Alimony

Nov 2019 : QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

With the elimination of taxable/deductible Section 71 payments effective January 1, 2019, using a QDRO transfer of an interest in a defined contribution plan (e.g., 401(k), 403 (b) account) by which a business owner spouse buys out the other spouse’s marital interest is a good fit in many situations.

General

In the past, Section 71 payments provided a means by which one spouse could buy out the other’s marital interest in a business with pretax dollars. But, with the 2017 Tax Cuts and Jobs Act of 2017 repeal of the alimony deduction, this method is no longer available as of January 1, 2019.
However, use of a transfer of an interest in a defined contribution plan account via a QDRO can be a “tax-smart” way to structure a business buy-out.

Example

  • H, 45 years old, owns ABC Company (ABC) which has been valued at $250,000 for his and W’s divorce settlement.
  • However, there are not sufficient other suitable marital assets to award W to offset the $250,000 business value.
  • But, H has a 401(k) account with a balance of $400,000.
  • His tax savvy lawyer proposes that H use his half of the 401(k) account to buy out W’s $125,000 interest in the business.
  • He tells H that he has the (1) business and (2) many years to replenish his 401(k) account for his future security.
  • He adds that, by using the 401(k) account, He will not need to use his personal cash or that of ABC for the buy-out.
  • Further, he states, since W no longer has the business as part of her future security, receiving additional 401(k) funds is ideal for her.
  • Since the $250,000 business value is largely after-tax and the 401(k) account is 100% pre-tax, the transfer to W must be tax affected.
  • So, assuming W federal and state tax rate will be 20%when she draws the 401(k) in the future, H transfers via a QDRO $156,250 of his $200,000 share of the 401(k) to W, the equivalent of $125,000 after-tax.

Observations

  1. Avoiding using cash for the buy-out may be particularly beneficial if H has spousal and/or child support obligations.
  2. Use of part of a 401(k) can also be used to buy-out an alimony obligation, as follows:
    • The present value of the projected stream of spousal support payments is calculated.
    • Then, the 401(k) amount is tax affected at the recipient’s tax bracket to its after-tax equivalent similar to what was done in the example.
    • The recipient can access the transferred amount from the 401(k) without the 10% penalty regardless of either parties’ age.

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… “QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions”
View / Download November 2019 Article – PDF File

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

Read More “Nov 2019 : QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions”

December 2018 : Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes

Posted by Joseph W. Cunningham, JD, CPA

View / Download December 2018 Article – PDF File

The 2017 Tax Cuts and Jobs Act limits the annual itemized deduction for state and local taxes to $10,000. Such taxes include (1) state and local income tax, sales tax, and property tax.

The $10,000 cap does not apply to taxes on land used for farming or a rental property. It does, however, apply to second homes – e.g. a cabin up north – and to investment property.

In the year of divorce, for which each party will file a separate tax return, it is common for real property taxes to have been paid from a joint account before date of divorce. Under federal tax law, payments made from a joint account in which both spouses have an equal interest are presumed made equally by them.

That presumption can be rebutted by evidence that funding of the account was other than equal.

Example

  • Assume that H, the higher earning spouse, contributed 80% to the account and W 20%. The property tax deduction is allocated accordingly.
  • But as the higher earner, H will have higher state (and possibly local) income taxes.
  • Depending on the amount of these taxes relative to the $10,000 cap, it may be advisable to split the deduction 50:50 even though H provided substantially more funds to the account.
  • This also provides W with 50% vs. 20% of the tax deduction if she itemizes deductions on her tax return.

Observations

So, as a practical matter, the parties have some flexibility on the allocation of the property tax deduction. Factors to consider are:

  • Amount of other taxes of each party relative to the $10,000 limit.
  • Funding of the joint account from which taxes were paid prior to the divorce.
  • Whether either party will likely use the increased standard deduction.

It is often advisable to provide for the allocation in the property settlement agreement to avoid post-divorce problems at tax return preparation time.

