Marital Estate Division Offers Challenges and Opportunities For Advisors
The emotional aspects of a divorce often interfere with planning for the efficient distribution of the marital estate. The shock and ill feelings may create a barrier between spouses that prevents even discussing issues. Tax practitioners need to know how to explain to a divorcing client the tax realities, to avoid any post-divorce tax surprises. Mistakes in property division or fraud can produce consequences that the tax practitioner may be unable to reverse.
Sec. 71(b)(1) defines alimony as a transfer of cash made under a divorce or separation instrument to a spouse or former spouse under the following conditions:1. The divorce or separation instrument does not designate the payment as anything other than alimony (not for child support). 2. The payments do not continue after the death of the recipient. 3. The provisions of the instrument do not preclude a deduction by the payor spouse and the recognition of income by the payee spouse. 4. Spouses who are legally separated under a decree of divorce or separate maintenance do not live in the same household when the transfer is made.
Certain payments to third parties on behalf of the spouse—for example, mortgage payments—qualify as payments in cash. Alimony does not include: child support payments (which are generally nondeductible by the payer and not included in the recipient’s gross income), non-cash property settlements, payments that are part of the community income of the payee, payments to maintain the payer’s property for use by the payee, or the value of such use. If the parties are married at the end of the tax year and file a joint return, payments made during the year do not qualify as alimony. Generally, alimony is deductible by the payer and included in the recipient’s gross income. Thus, there is inherent tension between property settlement and alimony. the payor may want a low property settlement and high alimony amounts for the tax deduction. The payee spouse, however, wants the reverse—that is, a property settlement not includible in income rather than taxable alimony.
To make property payments deductible, the payer spouse may try to disguise the payments as alimony. For example, the payer may make large “alimony” payments Sec. 71(f) prohibits excessive front-loading of alimony payments and requires the payer spouse to recharacterize (or “recapture”) part of the alimony payments as nondeductible property transfers if there is excessive front-loading. Tax advisers can help their divorcing clients by reviewing any nonuniform payment schedule to make sure it does not violate the anti-front-loading rules.
In planning for the division of assets and the obligations of the parties, safeguards can be put into place to avoid failed expectations. For example, parties may contractually decide that new life insurance is needed to fulfill the payer’s alimony and child support payment obligations in the event of death. The parties may contract to leave the ex-spouse as beneficiary (hanging beneficiary) on life insurance policies and retirement plans to ensure that the ex-spouse receives his or her bargained-for interests. If the beneficiary is designated as “my current spouse” and the owner spouse remarries, the ex-spouse no longer receives his or her interest when death or retirement occurs.
Safeguards also may be needed when a payer spouse has cyclical income business interests or illiquid business interests; the spouses may agree that an alimony trust or maintenance trust (Sec. 682 trust) is the best solution. An alimony trust can protect the payee (ex-spouse) from the death or financial insolvency of the payer before all of the payments have been made.
Spouses in divorce situations must disclose all property, and this property must be distributed to the proper party. When fraud, errors, or omissions occur, a CPA needs to be capable of helping his or her client avoid the negative tax consequences of transfers or payments made in connection with the divorce. The client’s objective is to emerge from the divorce economically whole while minimizing taxes.
Among the many tax practice resources the AICPA makes available to Tax Section members (see Resources box at the end of this article) is an eight-page checklist of tax considerations for CPAs representing clients who are divorcing or recently divorced. Some of its points are:1. Determine which party to represent and prepare a new engagement letter, privacy disclosure notice, power of attorney, and similar documents. 2. Consider obtaining conflict-of-interest releases where indicated. 3. Review any prenuptial agreement. 4. Consider the effect of joint liability for any taxes owed. 5. Consider the need for (or, if completed, obtain a copy of) a qualified domestic relations order for any individual retirement accounts and other retirement plans. 6. If there are children with investment income, reevaluate “kiddie tax” implications. 7. For a property settlement, obtain or prepare a schedule of assets with tax considerations for each asset. 8. Consider the effect of divorce on insurance coverage, beneficiary designations, mortgages and other debts, financial and estate planning, etc.
Source: Divorce Issues Checklist, AICPA Tax Section.
CPAs can provide forensic services and/or tax advice concerning identification and division of marital property for a client going through a divorce. Since divorcing spouses are likely to have competing interests, however, CPAs providing these services should take care to avoid conflicts of interest.
In the nine community property states, property is owned concurrently between spouses. In the rest, referred to as common law states, courts must determine an equitable distribution of the spouses’ property between them.
Property transfers by a spouse during a period of marital strife may be subject to heightened judicial scrutiny in an equitable distribution of property. A court may invalidate transfers made to deprive the other spouse of assets by fraud or dissipation.
A transfer incident to divorce from one spouse to the other generally will not result in taxable gain or loss. However, divorcing couples should be made aware of requirements in the Code and regulations for a transfer to be considered incident to divorce. Similarly, alimony typically entails tax planning.
by Ray A. Knight, CPA, J.D. and Lee G. Knight, Ph.D. (April 2013)
and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)