Awkward Though It May Be, Planning For Divorce Needs To Be Done
Divorce remains an unfortunate reality for many of our clients.
In the fall of 2000, Time magazine 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 that is often ignored in the planning process. Every estate 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 possibility that needs to be addressed. This article discusses some planning opportunities and traps in the course of a divorce.
Planning Recommendation: Use a competent attorney who does divorce work on a regular basis and understands the tax and retirement plan implications of a divorce. While the rules often seem fairly straightforward, this is one area where drafting documents without proper advice can create unforgiving results.
For example, in the Croteau decision a taxpayer drafted his own settlement agreement using someone elses agreement as a format. Because of improper language, the Tax 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.
In another recent decision, Hendon v. Dypont, the Sixth Circuit Court of Appeals ruled that even when a divorce decree and dissolution agreement provided that a wife waived her rights to a ERISA retirement plan, she was still entitled to the qualified plan assets upon the death of the plan participant, because the waiver was not in compliance with the requirements of ERISA.
Planning Recommendation: Documents should always be drafted in contemplation of the divorce of the client or an heir. Virtually all irrevocable trusts should be drafted in contemplation of divorce of a beneficiary.
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 over the trust, such as the right to remove other trustees and a limited power of appointment to reconfigure the trust for the benefit of the couples joint descendants. The trust instrument could provide that all rights and powers of the spouse, including her right to serve as co-trustee, immediately be terminated 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 assets.
As another example, assume a couple owns a business. 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 (i.e., by the divorce decree), but has the business redeem the interest, the business owner, not the ex-spouse may be taxable.
If the business is a C corporation and the business owner continues to hold significant interests in the corporation, it will be extremely difficult to qualify the distribution as a capital gain transaction. Instead the distribution may be treated as a constructive dividend to the owner. 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. In many cases, the business cannot afford to redeem the ex-spouses stock in one cash payment and will want to use the installment method to pay the redemption cost over time. However, if the transaction is treated as a deemed distribution to the business owner, the installment method may be lost, because the transaction is treated as a taxable dividend.
The solution? Provide in any buy-sell agreements that both the business entity and the owner have the right to purchase the departing ex-spouses business interest.
Planning Idea: 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 million in cash or $1.1 million in stock that has a basis of $1,000. Which is the better option? For tax purposes (assuming an immediate stock sale), the $1 million in cash is a better choice. Why? Assuming a combined state and federal capital gains rate of 25%, the $1.1 million in stock carries an inherent tax cost of roughly $275,000, meaning the asset has a true after-tax value of only $825,000.
Planning Idea: The tax status of a taxpayer is determined as of the end of the tax year. If the couple are divorced or legally separated at year-end, 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 final after the end of the year. 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.
If the couple remains married until the end of the year, they may be able to use gift-splitting to double the amount of the gifts each of them provides to their heirs. For example, assume a wife has 10 descendants and a taxable estate. Waiting until after Dec. 31 to divorce would allow her to double her annual exclusion gifts to $220,000. If her estate were taxable at 45%, this gift-split transfer would save almost $50,000 in transfer taxes (i.e., $110,000 times 45%).
There are also some disadvantages to filing a joint return. First, alimony deductions are not available if a joint return is filed. If one spouse is in a high income tax bracket, while the other spouse is in a lower tax bracket, 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” which states that neither has liability for the others tax reporting or taxes.
Third, 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.
Planning Idea: For purposes of qualifying for IRA contributions, alimony payments are treated as earned income (see IRC section 219(f)(1)). Assume a non-working spouse is getting divorced. Allocating a portion of any “property” settlement to long-term alimony (e.g., $3,000 per year, or $3,500 per year for those 50 and older) would both create an income tax deduction for the payor and allow the payee to make a tax-deductible IRA contribution.
Planning Idea: 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 insureds 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.
Often a life insurance policy is used to “insure” payment of divorce obligations to an ex-spouse. If the divorce decree or settlement agreement provides that an insurance policy will revert to the insured upon the end of the divorce obligations, this reversionary interest may result in the husband having to include the policy in his taxable estate, even when the spouse is the irrevocable beneficiary.
