29]
Divorce negotiations should take into account the after-tax value of an asset, not its fair market value. For example, assume a client has a choice between taking $1.0 million in cash or $1.1 million in stock which has a basis of $1,000. Which is the better option? For tax purposes (assuming an immediate stock sale), the $1.0 million in cash is a better choice. Why? Assuming a combined state and federal capital gains rate of 25%, the $1.1 million is stock carries an inherent tax cost of roughly $275,000, meaning the asset has a true after-tax value of only $825,000.
The divorce decree should also require that the transferor spouse provide the transferee spouse sufficient records to support both the basis of the property and its holding period. Without such information, the IRS could challenge the client's assertions and an ex-spouse may not be cooperative in providing the information. [30]
Deducting Legal Fees . Normally, the cost of personal, non-tax related legal advice is not a deductible expense. Thus, most legal expenses incurred in a divorce are not deductible. [31] However, if the legal costs are incurred by the taxpayer in order to obtain or force payment of taxable alimony (or an increase in taxable alimony) the costs will be deductible. [32] Tax advice obtained in the course of the divorce may also be deductible. [33]
However, the legal fees of the spouse paying the alimony, or attempting to reduce the amount of alimony are not generally deductible. [34] Moreover, if the spouse paying the alimony is also paying the legal fees of the ex-spouse, the fees will not be deductible. Therefore, it may make sense to have the ex-spouse be responsible for his or her own legal fees and just increase the alimony payment (a deduction for the paying ex-spouse) to cover the additional cost.
Payment of legal fees to determine child support and property settlements are not generally deductible, because they are treated as personal, non-income related expenses. The cost of preparing pre-nuptial agreements would probably fall into the same category of personal, non-deductible expenses.
In any divorce, the legal services may involve a number of areas. The divorce attorney should be encouraged to allocate appropriate portions of the legal costs to deduction-related alimony and tax issues. [35] Unfortunately, there are no specific rules governing such allocations and if the allocation is too aggressively bent to providing deductions to the client, the IRS or the courts may impose their own opinion of a more reasonable allocation. Accurate and detailed time records will be a pivotal part of any final determination.
If deductible, the legal fees are shown as an miscellaneous itemized deduction on the taxpayer's Schedule A. Only the expenses in excess of 2% if the taxpayer's adjusted gross income are deductible [36] and may be reduced by the reduction of itemized deductions for high income taxpayers. [37]
Innocent Spouse Relief . Many a divorced spouse has been surprised to discover their former loved one was not altogether honest about paying taxes. Unfortunately, if a joint return was signed, the IRS may be calling upon the "innocent" spouse to pay the couple's taxes, penalties and interest. In 1998 Congress greatly broadened the rules protecting innocent spouses. [38] On July 18, 2002, the IRS issued final regulations under the new rules. [39]
Even when the spouse is declared an innocent spouse for liability purposes, the IRS can claim that property transfers from the tax-burdened ex-spouse should be subject to recession and, therefore, subject to the unpaid tax liability. While most property transfers between spouses are treated as "disqualified" transfers (and subject to seizure for the payment of taxes of the transferor spouse), transfers under divorce or separation agreements are generally presumed to be valid. In such cases, the IRS bears the burden of showing that the payment was disqualified. This may be one situation in which the less the transferee spouse knows of the tax problems of the transferor spouse, the better.
Other Income Tax Planning
There are other income tax planning which clients should be aware of before finalizing their divorce, including:
Personal Residence . If the principal residence is to be sold, a single taxpayer recognizes no gain on the first $250,000 of realized gain. [40] But what if the house had more than $250,000 in gain? The couple may exclude up to $500,000 in taxable gain from the sale. If the house is not owned jointly [41] or one of the ex-spouses does not qualify for the exclusion [42] , delaying divorce till after the year of the sale of the principal residence could remove up to an additional $250,000 from the taxable income of the selling spouse. To qualify for the larger exemption, a joint return must be filed. In order to file a joint return, the couple must be married on December 31 st of the year of sale. As a result, the divorce would have to be finalized after the year end in which the sale occurred.
There may be better alternatives. For example, assume only one spouse owned the house and the expected gain exceeds $250,000. During the marriage the house could be placed in joint names, with the divorce decree providing that only one of them retained the right to use it. The residential use of the property by a former spouse stills qualifies the exclusion for the ex-spouse who has no use of the property [43] , producing a $500,0000 exclusion.
Year End Marital Status . The tax status of a taxpayer is determined as of the end of the tax year. [44] If the couple are divorced, legally separated or the "abandoned spouse" rule [45] applies, a joint income tax return cannot be filed. If the tax savings are significant, a settlement agreement could be entered into before year end, with the divorce decree being effective after the end of the year. [46] Among the considerations are:
A client may have a lower income tax cost from filing as married rather than single. As a part of any amicable divorce (and perhaps as a negotiating position in less amicable divorces), the income tax savings of remaining legally married until the end of the year should be examined.
If the delay can be arranged, the higher income taxpayer should consider accelerating income into the current tax year and delaying deductions until the following year. While projections must be run, such a move could lower the overall taxes.
There are also some disadvantages to filing a joint return. First, alimony deductions are not available. If the wealthier spouse is in a higher income tax bracket (e.g., 38.6% in 2002) and the other spouse is in a lower tax bracket (e.g., 15%), the payment of alimony can provide a significant tax savings to both spouses. Second, if a spouse signs the return, he or she has joint and several liability for the return. However, if such a decision is made, the spouses may want to file a "separate liability election" [47] which states that neither has liability for the other's tax reporting or taxes. Last, if both spouses have significant income, the "marriage penalty" and the loss of tax benefits at higher levels of income may actually mean that filing a joint return creates a higher level of income taxation.
IRA Contributions . For purposes of qualifying for IRA contributions, alimony payments are treated as earned income. [48] Assume a non-working spouse is getting divorced. Allocating a portion of any "property" settlement as long term alimony (e.g, $3,000 per year) would both create an income tax deduction for the payor and allow the payee to receive a tax-deductible IRA contribution.
Pre-Divorce Agreements, Wills and Trusts
Probably the last thing an engaged couples cares to do is meet with their paranoid lawyers to discuss the possibility of their premature death, incapacity or divorce. It should also be a vital part of the preparation for marriage.
Martial Agreements . Prenuptial agreements tend to take a bit of the romance out of the first marriage, but by the second or third marriage the historic reality of divorce often creates a different perspective. Prenuptial agreements have become a significant part of the estate planning and asset protection process. The agreement must be carefully drafted. Among the ways to increase the enforceability of the prenuptial agreement are: [49]
Pre-nuptial are governed by state law and the law governing pre-nuptial agreements is still developing in most states. Make sure the agreement addresses the unique requirements and rulings in the domiciliary state of the couple.
Make sure that the pre-nuptial thoroughly discloses the assets and liabilities of each person. Be as specific as possible. Listing specific account numbers and the date of valuation may be an important element when a judge or jury subsequently reviews the agreement. If a client anticipates a sizable inheritance, it may even be advisable to disclose the existence and possible ranges of value of such an inheritance.
Make sure that each party has competent legal representation in the development of the agreement. A court might rule that the less wealthy spouse lacked an adequate understanding of the agreement because competent counsel was absent. One attorney should never represent both parties. It might even make sense to have the signing of the document videotaped to show that each party was represented by counsel who thoroughly explained the document to the client.
Sign the agreement well in advance of the marriage. If one of the spouses has not had adequate time to review the agreement (e.g., it is delivered the day of the marriage), the court could focus on whether the signature was coerced and invalidate the agreement.
The agreement should not create a "unconscionable" result. This is an ambiguous concept at best [50] , but planners must take into account the potential review of the court as to the fairness and reasonableness of the document.
Make sure the agreement provides for relinquishment not only of rights in divorce, but also deals with the rights of either spouse against the estate of a deceased spouse. [51] Many states give a surviving spouse the right to be supported by the estate, even when the spouse is not listed as a beneficiary in the decedent's will.
In a series of decisions [52] , the federal courts have ruled that a spouse's right to an ERISA retirement plan cannot be waived prior to the marriage of the parties. Thus, if the parties intend for such waiver, a renunciation of such rights should be signed after the marriage occurs. A waiver before marriage may be void. However, although the waiver may not be effective upon the death of the plan participant, it might be effective upon the divorce of the parties. [53] Note that the ERISA rules do not apply to IRA accounts [54] and, if permitted by state law, rights in an IRA account could be waived before the marriage.