The following summarizes some general aspects of payments of mortgage interest and property taxes in a divorce context. It is drawn from the author’s Taxation Chapter in ICLE’s Michigan Family Law.

Payments Made in a Divorce Context

The deductibility of mortgage interest, property taxes, utilities, maintenance, etc., in a divorce context depends on the following:

  • ownership of the home
  • use of the home as a personal residence
  • liability on the mortgage loan
  • whether payments are made pursuant to a qualifying divorce or separation instrument.

Ownership. While some homes may be owned individually by one of the spouses during marriage, it is more common that a marital residence is owned by the spouses as tenants by the entireties, a form of ownership that is not severable and that provides survivorship rights for each party. A tenancy by the entireties is converted to a tenancy in common incident to divorce under Michigan law unless an alternative provision is made in the governing divorce instrument. MCL 552.102. Tenants in common do not have survivorship rights but do have a severable half interest in the home. It is not unusual for one of the parties to be awarded the family residence, often the custodial parent in cases involving minor children. It is also common for such a home to be owned as tenants in common subject to sale when the youngest child reaches the age of majority or graduates from high school.

As explained below, the form of ownership may affect the deductibility of payments related to the residence.

Use of the Home as a Qualifying Residence. IRC 163(h) permits the deduction of home mortgage interest, or “qualified residence interest,” on a taxpayer’s principal residence and a second qualifying home used by the taxpayer as a residence. If a noncustodial parent vacates the family residence and lives elsewhere, he or she may select the family residence as an “other residence” provided he or she uses the home for personal purposes for at least 14 days during the year. In this regard, the use of the home by a taxpayer’s child—again, for as little as 14 days—is attributed to the taxpayer. IRC 280A(d)(1).

IRC 164(a) allows a taxpayer to deduct property taxes that he or she (1) pays and (2) is personally obligated to pay. The obligation to pay generally tracks with ownership.

Liability on the Mortgage Loan. Spouses who own their marital residence as tenants by the entireties usually have joint and several liability on the mortgage loan on which the home is pledged. It is also not uncommon for both parties to remain jointly and severally obligated on the loan after the divorce since lending institutions often will not release one party from the debt even if the other has been assigned full responsibility for its payment in the divorce settlement.

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… “Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes”
View / Download December 2018 Article – PDF File

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

Read More “December 2018 : Strategy for Allocating the Property Tax Deduction in Year of Divorce to Minimize Effect of New Limits on Deducting Taxes”

November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2018 Article – PDF File

As previously reported in this column, the 2017 Tax Cuts and Jobs Act (Act), signed into law in December 2017, radically changes the tax treatment of alimony/spousal support beginning in 2019. The other changes made by the Act affecting divorce took effect January 1, 2018.

Thus, there is a small window within which to decide whether to have existing law – or the new law – apply to divorces that can be finalized this year or next.

The New Law

In a total reversal, alimony/spousal support will not be deductible by the payer or taxable to the payee for divorce and separation judgments and decrees entered on or after December 31, 2018.

This also applies to modified judgments of divorce or separation effective after 2018.

Additionally, it applies to divorce and separation decrees entered before December 31, 2018 if the parties elect to have
the new law apply.

The Act is Not Applicable to Divorce and Separation Decrees Entered Before December 31, 2018

For all existing divorce settlements and those entered by year-end, alimony will continue to be taxable/deductible.

Hence, a window of opportunity before year-end for the many situations in which the alimony payer is in a meaningfully higher tax bracket than the payee. This has set the stage for creative uses of “Section 71 payments” under which the disparity in tax brackets can be used to provide a tax subsidy. Examples include using Section 71 payments to:

  • Divide non-qualified deferred compensation on a taxable/ deductible basis.
  • Structure installment payments of a business buy-out of the non-owner spouse’s marital interest on a taxable/deductible basis.
  • Pay attorney fees on a taxable/deductible basis.

However, after 2018, these opportunities and similar others will no longer be available. In situations where there is significant disparity in brackets, using Section 71 payments in such circumstances may no longer be beneficial.

