Planning for Divorce - Part II

“Marriage is often due to lack of judgment, divorce to lack of patience and remarriage to lack of memory.”
- Will Rogers

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 & 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as a consequence of the divorce were deemed to be to hinder, delay or defraud creditors, then the transfer could be rescinded as a “fraudulent transfer.”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 or 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 exspouse. 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 considethe ex-spouse be both owner and irrevocable beneficiary of the policy. (8)
• However, if the policy has a significant cash value and the couple are no longer married, the transfer to the 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 estaassets 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 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. One of the things that divorce attorneys are not particularly good about is 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 tricker 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, a 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 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 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 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 prepay 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, 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 exspouse/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 Trusts. 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 assets step-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 allows other 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 type of 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, the Massachusetts Supreme 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. 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 (42) 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 surviving 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 settlement 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. (43) 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 nondescendant parent has custody of minor descendants, the trust should provide for how the exspouse is treated.

Particularly with irrevocable trusts like Dynasty Trusts, granting a person a “Limited Power of Appointment” (44) 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 nocontest provisions are outlawed in 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. (45) 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. (46) If an IRA account is transferred, the recipient spouse who withdraws the funds before age 591&Mac218;2, 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 591&Mac218;2 (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. (47) 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 (48) 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. (49) 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. (50) If the holding periods are meet (51), 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 valuation is 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. (52) For example:

• In Merchant v. Corder (53), 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 husband died the ex-spouse received all of the retirement fund.
• In Samaroo v. Samaroo (54), 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 exspouse’s rights in the plan.
• In Hendon v. Dypont (55) 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 (56), 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 exspouse 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 (57) 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 preempt 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.

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.