A growing phenomenon has been the development of post-nuptial agreements. [55] These agreements are drafted after marriage and provide for the treatment if the parties subsequently divorce. In most cases, they are a result of some traumatic event in the marriage (e.g. an affair) and the case law around them is still being developed. Such agreements are similar to legal separation agreements, but rather than focusing on separation, they are designed to foster reconciliation. They can also be a punitive mechanism fostered upon a wayward spouse who is unwilling to terminate the marriage.
New Planning Documents . Marriage necessitates a evaluation of whether the couples should revise all of their estate planning documents. Before the marriage, clients should carefully consider whether changes are appropriate in their designations of the decision makers in their medical and general powers of attorney (i.e., should the new spouse be appointed?). Beneficiary designations on retirement plans, annuities, life insurance and other assets should be reviewed. The client should determine whether to add the new spouse to any health care benefits.
In most cases, the clients are well advised to review and modify their wills. Among the reasons for adopting new wills are:
In some states, marriage automatically revokes all previous wills which were not drafted in contemplation of marriage. This can create some unique legal conflicts. For example, if one of the newly married spouses dies, the marriage revocation will result in an intestate estate. If there are no children, the new spouse could inherit 100% of the estate. [56] If there are children, then the children and the new spouse may share in the estate as intestate heirs.
There could be difficulties even if the couple signed a pre-nuptial agreement but failed to sign new wills. For examples, assume a couple married and neither had children. Both are injured in a car accident. The wealthier wife dies at the scene and the husband dies the next morning. Under the intestacy laws of most states, the husband inherits 100% of the wealthier spouse's assets for the few hours of his life. The only intestate heir of the husband is his family who have a financial incentive (i.e., 100% of the wife's assets) to argue that the pre-nuptial agreement did not govern intestate rights which could not accrue until after the marriage. [57]
The possible automatic revocation of an existing will eliminates the disposition and tax provisions of the couples' prior wills. Thus, bypass/unified credit trusts, generation skipping trusts, provisions for supplemental trusts for handicapped heirs, trusts for minor or spendthrift heirs and similar provisions would cease to exist as of the date of the new marriage.
If there is no will, the surviving spouse becomes the most natural representative of the intestate estate, giving the spouse greater authority in the fight over the enforceability of any pre-nuptial agreement and/or post-death support rights. If a new will is executed, because of potential conflicts of interest, a new spouse should probably not be appointed as the new representative of the estate.
Even if the will disinherits the surviving spouse, the spouse may still have a right to make "elective share" claims against the estate of the deceased spouse. Such rights vary widely from state to state but can provide substantial benefits to the surviving spouse and often cannot be taken away by a decedent's will. A pre-nuptial agreement can waive such rights. [58]
Pre-Divorce Trusts . Traditionally, states have not allowed individuals to set up "self-funded" spendthrift trusts. That is, the grantor of a trust was not allowed to set up a trust against which his creditors (including a divorcing spouse) could not make claim. As a result many clients have created overseas asset protection trusts to restrict the claims of future creditors. A number of states [59] in the last few years have begun changing these rules to allow limited protection for a grantor of such trust. For example, in Delaware, the statute provides that claims by a spouse at the time of the creation of the trust remain, but the claims by someone who married the grantor after the trust was created may not have a claim against the trust assets. [60] Alaska allows the creation of self-funded spendthrift trusts, which deny spousal claims even if the marriage existed at the time of the trust's creation. [61] This may open up the opportunity for a client to create a pre-marriage self-funded spendthrift trust which is protected from a new spouse without using an unromantic prenuptial agreement.
While a comparison of the state and foreign trust rules are beyond the scope of this article, planners should carefully consider the advantages and disadvantages of creating self-funded spendthrift trusts in one of the states which offer greater creditor protection. [62] Such trusts may be created in lieu of or as part of a pre-nuptial agreement. If created as a part of pre-nuptial agreement, the client should fully disclose the existence of the trust.
Summary
Divorces will happen. Clients will often be emotionally driven. Part of the advisor's roleshould be to break through this the emotional barrier to provide pragmatic advice on how to reduce the ravaging effects of the unpleasant experience. In the next article, we will discuss some other planning possibilities for families that are facing the possibility of divorce.
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Author : John J. Scroggin, J.D., LL.M. is a graduate of the University of Florida and is a nationally recognized speaker and author. Mr. Scroggin has written over 220 published articles, outlines and books. To be added to his free blast email system on estate and income tax planning, contact Penny@scrogginlaw.com.
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[1] Time magazine, September 25, 2000.
[2] See: Hopkins, "Income Tax Land Mines in Divorce and Separation," ABA Tax Section, January 2000 meeting materials; Robinson, "Tax Consequences of Divorce can be Avoided," 53 Taxation for Accountants 132( 1996).
[3] IRC sections 61(a)(8) and 71(a).
[4] IRC section 215(a).
[5] IRC section 71(b).
[6] IRC section 1441(a).
[7] TC Memo 1998-9; See Severin and Corrick, "How Not to Get an Alimony Deduction - Draft Your Own Settlement Agreement," Journal of Taxation, March 1998.
[8] IRC section 691. See Kitch , 103 F3d 104 (10 th Cir. 1996), aff'g 104 TC 1.
[9] IRC section 71(c) and 215(b).
[10] IRC section 152(e).
[11] IRC section 152(e).
[12] IRC section 25A(f).
[13] IRC section 1041.
[14] IRC section 1041(d).
[15] IRC section 1041(a) and (e).
[16] Revenue Ruling 87-112, 1987-2 CB 207.
[17] See: Gibbs v. Comm'r , T.C. Memo 1997-196 and Seymour v. Comm'r , 109 T.C. 279 (1997).
[18] Revenue Ruling 2002-22, 2002-19 IRB 849 (issued May 8, 2002).
[19] 981 F2d 456 (9 th Cir. 1992). See also M.R. Hayes 101 T.C.593 (1993).
[20] See: Swad, "Breaking Up is Hard to Do," Journal of Accountancy, December 1998 and August and Schepps, "Recent Cases Complicate Redemptions of Stock Incident to Divorce," 22 Journal of Corporate Taxation 112 (1995).
[21] Proposed Regulation section 1.1041-2, issued August 3, 2001.
[22] See: Coates Trust v. Comm'r , 55 T.C. 501(1970), acq 1972-2 CB 1, aff'd 480 F2d 468 (9 th Cir. 1973), cert denied, 414 U.S. 1045 (1974). But see: Maher v. Comm'r, 469 F2d 225(8th Cir 1972).
[23] c.f., in Georgia, O.C.G.A. section 14-2-640(c) and section 6.40(c) of the Model Business Corporation Act.
[24] See: IRC sections 311(b)(1) and 336.
[25] See IRC section 1041(a)(2) & (c)
[26] See. Treasury Regulation section 1.041-1T(d) Q&A 12 and PLR 9615026. This rule only applies to direct transfers to a ex-spouse.
[27] IRC section 469(j)(6) and 1041(b).
[28] See IRC section 1041(b)(2).
[29] IRC section 1041(b)(1) and 1015.
[30] Although Temporary Regulations 1.1041-1T, Q&A-14 requires that such information be provided at the time of any transfer, there are no penalties for not providing the information.
[31] See: U.S. v Gilmore , 372 U.S. 39 (1963).
[32] See IRC section 212(1) and Treasury Regulation 1.262-1(b)(7).
[33] See IRC section 212(2) and Treasury Regulation section1.212-1(l)
[34] Hunter v U.S. , 219 F2d 69 (2 nd Cir 1955).
[35] c.f., Revenue Ruling 72-545, 1972-2 C.B. 179.
[36] See IRC section 67.
[37] See IRC section 68.
[38] See IRC section 6015, enacted by the 1998 IRS Reform Act. For a discussion of this new code section see: Bryant and Fleischman, "How Innocent Spouses Spell Relief," Journal of Accountancy (March 2000). See also Revenue Procedure 2000-15, 2000-1 CB 447 for the procedure to apply for equitable relief.
[39] Treasury Regulation section 1.6015-0 through -9.
[40] IRC section 121.
[41] As jointly owed, each of them can qualify for the exclusion.
