Spousal Support

Nov 2022 : Use of QDRO Funds to Pay Spousal Support and Receive a “Disparity in Brackets” Tax Benefit

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

As is widely known, spousal support was previously taxable to the recipient and deductible by the payer. However, pursuant to the Tax Cuts and Jobs Act of 2017, alimony payments provided in divorce documents executed after January 1, 2019 are no longer taxable/deductible.

When they were taxable/deductible, the parties could take advantage of a disparity in tax brackets, hence “whipsawing” Uncle Sam, as follows:

  • H is required to pay W spousal support of $5,000 a month – $60,000 a year – for 5 years.
  • H is in a 40% combined federal & state tax bracket; W’s combined bracket – 20%.
  • On an annual basis, the payments and taxation thereof were as follows:
    • Payment Tax/Tax Savings Net of Tax
      H (60,000) 24,000 (36,000)
      W 60,000 (12,000) 48,000
    • So, because of the disparity in brackets, it cost H $36,000 to provide W $48,000. Uncle Sam pitched in the additional $12,000.
    • Multiply this by five years and the “tax subsidy” was $60,000.

Though no longer available due to the change in the law, the tax benefit from a disparity in tax brackets can still be achieved by use of a QDRO for a defined contribution plan – such as a 401(k) plan.

For example, assume the same facts as above – including H’s and W’’s respective tax brackets.

  • H & W sign a QDRO providing that his 401(k) plan pay W $60,000 a year.
  • W will pay $12,000 tax on the $60,000, netting her $48,000.
  • The payments are not subject to the 10% early withdrawal penalty regardless of W’s age under IRC Section 72(t).
  • H has used pre-tax funds to satisfy his spousal support obligation.
  • He has effectively shifted the tax on $300,000 – on which he would ultimately be taxed at his 40% bracket – to W at her lower 20% bracket.

Observations

  1. In situations where there are (1) a meaningful disparity in tax brackets; (2) a spousal support obligation; and, (3) the payer has a 401(k) savings plan, consider
    using a QDRO to shift the incidence of tax from the high bracket payer to the low bracket payee.
  2. This cannot be done, however, by transferring the entire amount – $300,000 in the example – which the payee would roll into an IRA.
    Reason – once transferred to an IRA, withdrawals are subject to the 10% penalty tax if the withdrawing party is under age 59 and a half.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Use of QDRO Funds to Pay Spousal Support and Receive a “Disparity in Brackets” Tax Benefit”
View / Download November 2022 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

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Jun/Jul 2022 : Divorce-Related Professional Fees May Be Added to the Tax Basis of Property Received or Retained in a Divorce

Posted by Joseph W. Cunningham, JD, CPA

View / Download June/July 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

For years prior to 2018, divorce-related professional fees were deductible as miscellaneous itemized deductions if they were incurred (1) for tax advice or (2) the procurement of taxable spousal support.

However, the 2017 Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions and, correspondingly, the deduction of otherwise qualifying divorce-related professional fees.

But, as under prior law, some divorce-related professional fees may be added to the tax basis of assets received or retained in a divorce, hence reducing taxable gain on disposition.

This was the holding in Gilmore v United States, 245 F Supp 383 (ND Cal 1965), which involved the protection of a business interest from claims of the nonowner spouse.

The portion of the fees that may be capitalized as additional tax basis is that which is attributable to services related to the protection, preservation, or acquisition of the business or investment property. In general, this portion is that part of the fees associated with the property settlement. The example at the end illustrates the determination of the addition-to basis component of legal and accounting fees.

It should be noted that for spouses who retain no assets, fees allocable to property settlement may nonetheless be an addition to the basis of marital assets transferred to the other spouse (who takes a carryover tax basis, increased by the fees, under IRC 1041).

Whenever there is a rational basis for allocating a fee, or part of a fee, to a particular asset (e.g., a fee for the valuation of a closely held business), that fee should be specifically allocated to the asset it relates to. Other fees that qualify as additions to a basis for a spouse are allocated among assets awarded
to that spouse pro rata their respective FMVs.