Unless the payment qualifies for a divorce-related deduction, the husbands estate will have to pay any estate taxes on the death proceeds. In many cases, it will be better to just let the policy lapse or have the ex-spouse own the policy and have the ex-spouses will provide for transfer of the policy into a trust for the benefit of descendants.
If the ex-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 a beneficial interest until the conditions of the divorce decree are met, 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). Properly created, the policy is also excluded from the insureds taxable estate.
Planning Recommendation: If divorce is anticipated, the client should discuss with his estate planner the possibility and benefit of executing a new planning document in contemplation of the divorce. The impact of the divorce on the couples existing estate planning (especially for their descendants) should be considered as a part of the divorce process.
Many clients have drafted powers of attorney granting spouses the right to handle their medical and property issues upon incapacity. Having an ex-spouse or a divorcing spouse in charge of your medical and property decisions is probably not advisable. The client should either modify the planning documents upon the first inklings of divorce or provide in the document that in the event divorce or legal separation proceedings are initiated, the right of the spouse to serve as power holder immediately terminates and the next named successor is automatically appointed.
Planning Idea: The choice of who owns the retirement plans is a critical issue in any divorce. For example:
If an ERISA qualified plan is transferred to an ex-spouse pursuant to a Qualified Domestic Relations Order (QDRO), the recipient spouse can make withdrawals from the account, without having to pay a 10% early withdrawal penalty. If an IRA account is transferred, the recipient spouse who withdraws the funds before age 591/2, 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 591/2 (e.g., a husband intends to take a year off from work), that spouse will be better off receiving the ERISA account.
Assume a husband has creditor problems. Creditors of an ERISA plan participant cannot generally invade the retirement plan account of the debtor. To provide maximum protection, the husband could retain all the benefit of his own retirement plan and, possibly, even receive a QDRO to obtain the wifes ERISA plan benefits. The wife could receive other assets.
Assume a husband is a participant in a 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 than calculated by the plan administrator.
Planning Idea: In considering whether to receive part of the ERISA benefit of a spouse, the recipient has two choices. The recipient can provide for a current distribution and then roll the funds over 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:
Creditors of ERISA plans are generally unable to invade the account assets of participants. Under federal law, IRAs do have the same creditor protection (although some states provide limited protection). Thus, if the recipient expects to have creditor problems, maintaining an existing ERISA account could provide better asset protection.
If the participant is not fully vested in the plan, it may make sense to retain rights in 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 (e.g., an ESOP), the value of the distributed employer stock may be taxed at the plans basis in the stock rather than its current fair market value. The subsequent sale of the stock may be taxed as a capital gain.
If the ERISA plan is maintained by a closely held or family business that 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 may want to hire an actuary to make their own evaluation of the future benefits.
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 bad spending habits.
Planning Recommendation: Always review beneficiary designations as a part of any divorce. Failure to address this important element has proven costly to many clients. For example:
In Merchant v. Corder, a taxpayer changed the beneficiary designation for his qualified plan prior to his divorce being final. Because the spouse had not agreed to the relinquishment of her rights before the divorce was final and there was not a qualified domestic relations order, the 4th Circuit Court of Appeals granted the ex-wife all of the husbands retirement account on his death.
In Samaroo, the 3rd 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 participants death resulted in the termination of all of the ex-spouses rights in the plan.
In Schultz, an Iowa court ruled that when a divorce decree did not include any waiver of a spouses IRA account and the IRA owner 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.
The solution? Clients should make sure to obtain properly drafted qualified domestic relations orders when plan assets are to be passed to an ex-spouse. If qualified plan assets are not to pass to an ex-spouse, a new beneficiary designation should be prepared and filed with the plan administrator immediately after the divorce decree becomes final or, if the soon-to-be ex-spouse will cooperate, a spousal waiver should be signed before the divorce is finalized.
Divorce is enough of a tragedy, without adding to it by making costly mistakes. Clients should be strongly advised to address the structure of their divorce as much as they address the structure of their estate plans. But given how many of our clients have approached estate planning, maybe they should be a bit more diligent.
John J. Scroggin, J.D., LL.M. is an estate planning attorney in Roswell, Ga., and author of “The Family Incentive Trust,” published by The National Underwriter Company. He can be reached via e-mail at firstname.lastname@example.org.
Reproduced from National Underwriter Life & Health/Financial Services Edition, November 18, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.