[42] e.g., one of them sold a house in the two years leading up to the current sale.
[43] IRC section 121(d)(3)(B).
[44] IRC section 7703.
[45] See IRC section 7703(b) for the abandoned spouse rules.
[46] In such a case, the divorce decree should discuss how any income tax refunds are allocated. In the absence of such language, the IRS has created a methodology for such allocations based upon each parties relative tax liability. See Revenue Ruling 74-611, 1974-2 CB 399; Revenue Ruling 80-7, 1980-1CB 296; Revenue Ruling 85-70, 1985-1 CB 361; Revenue Ruling 85-72, 1985-1 CB 347.
[47] See IRC 6015(c)(3)(C).
[48] See IRC section 219(f)(1).
[49] For more information on this concept see: Westfall & Mair, Estate Planning and Taxation , Chapter 11: Premarital Agreements (WG&L) and Baskies, "A Practical Guide to Preparing and Using Prenuptial Agreements", 27 Est. Plan. 8 (Oct. 2000); Springs & Bruce," Marital Agreements: Uses, Techniques and Tax Ramifications in the Estate Planning Context," 21 Univ Miami Inst. on Est. Plan, Chap 7, (1987).
[50] For example, in Dematteo V. Dematteo (SJC-08614(decided February 8,2002)), the Massachusetts Supreme Judicial Court provided that upon the divorce a husband (worth $83-108 million) a prenuptial agreement which provided the ex-spouse an annual payment of $35,000, the marital home, an automobile and medical insurance until death or remarriage was not unconscionable.
[51] For example, in Pysell v. Keck , Record No. 010506 (March 1, 2002) the Virginia Supreme Court ruled that the pre-nuptial agreement's failure to specifically waive rights against the estate of a deceased husband allowed the surviving wife to make certain statutory spousal survival rights against the estate - even when the will made no provision for the surviving wife.
[52] See: Hagwood v. Newton , CA-00-106-5-BR(3), decided February 26, 2002 (4 th Cir. 2002); National Automobiles Dealers & Assoc. Retirement Trust v. Arbeitman , 89 F3d 496 (8 th Cir. 1996); Howard v. Branham & Baker Coal Co. , 968 F2d1214(6th Cir 1992); Hurwitz v. Sher , 982 F2d778 (2 nd Cir 1992, cert denied, 113 S. Ct. 2345 (1993); 26 U.S.C. sections 417(a) and 1055 and Treasury Regulation section 1.401(a)-20 Q&A 28.
[53] c.f, In re Rahn 914P2d 463(Colo Ct. App. 1995)
[54] Labor Reg. Section 2510.3-2(d) and IRC section 417.
[55] See: Siegel-Baum and Averill, "Post-Nuptial Agreements can Resolve Personal and Estate Planning Issues," Estate Planning, August 2002; Spero, Asset Protection: Legal Planning, Strategies and Forms , section 4.10 (WG&L) and Westfall & Mair, Estate Planning and Taxation , Chapter 12: Settlement Agreements, Postmarital Agreements and Alternatives in Estate Planning (WG&L); Hansen, "Split-Up Insurance: Postnups are Gaining in Popularity for Couples in Property Predicaments, A.B.A.J., Nov. 1999 at 30.
[56] c.f., Georgia statutes, O.C.G.A. section 53-2-1(b)(1)
[57] A similar argument was used with ERISA retirement plan spousal benefits, because ERISA rights did not accrue until after the marriage and a future spouse cannot renounce a right he or she did not have at the time of the renunciation. Supra, note 52.
[58] c.f., Pysell v. Keck , supra note 51.
[59] e.g., Alaska, Delaware, Nevada, Rhode Island. Osbourne and Owen,"Asset Protection: Trust Planning," ALA-ABA, Planning Techniques for Large Estates, April, 2002.
[60] See: Del Code Ann. title 12, Section 3570, et seq.
[61] See: Blattmachr & Hompesch, "Alaska and Delaware: Heavyweight Competition in New Trust Laws," 12 Prob & Prop. 32 (Jan/Feb. 1998).
[62] See; Blattmachr & Hompesch, Id; Nenno and Sparks, Delaware Dynasty Trusts and Asset Protection Trusts (Wilmington Trust); Nenno, "Perpetual Dynasty Trusts, Total Return Trust Statutes and Domestic Asset Protection Trusts," ALA-ABA, Planning Techniques for Large Estates, April, 2002; and Osbourne and Owen, Supra note 59.
| PLANNING FOR DIVORCE - Part II Published in WG&L Practical Tax Strategies, January 2003 Copyright, 2002 John J. Scroggin, J.D., LL.M., All Rights Reserved. |
"Marriage is often due to lack of judgment, divorce to lack of patience and remarriage to lack of memory."
Although most divorces are do not foster compromise or planning, there are many tax planning opportunities and traps that clients need be aware during their divorce. Marriage, even when its dissolving, offers some unique planning opportunities for the creative and risks for the unwary.
Divorce Decrees and Agreements
Planning for a dissolution of a marriage raises a number of complicated issues. It's more than just signing a standard form document to dissolve a marriage. Among the issues:
Creditor Issues . Among the creditor issues which need to be addressed are:
- Many clients mistakenly believe that because the divorce decree or settlement requires one spouse to pay marital debts, that creditors cannot seek recovery from the other spouse. Because the creditor is not a party to the contest, it is normally not restricted in its rights. For example assume a couple had co-signed a note and the divorce decree assigned the liability to the husband. If the husband declares bankruptcy after the divorce, the ex-wife might still be responsible for the debt. [1]
- Money problems are often a central cause of divorce. If a divorcing spouse is in financial trouble a number of issues arise. [2] First, if property transfers as a consequence of the divorce were deemed to be to hinder, delay or defraud creditors, then the transfer could be rescinded as a "fraudulent transfer." Second, if there is the possibility of bankruptcy for an ex-spouse, the non-bankrupting spouse is well advised to obtain the advice of bankruptcy counsel. While a property settlement may be deemed a preference or fraudulent transfer, it is less likely that a support obligation to a spouse and children would be overturned. Moreover, payments for alimony, maintenance and support are not dischargeable in bankruptcy.[3] Therefore, one method of protecting a divorcing spouse of a financially distressed party may be to treat the payment as alimony and support - albeit at a potential tax cost to the recipient ex-spouse. [4]
Retirement Plans . ERISA generally provides that the retirement benefit of a qualified retirement plan cannot be assigned. An exception is provided for assignments incident to a divorce. [5] In order to pass a portion of a ERISA retirement benefit to an ex-spouse, the divorce decree must satisfy the requirements of IRC 414(p). It should also be noted that beginning January 1, 2002, the IRC section 457 deferred compensation plans for governmental and non-profit employees are subject to the qualified domestic relation orders. [6] Federal law does not require a qualified domestic relations order for an divorced-based IRA transfer.
Transfers in Contemplation of Divorce . Divorce is not usually a surprise. As a result many clients attempt to reduce the potential claims of a divorcing spouse. These techniques can include:
- Hiding assets to minimize the allocation of marital assets upon divorce. This approach is extremely dangerous because of the divorcing spouse may require statements about assets under penalties of perjury.
- Some planners have advised moving assets off-shore. Some have questioned whether the use of such off-shore trusts will provide better divorce protection than a US based spendthrift trust. Perhaps in the right jurisdiction, but review Reichers v. Reichers [7] in which the court recognized it had no jurisdiction over off-shore trust assets and did not require the movement of the off shore trust assets back to the US. Instead, the court took into account the off-shore assets in awarding Dr. Reicher's US property to Mrs. Reichers.
- If justifiable for other purposes, it may make sense to move assets into vehicles which restrict the ability of a spouse to access the underlying assets. For example, it might be possible to move assets into a family limited partnership that has both estate planning and asset protection benefits. Recapitalization of a family company and the passage of voting control of the company to entities (e.g., trusts) outside the client's control may also make sense.
- It may make sense to exchange assets for another right which limits the benefit to a ex-spouse. For example, a client could sell a piece of real estate for a private annuity payable over the client's lifetime. As a further example, a client might transfer the residence into a qualified residential trust, retaining a limited term of years, with the remainder passing to heirs.
- The gifting of important family assets might also make sense. For example, the use of annual exclusion gifts to gift a family farm to descendants might make sense. It might even make sense to have the spouse agree to gift-split the gift. See the later discussion on this topic.