The IRS accepted this method of allocation in Spector v Commissioner, 71 TC 1017 (1979), rev’d and remanded on other grounds, 641 F2d 376, cert denied, 454 US 868 (1981); Treas Reg 1.212-1(k). The portion of the fees. However, the IRS maintained that a ratable portion of the fees had to be allocated to cash (which can never have a basis in excess of its face value) as well as to noncash properties. The Tax Court upheld the IRS position, thus eliminating any tax benefit of the fees allocated to the cash. The same applies to retirement benefits. That is, a portion of fees should be allocated to them but cannot increase their tax basis.

Similarly, with the large exclusion of gain available on most sales of principal residences, the allocation of fees thereto will often provide no tax saving benefit.

Contemporaneous Documentation

Whenever a divorce-related professional fee qualifies as an addition to basis, it is important that the tax benefit portion of the fee be specifically allocated to the related work. McDonald v Commissioner, 52 TC 82 (1969); Hall v United States, 78-1 US Tax Cas (CCH) ¶9126 (Cl Ct 1977), adopted, 78-1 US Tax Cas (CCH) ¶9420 (Cl Ct 1978). Rev Rul 72-545 stressed the importance of clearly establishing “a reasonable basis for allocating to tax counsel a portion of the legal fees incurred in connection with the divorce proceedings.” Some attorneys issue separate invoices for tax benefit work. Regardless of how such work is invoiced, it should be described in appropriate detail. Moreover, it is clearly preferable that the actual detail be provided when an invoice is submitted, rather than a year or more later when a client is being examined by the IRS concerning the estimated deductible portion of the fee.

Practice Pointer

Counsel should, at the close of every case, determine whether any of the professional fees incurred qualify as additions to tax bases of assets his or her client received. Also at that time—not later—counsel should include the results of the determination in a letter to the client and suggest it
be given to the client’s tax advisor. Not only is this a moneysaving service to the client, it is in counsel’s “enlightened self interest,”
since it will often reduce the client’s cost of paying the attorney fees.

Allocation of Fees to Tax Basis

  • $2,000 property settlement legal fee – Allocable to property awarded to client pro-rata to their respective values.
  • $500 legal fee consulting with valuation expert – Allocable to assets valued by the expert, pro-rata to their respective values.
  • $2,500 accountant’s fee – Allocable to assets valued by the accountant pro-rata to their respective values.

It should be noted that allocating fees as described above will provide minimal benefit in the many cases where the assets consist, in the main, of retirement benefits and equity in a home. However, it is important to be aware of the potential for benefit in every case and then take advantage where there is the opportunity to do so.

The author once worked on behalf of a woman who had inherited a large stock portfolio. Her divorce attorney billed her $50,000 – largely to protect her inheritance. Post-divorce, she married a stockbroker who promptly sold and reinvested the entire portfolio. $45,000 of the $50,000 divorce lawyer fee was added to the basis of the stock sold, hence reducing the taxable gain by same amount and saving substantial federal and state income taxes.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Divorce-Related Professional Fees May Be Added to the Tax Basis of Property Received or Retained in a Divorce”
View / Download June/July 2022 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “Jun/Jul 2022 : Divorce-Related Professional Fees May Be Added to the Tax Basis of Property Received or Retained in a Divorce”

Nov 2021 : Court of Appeals Rules on Double-Dipping Issue Fort v Fort, Mich App No. 351568 (4/22/21) – Unpublished

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2021 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Facts

H and W were divorced in 2019 after 14 years of marriage and three children.

  • Per their agreement, W was a stay-at-home mom.
  • H owned and worked at a business (Company), which was valued for the divorce settlement.
  • The trial court used the appraised value of the Company and ordered H to pay W spousal support.
  • H appealed, claiming that the property award and spousal support award, taken together, “constitute an impermissible “double-dip” that results in an inequitable outcome.”

