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.