To minimize fraudulent conveyance issues, any transfer in contemplation of divorce should be made as far in advance of the divorce as possible. In addition, if the transferor receives no consideration for the transfer, a divorcing spouse may have a right to rescind the transaction.
Life Insurance . Many divorce decrees require the wealthier spouse to maintain a life insurance policy to fund any alimony or child support obligations which remain at the insured's death. In deciding how to handle the policy there are a number of options:
- In order to deduct the insurance premiums as alimony, the insured should consider having the ex-spouse be both owner and irrevocable beneficiary of the policy. [8]
- If the policy has a significant cash value and the couple are no longer married, the transfer to the ex-spouse may be taxable gift for gift tax purposes. [9] Moreover, if the insured dies within three years, the death benefit would be pulled back into the insured's estate. [10] To avoid these issues, the client could have a new policy issued with the spouse being the applicant, owner and beneficiary of the policy.
- If the insured retains any incidents of ownership in the policy it will be included in the insured's taxable estate. [11] State law may provide that any applicable estate taxes from the policy must be paid from the insurance proceeds, effectively reducing the benefits to the ex-spouse and/or children. [12] The divorce settlement should provide a clear statement on whether any estate taxes on the policy proceeds are paid from the insured's assets or the policy proceeds.
- If the spouse is owner of the policy, the spouse will direct the ultimate disposition of the death proceeds. Instead, the insured could place the policy in an irrevocable life insurance trust and give the ex-spouse an beneficial interest until the spouse has died, married or co-habitated, at which time the benefits of the trust could pass free of transfer taxes to other heirs (e.g., the children from the first marriage). If the policy is owned by an irrevocable insurance trust, the insured will lose the alimony deduction for the payment of insurance premiums, but as the grantor of the trust, the insured can also direct the ultimate disposition of the death proceeds. Properly created, the policy is also excluded from the insured's taxable estate.
- If the divorce decree provides that the an insurance policy will revert to the insured upon the satisfaction of the divorce obligations it was designed to fund , this reversionary interest [13] may result in the husband having to include the policy in his taxable estate, even when the spouse is the irrevocable beneficiary. [14] However, the decedent's estate may qualify for a deduction for the amount of the proceeds, even if they exceed the remaining alimony or support obligations of the deceased ex-spouse. [15] In many cases it will be better to just let the policy lapse, or have the ex-spouse 's will provide for transfer of the policy into a trust for the benefit of joint descendants.
Prior Planning Documents . If divorce is anticipated, the client should discuss with his estate planner the possibility and benefit of executing a new will in contemplation of the divorce. The impact of the divorce on the couple's existing estate planning (especially for their respective descendants) should be considered as a part of the divorce process. Leaving the decision to the inflexibility of statutory law [16] is not generally the best solution.
However, the attempt to disinherit a future ex-wife may be problematic if the client dies before the divorce is finalized. First, state law may limit the ability of a decedent to disinherit family members when death occurs soon after the will is executed. Second, the state may have a state statute which provides statutory rights to a surviving spouse, notwithstanding the terms of the decedent's will. One method of avoiding the application of such "probate-driven" restrictions might be to make the same dispositions, but use a funded living trust as the dispositional vehicle.
If a divorce or separation has occurred and the resulting agreement places financial obligations on the client, the will should reflect that the terms of the agreement be carried out. Drafters should be careful to provide that any bequests to an ex-spouse are in satisfaction of the decedent's legal obligations. For example, assume the divorce decree provides that a payment of $100,000 be made to an ex-spouse in ten years. The will says "If my ex-spouse is alive in ten years, I convey to her $100,000." As a result, the ex-spouse may receive a double benefit of both the bequest and divorce settlement rights.
Many clients have drafted powers of attorney to provide for the handling of medical and property issues upon incapacity. Such powers of attorney are not normally revoked by divorce or legal separation. In many cases, the clients do not focus on revising these important documents during or after divorce. Having an ex-spouse or a divorcing spouse in charge of your medical and property decisions is probably not advisable. Either the client should be strongly encouraged upon the first vestiges of divorce to change his or her powers of attorney or the document may provide that in the event that divorce or legal separation proceedings are initiated, then the right of the spouse to serve as power holder immediately terminates and the next named successor is automatically appointed.
Transfer Tax Consequences of Divorce
A number of unique gift, estate and generation skipping tax issues surround divorce or separation. Some of these issues include:
Property Transfers and Gift Taxes . Property settlements must be reviewed in light of the possible imposition of a gift tax. IRC section 2523 provides for an unlimited marital deduction for transfers between spouses. However, transfers after divorce to do not fall into this exception.
IRC section 2516 provides some gift tax protection for property settlements entered into after a divorce in finalized. The section provides that transfers for settlement of property rights, or child support are exempt from gift tax if:
- The parties enter into a written agreement. The agreement does not need to be approved by any court.
- The transfers are payments of cash or property in settlement of spousal martial rights and a "reasonable allowance" [17] of support rights of a "issue of the marriage" [18] who are minors. [19] Transfers for other purposes (e.g., requiring a spouse to fund education costs of a step-son [20] ) are not excluded from gift tax.
- The agreement must be entered into within a period beginning two years before the divorce and one year after the divorce. The agreement, but not the transfer of assets, must occur during this three year period. [21] The IRS may require the modifications of the agreement also occur within these time frames. [22] Note that a pre-nuptial agreement which was entered into more than two years before the divorce would not qualify as the required agreement. In addition, if one of the parties voluntarily increases the benefits to an ex-spouse after the period has run, IRC section 2516 does not apply and the change may be treated as a taxable gift.
It should be noted that IRC section 2516 does not require that the divorce decree mention the settlement agreement. It can be entered into by the parties independently of the decree, allowing clients to keep their property settlements out of the public records. In addition, if the parties fail to enter into a written agreement, but make the transfers prior to a final decree of divorce becoming effective, the gift tax martial deduction permitted by IRC section 2523(a) may eliminate any gift tax on the transfer. However, if the parties intend to make post-divorce transfers, they would be foolish not to execute an agreement meeting the requirements of IRC section 2516.
As noted above, there are numerous situations in which the client cannot qualify for the protection of IRC section 2516. However, there has also developed a series of judicial exceptions to the imposition of a gift tax on transfers made after the marriage has dissolved. For example, in Harris v. Comm'r, [23] the U.S. Supreme Court ruled that divorce related transfers which were founded upon a court decree were involuntary and therefore do not constitute voluntary taxable transfers. Treasury Regulations [24] also provide that any obligation imposed by law is a deductible debt of the estate. However, planners need to be careful to assure that the property transfer provisions of the divorce decree are specifically incorporated into the divorce court's ruling. If the decree merely declares the marriage terminated, but does not approve the property transfer, then the IRS could argue that Harris is not applicable. Modifications of the original settlement agreement should also be approved by the court.
Property Transfers and Estate Taxes . Divorce attorneys are often not particularly good about examining the estate tax implications of the divorce decrees. IRC section 2056 provides for an unlimited marital deduction for death transfers to a spouse, but does not provide any marital deduction for transfers to a ex-spouse. A liability accruing pursuant to a divorce settlement agreement is not necessarily a deductible debt of a deceased's estate. It is important to make sure the divorce documents create an enforceable debt against the estate to create an estate tax deduction, rather than creating a taxable transfer.
In order to be deductible the obligation must be treated as a deductible debt of the estate. IRC section 2053(a)(3) provides for the deduction of the decedent's personal obligations to the extent incurred for adequate consideration. If the decedent's obligations are founded upon a court decree, then Harris would apply and the post-death obligations would be deductible. However, if the court did not the power to require the property transfers (e.g., transfers to fund a step-child's education), Harris will not apply and the post-death transfers may not be deductible for estate tax purposes.
If Harris is not applicable, then the post-death obligations will only be deductible is the decedent's obligations were entered into for "full and adequate consideration." IRC section 2043(b) provides that transfers which satisfy the above gift tax requirements will be treated as an expense of the estate. Thus, if former spouses have a written agreement which satisfies IRC section 2516, testamentary transfers to a former spouse pursuant to the agreement are treated as deductible claims against the estate. It gets harder when the property transfer does no fit neatly into section 2516. For example, section 2053 provides that a deduction against the estate is permitted only if the claim rests upon a "bona fide and for adequate and full consideration in money or money's worth." To the extent that the obligation at the decedent's death exceeds such sum, an estate tax deduction may be denied on the excess.