Court of Appeals Decision (Unpublished)

  • The Court of Appeals (Court) noted that “double-dipping” – or tapping the same dollars twice – refers to situations where a business or professional practice is valued by capitalizing its income, some or all of which is also treated as income for spousal support.
  • The Court referred to the published Loutts case (Loutts v Loutts, 298 Mich App 21 (2012), in which the Court stated “[s]pousal support does not follow a strict formula” and “there is no room for the application of any rigid and arbitrary formulas when determining the appropriate amount of spousal support.”
  • Thus, the Court in Loutts “declined to adopt a bright-line rule” with respect to double-dipping.
  • The Loutts decision is consistent with preceding Court of Appeals cases on the issue.
  • However, the Court in Loutts indicated that if an appropriate spousal support award can be made without double-dipping, then such should be done.
  • The Court in the Fort case stated that it was unclear whether the trial court engaged in an inequitable “double-dip” because it did explain how it calculated spousal support.
  • Thus, the Court remanded the case so that the trial court could make factual findings concerning the relevant factors in a determination of spousal support.

Comments on the Case

  • The Court once again affirmed that spousal support is the be determined based on the factors set forth in Sparks v Sparks, 440 Mich App 141, (1992) and in Olson v Olson, 256 Mich App 619 (2003).
  • In doing so, income used in valuing a business or professional practice should not automatically be excluded from income for spousal support to avoid double-dipping.
  • However, if a proper balancing of the parties’ needs and income, taking all relevant circumstances into account, can be achieved without double-dipping, then such should be done in determining spousal support.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Court of Appeals Rules on Double-Dipping Issue Fort v Fort, Mich App No. 351568 (4/22/21) – Unpublished”
View / Download November 2021 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “Nov 2021 : Court of Appeals Rules on Double-Dipping Issue Fort v Fort, Mich App No. 351568 (4/22/21) – Unpublished”

Nov 2020 : Court of Appeals Rules on Use of Pension as Income for Spousal Support Despite the Pension’s Treatment as Property in the Divorce Settlement. Osim v Scott, Mich App No. 342237 (10/31/2019)

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Facts

  • After a 35-year marriage, H and W agreed to a settlement which provided, inter alia, that (1) H was awarded his pension – “free and clear of any claim” of W – and (2) W received the marital residence which had an equity of around $100,000.
    • However, they asked the trial court to determine spousal support. The judge awarded W, who had some health issues, permanent spousal support of $2,000 a month.
    • The judge notified the parties that H could ask for spousal support to be modified when he retired.
    • When H did retire, he took an approximately $440,000 lump sum pay-out for his pension which is what he had to live on for the rest of his life.
    • H petitioned the court to terminate spousal support since his only source of income was his pension which he received as his property in the settlement.
    • The trial court, after reviewing the circumstances of each party – including the disparity between $440,000 pension and the $100,000 home equity – reduced spousal support to $961.50, calculated by taking the approximate $300,000 difference and dividing it by W’s life expectancy.
    • H appealed.

Court of Appeals Ruling

  • The Court upheld the lower court’s decision to reduce, but not terminate, spousal support.
  • But, the Court ruled that the trial court failed to consider several relevant factors including:
    • The taxes H had to pay on receipt of the lump-sum;
    • That contributions were likely made to H’s retirement after the divorce and, hence, were not marital; and,
    • That the lump-sum was all H had to live on for the rest of his life.
  • The Court noted that the parties agreed that H would have the pension as his property and, further, that once an asset is awarded, it “is not subject to invasion by the former spouse, even indirectly, which is precisely what occurred when the trial court … considered the pension” as H’s income for determining spousal support.
  • However, the Court also noted that a previously awarded pension is a consideration in balancing the “incomes and needs of the parties in a way that will not impoverish either party.”
  • Thus, the Court remanded the case so that the trial court takes these factors into account.

