Planning for Divorce - Part I

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(6). 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. 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. This 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.
• 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 ascooperative 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, nondeductible 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 rescission 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 31st 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 theirmedical 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 no 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 in testate 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 interstate 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 interstate 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 interstate 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 premarriage 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 role should 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.

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 300 published articles, outlines and books, including The Family Incentive TrustTM.