Even if IRC section 2516 is not applicable, the IRS [25] and the courts [26] have ruled that the release of support rights and child support obligations will be deemed "adequate consideration." This opens the issue of the equality of the consideration each party gave in the bargain. If the decedent's obligations are larger than the value of what he or she received, the excess may not deductible.
While rights of a spouse and children to support is adequate consideration, transfers in exchange for martial rights to the couple's property is not treated as adequate consideration. Effectively, equitable distribution rights are not vested legal rights in a marriage and therefore cannot constitute adequate consideration.
Gift Splitting. The law permits a spouse to elect to be treated as the donor of a gift, even when the other spouse is the sole transferor. [27] In order for the "gift-splitting" to apply, the donor must file a gift tax return, on which the spouse consents to the treatment of the gifts as made one-half by the spouse. [28] Gift splitting for any year applies to all gifts and cannot be made on a gift-by-gift basis. If gift splitting is elected, the spouses have joint and several liability for any gift tax which may be due. [29] If neither spouse has filed a gift tax return for the applicable year, the consent may be filed late, without any adverse tax impact. [30] If a married couple agrees to "gift-splitting" each is treated as though they made the gift for generation skipping tax purposes also. [31] If gift splitting was anticipated early in the year, divorce before year end will terminate the right to gift split. For example, assume the wife made $22,000 in gift-split annual exclusion gifts to 15 heirs at the beginning of the year. If divorce occurs before year end and the wife is in a 50% tax bracket, delaying the divorce until after the end of the year could save the wife $82,500 in gift taxes. [32] Gift splitting offers a number of planning opportunities, including:
- A divorcing wife has three married children and ten grandchildren. Four grandchildren are married. She has a sizable estate. In the final year of marriage, she can make gift-split annual exclusion gifts of $440,000 to her family, saving transfer taxes of $90,200 to $110,000. [33] The marriage would have to remain in place until after the end of the year and the soon to be ex-spouse would have to agree to the gift-splitting. Given the significant tax savings, the wife might even consent to make some annual exclusion gifts to his heirs.
- Assume the same fact pattern, but with the divorcing husband has an estate of only $200,000. If the wealthy spouse makes taxable gifts of $1.6 million in addition to the annual exclusion gifts, both spouses' unified tax credits would be used and up to $400,000 in estate tax savings could occur. [34]
- A entrepreneur wants to begin transferring equity in his family business to children from a prior marriage. He has a pre-nuptial agreement which restricts the rights of the current spouse. The appraiser has provided a discount in value of 40% for the minority interest he will transfer in the business. If the spouse elects gift splitting, the donor spouse can effectively transfer his and his spouse's unified credit amount (with an applicable valuation adjustment of 40%) to a generation skipping trust and save up to $833,000 in estate taxes. [35] - in effect agreeing to the utilization of the poorer spouse's unified credit without any actual transfer by that spouse. The wealthier spouse's will could be modified to provide a trust for the benefit of the ex-spouse or the wealthier spouse could create a life insurance trust that provides a life interest to the ex-spouse, but passes the value at the ex-spouse's death to the wealthier spouse's family.
- The spouses have been married before and both are wealthy. One spouse has 10 potential donees and the other has 20 potential donees. If they both elect gift splitting, each of them can double the non-taxable gift of the other, without any adverse impact to either spouse's estate planning, while saving both families significant estate taxes.
Tuition Payments . A divorce decree may require that the wealthier spouse fund the college education of the couple's children. Clients should be careful to make the payments in a manner which does not produce a taxable gift. For example, instead of reimbursing an ex-spouse for the cost of tuition, the payment should be made directly to the institution, allowing an unlimited gift tax exclusion. [36] Other payments to the child may be covered by the $11,000 annual exclusion.
As a part a divorce decree, the couple might also consider the pre-funding of college costs for children (especially younger children) using section 529 Plans. Section 529 permits donors to pre-pay up to five years of annual exclusion gifts to fund a section 529 plan. [37] However it is unclear how advance usage of the annual exclusion would apply to the years after the divorce.
Using the Unified Credit . The unified credit should be viewed as an asset of a couple's divorcing estate. For example, a wealthy wife is required to make a significant property settlement for the benefit of a less wealthy second husband. She wants the funds to eventually revert to her children from a prior marriage. She could create a lifetime QTIP marital trust during the marriage for the benefit of the soon to be ex-spouse. Properly created, the trust would create no gift taxes. At the ex-husband's death, his unified credit (which he might not otherwise have used in full) benefits her children by reducing the overall transfer taxes. A similar arrangement could be made in creating a generation skipping trust and annual exclusion gifts using the couple's combined generation skipping and annual exclusion exemptions.
In an amicable divorce, clients should also review the possibility of using their unified credit more effectively. For example, assume a husband and wife could each create unified credit trusts naming the other as beneficiary. These irrevocable trusts could grow tax-free and protect the ex-spouse/beneficiary from creditor claims. Clients should make sure that the terms of the trusts do not "mirror" each other to avoid the reciprocal trust doctrine. [38] If the doctrine applies, both trusts will be ignored for transfer tax purposes.
Marital Trust s. Assume a husband and wife are divorcing and the husband is concerned and wants to provide significant assets to the spouse, but wants to assure that the assets ultimately flow through to his children and not to a new husband. The husband creates a lifetime Q-TIP trust for the wife, with the provision that the trust rolls over to a trust for his descendants at her death. The assets remain available to benefit the wife for life. At her death the basis in the assetsstep-up to fair market value and her Unified Tax Credit reduces the overall family's estate tax. The husband makes a timely election to treat the trust as a Q-TIP trust [39] eliminating any gift tax on the transfer to the trust.
Divorce Trusts . Divorces are seldom amicable. A less wealthy spouse will be concerned that the wealthier spouse will renege on support payments or have future financial problems. One solution may be the creation of a divorce trust. The trust can be irrevocable to assure future benefits. The wealthier spouse transfers property equal to the spousal and children's support rights to the trust. The trust could provide for payments equal to the settlement terms between the divorcing couple. If the trust provides that it reverts to the settler at its termination (i.e., the end of support obligations), then the trust may be includable in the settler's estate. [40] However, assuming the divorce obligations are deducible pursuant to the rules discussed earlier in this article, there may be an offsetting deduction.
Planning for Divorcing Heirs
Many parents recognize that their children's marriages are not stable. Because 49% of the marriages end in divorce, a couple with four children (on average) can expect almost two divorces within their family. In contemplation of this, clients should consider inheritance vehicles which restrict the ability of a divorced spouse to obtain part of the family money. Among the approaches which should be considered are:
Limiting Control . The single most important aspect of any asset is its control. This is especially true in the context of the divorce of an heir. For example, the last thing most family businesses need is an ex-spouse attempting to gain some control over the family business. In many cases, a client's spouse or the spouses of his or her heirs hold interest in a family business or may obtain an interest in a family business as a result of divorce. Buy-sell agreements [41] should contemplate this possibility and provide a mechanism that allowsother family members to buy-out the divorcing spouse on reasonable terms. If the terms are designed to penalize an ex-spouse, they may be considered unenforceable. Included in those terms should be a long term buy-out to minimize the cash flow problems for the business. Such terms may also reduce the risk that their spouse would want to receive business interests in the divorce.
Spendthrift Trusts . Spendthrift Trusts have long been a part of the estate planners tools. In recent years as clients increasingly express concern about asset protection and/or spendthrift children, these trusts have become a major part of the estate planning business. Basically a spendthrift trust is any trust which provides for two major restrictions. First, it restricts the ability of any trust beneficiary to assign or otherwise transfer his or her interest in the trust. In most states a trust right is freely assigned by the beneficiary (e.g., as collateral for loans or for other personal purposes). Second, a spendthrift trust restricts the right of creditors of a beneficiary to demand payment of income or principal to satisfy the obligations of the beneficiary. Such trusts also restrict the ability of spouses to put pressure on an heir to put assets into a joint name. Virtually every trust should contain a spendthrift provision. It's simply good planning.
But there are other cases which should provide some caution. For example:
- The permissible terms of spendthrift trust vary widely from state to state. Several states restrict or prohibit spendthrift trusts. In some states creditors are still free to garnish actual distributions to the beneficiary, but are unable to force distributions in order to garnish them. Some states allow certain creditors (e.g., the government) to pierce a spendthrift trust.