Comments on the Case

  • The Court’s ruling is essentially as follows:
    • Income from a retirement bene/t awarded as property in a divorce settlement may not be included as income in a subsequent modification of spousal support.
    • But, such income is properly a consideration when doing so because the principles governing modification of spousal support are that “support must be just and reasonable under the circumstances and should balance the incomes and needs of the parties” so as not to impoverish either.
    • The tension between these two principles presents a tightrope to tread in attempting to achieve an equitable result in the “case specific” nature of divorce.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Court of Appeals Rules on Use of Pension as Income for Spousal Support Despite the Pension’s Treatment as Property in the Divorce Settlement. Osim v Scott, Mich App No. 342237 (10/31/2019)”
View / Download November 2020 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “Nov 2020 : Court of Appeals Rules on Use of Pension as Income for Spousal Support Despite the Pension’s Treatment as Property in the Divorce Settlement. Osim v Scott, Mich App No. 342237 (10/31/2019)”

May 2020 : “Double Dipping”

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Similar to Michigan law, the Ohio Court of Appeals rejected the arbitrary limiting of owner spouse’s income in determining spousal support to avoid “double dipping.” Kim v. Kim, 2020-Ohio-22 (1/8/2020).

Background

So-called “double dipping” occurs if these four conditions are met:

  1. The business or professional practice (enterprise) owned by one spouse (owner spouse) is valued by capitalizing excess earnings (or cash flow).
  2. Part of such excess earnings results from reducing owner spouse’s actual compensation from the enterprise to a “market” – or, “normal” level, reasonable compensation.
  3. The capitalized value of the enterprise is included in the marital estate divided between the parties.
  4. The total amount of the owner spouse’s compensation is included in determining income available for spousal support.

Example: H owns 100% of ABC Company (ABC). His average compensation from ABC is $200,000 annually. Reasonable compensation for his services, based on industry statistics, is $100,000.

If H’s actual compensation of $200,000 is used for determining spousal support, “double dipping” occurs since $100,000 of his actual compensation has been incorporated in the $1,200,000 value of ABC included in the marital estate divided between him and W. To avoid double dipping, H’s income for determining spousal support would be limited to $100,000.

Kim Case

Facts

  • H owns and works at two businesses from which his average compensation is $520,000 annually.
  • In calculating the value accepted by the trial court, H’s expert determined H’s “reasonable” or “market” compensation at $416,000.
  • The trial court used H’s total compensation – $520,000 – in determining spousal support.
  • It stated that, based on the circumstances of the case, equity does not require limiting H’s income for support purposes to avoid double dipping. In this regard, the court noted various factors indicating that H was in a much stronger financial position than W.
  • H appealed the court’s decision.

Court of Appeals Decision

  • The Court of Appeals (Court) upheld the trial court decision.
  • In so ruling, the Court stated that it agreed with the analysis made in another Ohio case that the statute “precludes an outright prohibition of double dipping” and that the trial should, “in the interest of equity,” consider the effects of double dipping.
  • In Kim, the Court noted that the trial court cited circumstances that were “overriding the unfairness of double dipping.”

Relevance to Michigan

Ohio, like Michigan, is an “equitable distribution” state. As we know, equitable distribution does not mean equal distribution to divorcing parties. Rather, trial courts have considerable discretion in tailoring a settlement to the equities of a case.

Double Dipping in Michigan – Loutts v. Loutts, Mich App No. 297427 (9/4/12)

  • The Michigan Court of Appeals (COA) published decision in Loutts is consistent with the Ohio Kim decision and COA decisions in four previous Michigan unpublished decisions on “double dipping.”
  • Essentially, the COA ruled that:
    • The effect of “double dipping” can be taken into account in determining spousal support to achieve a proper balancing of incomes and needs.
    • Hence, arbitrary limiting of the owner spouse’s income to avoid double dipping on a “bright line” basis is improper pursuant to MCL 552.23 and case precedents on using formulaic approaches to determining spousal support.
    • However, if not needed to achieve a proper balancing of incomes and needs, double dipping should be avoided.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Double Dipping”
View / Download May 2020 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “May 2020 : “Double Dipping””