Posts by Joseph W. Cunningham, JD, CPA

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)

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

Oct 2022 : Division of Federal Income Tax Debt — Lezotte v. Lezotte, Unpublished per curiam opinion of the Court of Appeals, issued July 28, 2022 (Docket #360244)

Posted by Joseph W. Cunningham, JD, CPA

View / Download October 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Facts

  • During most of their twenty-two year marriage, H & W owned a McDonald’s franchise which provided them a relatively high standard of living.
  • They sold the franchise in 2015 and netted approximately $850,000. However, rather than using the money to pay income tax due on the sale, the funds were invested in various business ventures all of which failed.
  • H and W filed for bankruptcy which was concluded in July 2020.
  • Regarding the federal tax debt remaining after bankruptcy, W claimed (1) that H had “hid financial circumstances from her” and (2) that H “controlled the finances and she had little input on” the disposition of the sale proceeds.
  • Further, it was acknowledged that H often signed W’s name – with her consent – on various documents including income tax returns.
  • The trial court divided the income tax on the gain from the McDonald’s sale equally between H & W in pertinent part because W “had enjoyed the financial benefits of the business during the marriage, including trips, jewelry, and clothing.”
  • W appealed.

Court of Appeals Decision

  • The Court upheld the trial court decision.
  • The Court noted that H had brought documents for W to sign and, further, that she had attended a meeting related to the bankruptcy proceedings.
  • Thus, the Court ruled, “the trial court’s division of marital debt was fair and equitable.”

Comments on the Case

  • It is not uncommon for one spouse to handle a couple’s finances, including income tax matters.
  • In many such instances the other spouse simply signs tax returns and other documents without reading and/or understanding what is being signed.
  • Sometimes, such a spouse may qualify for innocent spouse status and, thereby, avoid responsibility for joint tax liabilities.
  • But, one of the qualifying factors for innocent spouse status is that the spouse seeking such status did not significantly benefit from the unpaid tax.
  • In the Lezotte case, Ms. Lezotte did not in fact benefit from the unpaid taxes since the investments of the net sale proceeds all failed.
  • Rather the trial court appeared to rely on the fact that she “enjoyed the fruits of marital business decisions for seventeen years” and cannot “disavow herself from the debt that comes from those same business decisions.”
  • It was not indicated in the decision whether Ms. Lezotte had applied for innocent spouse protection.
  • Because there were virtually no assets to divide, the result to Ms. Lezotte was harsh.
  • The case serves as a reminder of how important it is for both spouses to have some level of understanding of their finances, including taxes, affecting them.
  • Also, in a divorce action in circumstances where that did not happen, innocent spouse status should certainly be considered regarding federal income tax debt.

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… “Division of Federal Income Tax Debt — Lezotte v. Lezotte, Unpublished per curiam opinion of the Court of Appeals, issued July 28, 2022 (Docket #360244)”
View / Download October 2022 Article – PDF File

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

Read More “Oct 2022 : Division of Federal Income Tax Debt — Lezotte v. Lezotte, Unpublished per curiam opinion of the Court of Appeals, issued July 28, 2022 (Docket #360244)”

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”

May 2022 : Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

General

Use of a stock redemption can be a “tax-smart” way to structure a divorce-related buy-out of the non-owner spouse’s marital interest in the stock. To do so, the owner spouse transfers stock to the non-owner, which is then immediately redeemed by the corporation. The difference between what the non-owner receives and the owner’s carryover tax basis in the stock is taxed favorably as a capital gain or loss. Stock redemptions can be particularly suitable in the following circumstances:

  • The company has excess liquidity.
  • The stock has a relatively high tax basis, as is not uncommon if the company is an S corporation.
  • The spouse who will not end up with the business individually owns stock.
  • The owner spouse may not draw more compensation because of “reasonable compensation” tax constraints or legal restrictions.
  • The dilution, if any, caused by the redemption will not be problematic for the owner spouse.

Other than in a divorce context, this approach would be treated by the IRS as a step transaction—the non-owner spouse’s stock ownership would be considered merely transitory and lacking independent legal significance, which would result in a constructive dividend to the owner spouse. However, this technique is available in a divorce setting because of an expansive IRS interpretation of IRC 1041 incorporated in regulations issued by the IRS. Treas Reg 1.1041-2.

Regulations and Illustrations

The following example explains the essential provisions of the regulations by way of illustration:

  • H and W each own 50 percent of ABC Company. They agree that H will continue to own and operate the company while W will tender her stock for redemption.
  • H has at no time assumed a “primary and unconditional obligation” to acquire W’s stock.
  • He has agreed, however, (1) to cooperate in his role as a corporate officer and shareholder so that the company implements the planned redemption and (2) to guarantee the company’s payment of the redemption proceeds.
  • Because H does not have a “primary and unconditional obligation” to acquire W’s stock before ABC redeems it, the redemption is not a constructive distribution to him.
  • Thus, W will be taxed at the long-term capital gain rate on the difference between the redemption proceeds she receives and her tax basis in the stock.

In the above illustration, both spouses own stock in the company. It is more common, of course, for the interest in the company to be owned by one of the spouses. The regulations do not directly address the situation involving (1) one spouse—say, H—owning 100 percent of the stock and (2) a divorce settlement providing for the following transactions:

  • H’s transfer of 50 percent of his stock to W.
  • W’s tender of the stock to the company in redemption of her newly acquired stock interest.