- In Dwight V. Dwight [42] , a Massachusetts Appeals Court ruled that a trust created by a divorced husband's father could be treated as an increase of the divorced husband's income, allowing the ex-spouse to claim a portion of it as alimony. A narrow reading of the case out seem to indicate that the decision was at least partially based upon the existence of the ex-husband having an ascertainable standard right to the trust benefits. Had any distributions been in the absolute and unfettered discretion of the trustee, the ruling might have been different.
The best approach? Do not use ascertainable standards for heirs. Instead, give an independent trustee absolute discretionary authority to "spray" benefits among a broad class of beneficiaries (e.g., children and grandchildren).
Discretionary Trusts. As discussed above, when clients are concerned about the financial and marital problems of an heir, they would be well advised to adopt provisions in their trusts which grant trustees the total discretion to decide when to make distributions to or for the benefit of a beneficiary. The effective result is that the beneficiary has no vested or attachable rights in the trust for a creditor to make claim against.
If such provisions are adopted, it may be important to provide some additional safeguards for both trustees and beneficiaries, such as giving beneficiaries the right to remove Trustees and indemnifying Trustees for their good faith acts. It may also be advisable to place responsive trustees in charge of such heir's trust, so that if the marriage is dissolved, additional benefits (i.e. , greater principal distributions) may pass to the heir.
Generation Skipping Trusts . Given that 49% of marriages will end in divorce, clients should consider using generation skipping trusts, not only for tax purposes, but also for divorce protection. A generation skipping trust assures that a divorcing spouse must pierce the limits of the trust rather than making claims against the assets of an soon-to-be ex-spouse.
Garnishment of Distributions . Even though a trust may limit the claims of a divorcing spouse against the assets of the trust, the divorcing spouse might still be able to make a claim against actual distributions made to the beneficiary/ex-spouse. For example, the Georgia statutes [43] provides that unless the beneficiary of a spendthrift trust is suffering under significant physical or mental disability that impairs the beneficiary's ability to provide for their care, then an alimony claim can be made against "a distribution to a beneficiary."
Jointly Held Accounts . Many couples hold significant assets in joint name (e.g., a brokerage account). As a deemed marital gift, the spouse may have a right to 50% of the account in the event of divorce, even though the spouse may have made no contributions to the joint account. The solution? Encourage clients who have sizeable assets before marriage or receive sizable inheritances to keep the funds in individual accounts.
Irrevocable Trusts . Virtually all irrevocable trusts should be drafted (and maybe even some revocable trusts), in contemplation of the possibility that one or more of the beneficiaries may get divorced. For example, assume a client creates an irrevocable life insurance trust, the spouse is named as a beneficiary and co-trustee and is given significant power, such as the right to remove other trustees and a limited power of appointment to reconfigure the trust for the benefit of the couple's joint heirs. The documents should contemplate the possibility that the insured grantor and the beneficiary/spouse are later divorced. The document could provide that all rights and powers of the spouse, including her right to serve as co-trustee, immediately terminate upon either legal separation or divorce. Few clients want an ex-spouse to financially benefit from their death or be able to control the inheritance of their assets.
Similar issues involve planning for surviving spouses. For example, assume a widow remarries and then dies. There could be claims against the deceased spouse's assets by the second husband. State statues may permit the new husband to claim support from the deceased wife's estate, or assets may have been placed in joint name, with the surviving new husband taking survivorship rights. However, if assets are held in unified credit and Q-Tip trusts, the divorcing spouse can have no property rights to those assets.
Flexible Drafting . A key element to planning for the potential divorce of the client or the client's heirs is flexible drafting. [44] Any trust instrument should contemplate the impact of divorce or marriage of beneficiaries on the plan. For example, if a descendant is divorced and the non-descendant parent has custody of minor descendants, the trust should provide for how the ex-spouse is treated.
Particularly with irrevocable trusts like Dynasty Trusts, granting a person a "Limited Power of Appointment" [45] can provide significant flexibility to the planning process. For example, a client creates a lifetime unified credit GST trust for the benefit of his wife and minor children. He is concerned that the trust has no flexibility to deal with issues which may exist when his children are older (e.g., they develop alcohol or drug problems).While the husband may want to have the trust restrict the ability of the wife to make distributions to benefit a new husband, the spouse could be given a limited power of appointment to reconfigure the trust for the benefit of the grantor's descendants at any time before her death - adding flexibility to the plan.
The trust instrument can provide that a trustee is not legally liable to the trust or beneficiaries for actions taken in good faith. In addition, the trust instrument can indemnify a trustee for suits from beneficiaries and third parties, if the trustee's actions were taken in good faith.
One helpful addition to the spendthrift trust provision is a non-contest provision. Although no-contest provisions are outlawedin a few states, they can serve as useful impediment to an heir or creditor who wants to pierce the spendthrift provisions of his or her trust. [46] In addition, except in the case of a martial trust, the spendthrift provision can provide that the attempted assignment by a beneficiary of his or her trust benefits would automatically terminate those benefits.
Retirement Plans & Divorce
Clients should understand the differences in the tax-treatment of various retirements plans. For example:
- If an defined contribution or defined benefit plan is transferred to an ex-spouse pursuant to a QDRO, the recipient spouse can make withdrawals from the account, without having to pay an early withdrawal penalty. [47] If an IRA account is transferred, the recipient spouse who withdraws the funds before age 59½, may have to pay an early withdrawal penalty of 10%. Thus, if a divorcing couple has both IRA and ERISA retirement plans and one spouse intends to begin taking distributions before age 59½ (e.g., a husband intends to take a year off from work), the withdrawing spouse will be better off receiving the ERISA account. The parties might even consider swapping retirement benefits to place the best retirement vehicle in the appropriate ex-spouse's name.
- Assume a husband has creditor problems. ERISA plans are not subject to the claims of most creditors. [48] To provide maximum protection, the husband could retain all the benefit of his own ERISA retirement plan and, possibly, even receive a QDRO to obtain the wife's ERISA plan benefits. The wife could receive other assets.
- Assume a husband is a participant in an defined benefit plan. Based upon his health and family history, the husband believes he will live longer than the mortality tables indicate. By retaining all of the defined benefit account and giving other assets to his wife, the husband would retain a greater financial benefit then actuarially calculated by the plan administrator.
A recent Tax Court ruling, Bunney [49] may give a client pause when trying to extract revenge from a wife in divorce. In the ruling, a couple divorced and the wife was entitled to half of the husband's IRA. The husband cashed out the IRA and paid the cash to her. He apparently anticipated that she would be responsible for both the income taxes and the early withdrawal penalty on the $111,600 withdrawal. Instead, it was ruled that all the taxable income went to the husband, and he was responsible for the 10% early withdrawal penalty, resulting in his paying all of the taxes and penalties, while the wife got $111,600 tax free. To avoid this situation, the husband should have either directed the plan administrator to change the name on the IRA account, or make a trustee to trustee transfer to the wife's IRA account.
In considering whether to receive part of the ERISA benefit of a spouse, the recipient has two chooses. The recipient can provide for a current distribution and then roll the funds into an IRA, or the spouse can leave the funds in the ERISA plan and receive benefits in the future. In deciding which option makes the most sense, a number of issues should be considered:
- Most creditors of ERISA plans are unable to access the account assets of participants. IRAs do no generally provide the same creditor protection. [50] Thus, if the recipient expects to have creditor problems, maintaining an existing ERISA account could provide better asset protection.
- The parties should review the plan documents to make sure that current distribution of plan benefits is even permitted.
- If the participant is not fully vested in the plan, it may be more beneficial to maintain the existing accounts to obtain full vesting.
- The advisor should review the historic rates of return and financial risks in the ERISA plan and compare them to expected returns in an IRA.
- If a retirement plan distributes employer securities, the value of the employer stock which is distributed may be taxed at the plan's basis in the stock rather then its current fair market value. [51] If the holding periods are meet [52] , the subsequent sale of the stock receives capital gain benefit. If a retirement plan holds appreciated employer stock, the after-tax benefit of receiving employer stock from the plan should be part of the decision process on deciding which assets an ex-spouse will receive.
- If the ERISA plan is maintained by a closely held or family business which will be run by the ex-spouse, the recipient may want to roll the funds into an IRA to gain control over the retirement benefits.
- If the plan is a defined benefit plan, the plan administrator must value the benefits to the divorcing spouse. The valuationis made upon certain actuarial assumptions, which may not accurately reflect the future value of the benefits. Before making a decision, the client and advisor must understand the underlying assumptions used to calculate the benefits and should hire an actuary to make their own evaluation of the future benefits.
- If the assets are rolled over to an IRA, the account owner will have the ultimate responsibility for the fund's management. The advisor should discuss whether is the client is able or willing to manage the funds.
- The IRA account holder may also be tempted to make early withdrawals from the IRA. If the recipient spouse has tended to be a spendthrift, leaving the money in the ERISA plan may protect the recipient from both bad spending habits and the lack of financial savvy.
Improper beneficiary designations changes have created huge problems in divorce cases. [53] For example:
- In Merchant v. Corder , [54] the Fourth Circuit Court of Appeals ruled that a change in beneficiary designation to a retirement plan prior to the issuance of a final judgment of divorce was invalid. Because the ex-spouse had not agreed to the relinquishment of her rights to the plan at the time of the change and there was not a qualified domestic relations order, when the former husband died the ex-spouse received all of the retirement fund.
- In Samaroo v. Samaroo , [55] the Third Circuit Court of Appeals provided that even when a QDRO exists, the rights of an ex-spouse may terminate upon the death of the plan participant before retirement. The failure of the QDRO to name the ex-spouse as a survivor beneficiary at the participant's death resulted in the termination of all of the ex-spouse's rights in the plan.
- In Hendon v. Dypont [56] the Sixth Circuit Court of Appeals ruled that even when a divorce decree and martial dissolution agreement provided that a divorced spouse waived their rights to a ERISA retirement plan, the ex-spouse was still entitled to the qualified plan assets upon the death of the account participant. The Court ruled that the waiver was not in compliance with the requirements of ERISA.
- In Schultz v. Schultz [57] , The Iowa court ruled that when a divorce decree did not include any waiver of a spouse's IRA account and the spouse never removed the ex-spouse as a named beneficiary, the ex-spouse was entitled to the IRA assets upon the death of the account owner, even when the account holder had remarried.
- In Egelhoff v. Egelhoff ex rel. Breiner [58] the US Supreme Court ruled that a Washington statute which purported to terminate a divorced spouse's rights in a retirement plan did not apply to ERISA plans. The state statute was not allowed to pre-empt the federal rules.
The solution? There are a number of actions that clients and their advisors should take, including:
- Clients should make sure to obtain properly drafted qualified domestic relations orders when plan assets are to be passed to an ex-spouse. These orders should be completed by lawyers with a working knowledge of the related tax issues and statutory requirements.
- If qualified plan assets are not passing to an ex-spouse, a new beneficiary designation should be prepared and filed with the plan administrator immediately after the divorce decree becomes final. If the soon-to-be ex-spouse will agree to sign a waiver, the change can be made prior to the divorce being finalized.
- As noted in the first article, the courts have consistently ruled that pre-nuptial agreements in which couples relinquish their rights to each others retirement accounts do not apply to an ERISA retirement plans. Therefore, any spouse who has entered into a pre-nuptial agreement that relinquishes such rights, needs to sign an additional waiver after the marriage to relinquish such benefits. In the event of divorce, the early waiver of spousal benefits can provide significant negotiation benefits to the plan participant.
Summary
Divorce may not be an inevitability, but it certainly has a strong probability of impacting any family of significant size. Discussing the difficult planning and drafting issues surrounding divorce may not be comfortable for the client or for the advisor, but it is essential if a client and the client's family are to be properly protected.
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Author : John J. Scroggin, J.D., LL.M. is a graduate of the University of Florida and is a nationally recognized speaker and author. Mr. Scroggin has written over 220 published articles, outlines and books. To be added to his free blast email system on estate and income tax planning, contact Penny@scrogginlaw.com.
Partial Checklist of Actions as a Result of Divorce
Copyright 2002, FIT, Inc. All Rights reserved.
Change Beneficiary Designations on:
•ERISA Qualified Plans ( ONLY after the divorce is finalized, or with signed spousal approval before divorce )
•IRAs
•Deferred Compensation Plans
•Stock Option Plans
•Life Insurance Policies
__ Complete Any Title Transfers on Assets (preferably before the divorce is finalized), Such as:
•Residence Ownership
•Other Real Estate Ownership
•Automobiles
•Stock or Equity Rights in a Business or Investment
•Life Insurance (e.g., ex-spouse owns policy)
___ Redo All Estate Planning Documents (to the extent an ex-spouse is named)
•Will (especially if revoked by divorce)
•Revocable Trust(s)
•Medical or Healthcare Power of Attorney
•General Power of Attorney
•Decide whether to Retain any Irrevocable Insurance Trusts which Name Spouse as Beneficiary
__ Create Any Required Funding Arrangements Under the DivorceDecree (e.g., new trust)
____ Enter a Modification for any Employee Benefit Cafeteria Plan (permitted under the Code)
____ Make Changes in Personal or Employer-Based Insurance Coverages That Names Ex-Spouse (perhaps obtain a refund)
•Life Insurance
•Health Insurance
•Long Term Care Insurance
•Disability Insurance
•Property & Casualty (e.g., auto, home, umbrella)
_ ___ Terminate Joint Liabilities, for example:
•Credit Cards
•Lines of Credit
•Guarantees of Ex-Spouse's Liabilities (e.g., business interest)
•Mortgages (may not be permitted)
•Utilities
___ Change of Address for (Notice to Post Office and Notice to Each Party),for example::
•IRS (i.e., tax returns and audits) Form 8822
•Employer(s)
•Credit Mailings
•Drivers License
•Passport
Terminate Joint Accounts (and change direct deposits) or Permitted Access by an Ex-Spouse, for example:
•Banking (i.e., checking, savings, etc.)
•Brokerage
•Safety Deposit Boxes
•Terminate Automatic Withdrawals Which Are No Longer Appropriate (e.g. to ex-spouse's account or benefit)
Change Access Codes, for example:
•Web Based Access (e.g., bank, brokerage)
•Credit, Debit and ATM Cards
•Frequent Flyer Accounts
- Email Accounts
[1] For more information on this issue see: Henkel, Estate Planning and Wealth Preservation: Strategies and Solutions , section 53.17 (WG&L 1994).
[2] Id.
[3] See 11 UCCA section 523(a)(5), 727, 1141(d)(2), 1228(c)(2) and 1328(a)(2).
[4] i.e., the recipient of the alimony is taxable. See IRC sections 61(a)(8) and 71(a).
[5] The Pension Benefit Guaranty Corporation has issued a helpful booklet on divorce and Qualified Domestic Relations Orders. The booklet includes sample forms and a checklist. Copies can be found at http://www.pbgc.gov/
[6] See IRC section 414(p)
[7] 679 N.Y.S.2d 233 (N.Y.Sup.Ct. 1998).
[8] See Revenue Ruling 70-218, 1970-1 CB 19.
[9] See the portion of the article dealing with Property Transfers and Transfer Taxes.
[10] See IRC section 2035.
[11] See IRC section 2042
[12] But see IRC section 2206.
[13] See IRC section 2042(2).
[14] Revenue Ruling 76-113, 1976-1 CB 276.
[15] Id. See IRC section 2053(a)(4).
[16] For example, in Georgia, the divorce results in the ex-spouse being treated as a pre-deceased heir of the maker of the will. See: O.C.G.A. section 53-4-49.
[17] Unfortunately neither the Code or Regulations define "reasonable allowance." Any payments which exceed this ambiguous amount are not protected by IRC section 2516.
[18] See IRC sections 2516(1) & (2). While IRC section 2516(2) provides for support of "issue of the marriage during minority," Treasury Regulation section 25.2516-2 restricts the language to minor children of the marriage. Black's Law Dictionary provides that issue means " all persons who have descended from a common ancestor." The Treasury's language would appear to be an attempt to provide a greater restriction than the one provided for in the Code.
[19] Thus, support payments (e.g., while in college) for children who have reached majority are not protected by IR C section 2516.
[20] However, it is not clear whether payments for tuition costs for a step-child might be treated as non-taxable gifts under IRC section 2503(e). The placement of such language in a martial agreement might mean that the payment was not a gift, but rather was consideration for the release of marital rights.