Though not specifically addressed in the regulations, it appears that the tax treatment for this fact pattern would be the same that applies when both spouses initially own stock, as follows:

  • The form of the transactions—(1) the nontaxable transfer under IRC 1041 of stock from, in our example, H to W, followed by (2) the redemption of W’s stock taxable at capital gains rates—will be honored, provided H does not have a primary and unconditional obligation to pay W for her interest in the stock.
  • Alternatively, if there is such a primary and unconditional obligation, the redemption distribution would be deemed constructively received by H and taxed to him as a dividend.

To illustrate, assume that H is the sole owner of the company and that, as part of his divorce settlement with W, they agree he will transfer a 50 percent interest to her, which she will tender to ABC in exchange for redemption proceeds. Though not expressly covered in the regulations, this fact scenario would appear subject to the following tax treatment:

  • Provided H does not have a preexisting primary and unconditional obligation to pay W for her marital interest in the stock, the form of the two-step transaction will be honored for tax purposes.
  • In effect, the transfer of the 50 percent interest from H to W as part of the divorce settlement will be tax free under IRC 1041, and the redemption distribution is not a taxable dividend to H.

A principal reason to assume the above tax treatment will apply when one spouse owns all the stock is the following statement in the background section of the regulations:

“By enacting the carryover basis rules in section 1041(b), Congress has, in essence, provided spouses with a mechanism for determining between themselves which one will pay tax upon the disposition of property outside the marital unit. For example, assume Spouse A owns appreciated property that he or she wishes to sell to a third party. The spouses may agree that Spouse A will sell the property to the third party and recognize the gain. Any subsequent transfer from Spouse A to Spouse B of the sales proceeds will be nontaxable under section 1041. In the alternative, the spouses may agree that Spouse A will first transfer the property to Spouse B. This transfer is nontaxable under section 1041, with Spouse B taking a carryover basis in the transferred property. Spouse B will then recognize the gain or loss on the sale of the property to the third party because a sale to a third party is not covered by section 1041. In this latter scenario, the tax consequences of the sale are shifted to Spouse B.”

 

66 Fed Reg 40,659 (2001).

Viability of Redemptions in Divorce

Certainty of Tax Treatment. Provided there is no such primary and unconditional obligation, the parties may structure a divorce-related redemption with certainty of the tax treatment. Nonetheless, because things change, including the minds of divorcing parties, a savings clause appears advisable.

Guarantee Allowed. With the IRS’s clear statement that a primary and unconditional obligation does not include a guarantee of another party’s performance, there should be no concern to provide that the remaining shareholder guarantee the corporation’s performance under the redemption agreement.

This is highly significant because, without a guarantee, it is conceivable, particularly where the remaining spouse would transfer a minority interest to the other spouse, that the remaining spouse would use his or her influence to obstruct the redemption, leaving the other spouse with a minority interest in a closely held company.

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 Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations”
View / Download May 2022 Article – PDF File

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

Read More “May 2022 : Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations”

Apr 2022 : Flexible Use of Funds in a Defined Contribution Plan E.G. – 401(K) – Received Via a QDRO in a Divorce Settlement

Posted by Joseph W. Cunningham, JD, CPA

View / Download April 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Receipt of an interest of a defined contribution (DC) plan pursuant to a QDRO can provide funds to serve many purposes on a relatively low-cost basis. DC plans are also referred to as “account balance” plans.

First, most such assignments of an interest in a DC plan – such as a 401(k) or savings plan – can be drawn as a lump sum distribution.

Second, such distributions are not subject to the 10% federal penalty tax applicable to distributions payable to someone under 59.5 years old.

Third, the recipient of such a distribution has 3 options regarding the funds:

  1. Pay regular tax on the distribution.
  2. Roll the distribution into an IRA – either existing or newly created – so that the funds can grow tax-free until later drawn out, usually at retirement
  3. A combination of options 1 and 2 – that is, pay tax on part of the distribution while rolling the balance into an IRA.

The above sets the stage for some creativity when there is a need for cash.

Example 1

  • The wife (W), 40 years old, receives $50,000, half of H’s $100,000 401(k) account balance, via a QDRO assignment.
  • She needs $15,000 to pay her attorney.
  • So, she rolls $32,000 into an IRA, pays $3,000 tax on the other $18,000, netting the $15,000 she needs for attorney fees.

Example 2

  • H and W owe $20,000 of credit card debt.
  • W has a $100,000 401(k) account balance.
  • She transfers $62,500 to H via a QDRO, retaining $32,500.
  • Their divorce settlement provides (1) that H is solely obligated to pay the credit card debt; (2) that he will do so within 5 business days of receiving the 401(k) distribution; and (3) that he will provide documentation of the payment to W within 5 days thereof.
  • H rolls $32,500 into an IRA, pays $5,000 tax on $25,000, netting the $20,000 needed to pay the credit card debt.

The above are simple examples of strategic use of DC plan funds in a divorce settlement. The uses are as varied as the cash needs of divorcing parties – such as a down payment on a new condominium, paying student loans, college expenses, etc.

It is noteworthy that:

  • Once DC plan distribution funds are rolled into an IRA, they are no longer exempt from the 10% penalty tax if withdrawn before age 59.5.
  • Regarding rolling some or part of a distribution into an IRA, it is highly advisable to arrange in advance for a “trustee-to-trustee” transfer directly from the plan into the IRA.
  • DC plans will generally withhold 20% federal tax on lump sum distributions. This can be avoided if a “trusteeto- trustee” transfer is arranged in advance.

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… “Flexible Use of Funds in a Defined Contribution Plan E.G. – 401(K) – Received Via a QDRO in a Divorce Settlement”
View / Download April 2022 Article – PDF File

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

Read More “Apr 2022 : Flexible Use of Funds in a Defined Contribution Plan E.G. – 401(K) – Received Via a QDRO in a Divorce Settlement”