[21] c.f., PLR 7940022.
[22] See Revenue Ruling 79-118, 1979-1 CB 315.
[23] 340 US 106 (1950),
[24] See Treasury Regulations section 20.2053-4.
[25] Revenue Ruling 71-67, 1971-1 CB 271.
[26] Kosow Est. v. Comm'r , 45 F3d 1524 (11 th Cir. 1995) and Scholl Est. v. Comm'r , 88 T.C. 1265 (1987).
[27] IRC section 2513.
[28] T.R. section 25-2513-2(a). The return must be filed by the donor spouse, even if a gift tax return was not otherwise required (e.g., only annual exclusion gifts were made).
[29] T.R. section 25-2513-4. Because of this rule, consenting spouses should be very careful to assure that the value of the gifts are accurate.
[30] IRC section 2513(b) and Revenue Ruling 80-224, 1980-2 CB 281.
[31] IRC section 2652(a)(2).
[32] i.e., because gift splitting is not permitted, one-half of the gifts are not covered by the ex-spouse's annual exclusion and a gift tax may be due from the donor.
[33] i.e., One-half of the gifts ($220,000) times the lowest tax rate (41%) or the highest rate (50%) in 2002.
[34] ½ of the gift ($800,000) deemed made by the spouse times the top estate tax rate of 50% in 2002.
[35] $1,000,000 (spouse's unified credit) discounted at 40% ($1,666,666 in transferred value) times top estate tax rate of 50% in 2002.
[36] See IRC section 2503(e).
[37] IRC section 529(c)92)(B).
[38] See: Hader, "Planning to Avoid the Reciprocal Trust Doctrine," Est.Plan., Oct. 1999; Revenue 86-24, 1985-1 CB 329.
[39] IRC section 2523(f)(4).
[40] See: IRC section 2036.
[41] See: Zaritsky, Planning for Family Wealth Transfers: Analysis with Forms , section 9.05: Retaining Family Ownership Through Buy-Sell Agreements (WG&L).
[42] 756 N.E.2d 17 (Mass.App.Ct.2001).
[43] O.C.G.A. section 53-12-28. Note that a literal reading of the statute would mean that distributions for the benefit of the beneficiary might not be subject to garnishment for alimony.
[44] Barry A. Nelson & Rosario F. Carr, "Drafting to Achieve Maximum Flexibility in the Estate Plan", Est. Plan., July 1998; Alan S. Acker, "Every Drafter's Dream: The Flexible Irrevocable Trust", BNA Tax Memorandum, 1998, at 295; Neill G Keydel & Frederick R. McBryde, "Building Flexibility in Estate Planning Documents", Tr. & Est., Jan. 1996.
[45] William S. Forsberg, "Special Powers of Appointment: The Key to Flexibility in Planning," Est. Plan., Jan. 2000.
[46] See: Raithel, Drafting Estate Planning Provisions to Avoid Litigation, Estate Planning, February 2000; "No Contest Clauses in California Will and Trusts," 18 Whittier L. Rev., 613-633, 1997.
[47] IRC section 72(t)(2)(C).
[48] Some state laws provide some protection for IRAs. c.f., O.C.G.A. section 18-4-22 and Meehan V. Wallace , 102 F3d 1209 (11 th Cir. 1997). See also 11 U.S.C. 541(c)(2).
[49] 114 TC 259 (2000).
[50] Supra Note 47.
[51] IRC section 402(e)(4)(A) and IRS Notice 98-24, 1998-17 I.R.B. 5.
[52] See IRS Notice 98-24, 1998-17 I.R.B. 5 for the rules governing applicable holding periods.
[53] See: Roush, Beneficiary Designations After Divorce: Will the Ex-Spouse Benefit?" 25 Est. Plan. 5 (June 1998).
[54] 1999 WL 486590 (unpublished opinion) (4 th Cir. 1998).
[55] 23 EBC 1761 (3 rd . Cir. 1999).
[56] (1998 CA6) No. 96-6233.
[57] 591 NW2d 212.
[58] 149 2d 264 (2001). See Susan Gary, "State Statue Does Not Revoke Beneficiary Designation After Divorce," 28 Est. Plan. (August 2001).
| PARTIAL CHECKLIST OF ACTIONS AS A RESULT OF DIVORCE |
There are a multitude of practical issues which surround any divorce. This list is intended to provide a least a partial list of some of the issues which clients should address before and after their divorce is final. The list is not intended to cover every issue, but can help clients understand that the divorce involves far more than just the signing of a divorce decree.
X ERISA Qualified Plans ( ONLY after the divorce is finalized, or with signed spousal approval before divorce )
X IRAs
X Deferred Compensation Plans
X Stock Option Plans
X Life Insurance Policies
X Accounts Paid to the Order of or Paid at your Death to the Ex-Spouse
Complete Any Title Transfers on Assets (preferably before the divorce is finalized), Such as:
X Residence Ownership
X Other Real Estate Ownership
X Automobiles
X Stock or Equity Rights in a Business or Investment (make sure to get the original certificates)
X Brokerage Accounts
X Life Insurance (e.g., ex-spouse owns policy)
_ __ Terminate Joint Liabilities, for example:
X Credit Cards
X Lines of Credit
X Personal Guarantees of Ex-Spouse's Liabilities (e.g., business interest)
X Mortgages (may not be permitted by the terms)
X Utilities
Terminate Joint Accounts (and change direct deposits to these accounts), for example:
X Banking (i.e., checking, savings, etc.)
X Brokerage
X Safety Deposit Boxes
X Terminate Automatic Withdrawals (e.g. to ex-spouse's account or benefit)
___ Remove Permitted Access or Signing Authority by an Ex-Spouse, for example
X Personal Banking (i.e., checking, savings, etc.)
X Business Payroll Service
X Business Checking Accounts
X Personal Brokerage Accounts
Do a Change of Address for (Notice to Post Office and Notice to Each Party),for example::
X IRS (i.e., tax returns and audits) - Use IRS Form 8822
X Employer(s)
X Creditor, Bank, Brokerage and Similar Mailings
X All Insurance Companies
X Drivers License
X Passport
X Military and Veterans Benefits
Redo All Estate Planning Documents (to the extent an ex-spouse is named)
X Will (especially if revoked by divorce under state law)
X Revocable Trust(s)
X Medical Directive or Healthcare Power of Attorney
X General Power of Attorney
X Decide whether to Retain any Irrevocable Insurance Trusts which Name Spouse as Beneficiary
X If your Relatives have named your Ex-Spouse in their Documents, Alert them to the Need to make Changes
___ Enter a Modification for any Employee Benefit Cafeteria Plan
___ Make Changes in Personal or Employer-Based Insurance Coverage That Names Ex-Spouse If permitted by the Divorce Decree (perhaps obtain a refund)
X Life Insurance
X Health Insurance
X Long Term Care Insurance
X Disability Insurance
X Property & Casualty (e.g., auto, home, umbrella)
Change Access Codes and Passwords, for example:
X Web Based Access (e.g., bank, brokerage)
X Credit, Debit and ATM Cards
X Frequent Flyer Accounts
X Email Accounts
X Personal Safe
___ Change the Locks to and Change the Location of any Hidden Keys (do not just take back keys)
X Personal Home
X Studio Apartments
X Vacation Home
X Office
X Personal Safe
X Mailbox
___ Take Back Keys and Change the Location of any Hidden Keys
X Rental Properties
X Vehicles
___ Obtain Signature of Ex-Spouse
X Resigning an Officeror Director of any Business
X Signing over any Life Insurance, Long Term Care, Disability or Other Insurance Benefit
X To Permit any Continued Military or VA Benefits
X Relinquishment of any Rights to a Family Burial Plot
___ Notify the School of any Minor Children of any Changes in Custody
Create Any Required Funding Arrangements Under the Divorce Decree (e.g., new trust)
ALL INFORMATION IN THIS WEBSITE IS PROVIDED "AS IS", WITH NO GUARANTEE OF COMPLETENESS, ACCURACY, TIMELINESS OR OF THE RESULTS OBTAINED FROM THE USE OF THIS INFORMATION. ALL INFORMATION IN THIS WEBSITE IS WITHOUT WARRANTY OF ANY KIND, EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO WARRANTIES OF PERFORMANCE, MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE. See complete disclaimer.