Effect of Judgment Amendments Post 2018

If a pre-2019 divorce or separation judgment or decree is amended on or after December 31, 2018, the new nontaxable/nondeductible law applies.

Query: Would this be the result even if the amendment does not pertain to spousal support? If the answer has not become clear by year-end, the distinct possibility of losing taxable/deductible status of spousal support payments must be considered before advising the post-2018 amendment of a pre-2019 judgment providing for taxable/deductible alimony.

Fundamental Change in the Dynamic of Alimony/Spousal Support

When the alimony deduction was enacted in 1948, the theory was that, if a former family’s income is split between the parties in some manner post-divorce, the tax treatment should correspond.

The result in many cases has been less combined tax paid on the payer’s income. Because of budgetary concerns—including the enormous cost of the Act—eliminating the alimony deduction became a revenue raising option to help alleviate the Act’s deficit-increasing effect.

This creates a new paradigm for divorce practitioners and alimony guideline providers. That is, we will need to think in terms of after-tax dollars for spousal support, similar to child support.

How to Avoid Paying Alimony with After-Tax Dollars Under the New Law?

One approach is to negate the adverse tax consequences of the new law by using 401(k) funds. As we know, more and more employees have 401(k) accounts than in years past.

Example

  • H, 40 years old, is a middle-management employee at a small company. He earns $60,000 a year. He has a combined 26% federal-state income tax bracket.
  • W is a stay-at-home mom who works part time and earns $10,000 annually. Hence, as head-of-household, her standard deduction offsets her income for federal taxable tax. Her income is subject to minimal Michigan tax.
  • The parties agree on alimony of $1,250 a month, i.e., $15,000 annually, for 5 years when their youngest child will be either working or in community college.
  • H has a 401(k) balance of $150,000, which is split evenly with W receiving $75,000 and H receiving $75,000.
  • In addition to W receiving her $75,000 share, the parties agree that H will transfer his $75,000 share of the 401(k) to W in lieu of spousal support. She can withdraw $15,000 annually, paying approximately $2,000 in tax. H will pay W $2,000 per year to reimburse her for the taxes she will pay on her withdrawals. Thus, W will have $15,000 per year, which is $1,250 a month after-tax spousal support.
  • While W ends up with $15,000 a year after tax either way, using the 401(k) account saves H tax as follows:
Not Use 401(k) Use 401(k)
Payments Over 5 Years:
Payments $75,000 $10,000
Tax at 26% to Provide Funds $26,000 $3,500
401(k) Funds 0 $75,000
Total Cost to H $101,000 $88,500

Observations

  1. The example shows that, in relatively modest circumstances, use of a 401(k) account can result in considerable tax savings.
  2. It provides a means of using pre-tax dollars to fund aftertax obligations – an advantage where there is disparity in brackets.
  3. In the example, the tax on H’s $75,000 share of the 401(k) was shifted to W – at her lower bracket – incident to satisfying his after-tax spousal support obligation.
  4. At 40, H has ample time for his 401(k) account to be replenished.
  5. Using 401(k) funds for a spousal support obligation as shown in the example requires that the plan allow for annual withdrawals, Many plans do not do so. But, a small business plan, as in the example, often does.
  6. A 401(k) account can be used for other purposes, such as buying out the other spouse’s marital interest in (1) a business or (2) a cottage up north.

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… “Beware: Spousal Support Tax Treatment Changes January 1, 2019”
View / Download November 2018 Article – PDF File

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

Read More “November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019”

Aug / Sept 2018 : Calculation of an Equitable Award for the Non-Degreed Spouse Under the POSTEMA Decision

Posted by Joseph W. Cunningham, JD, CPA

View / Download Aug / Sept 2018 Article – PDF File

— Background on Postema

In 1991, the Court of Appeals set forth the divorce settlement remedy for a non-degreed spouse who made “sacrifices, efforts, and contributions” to enable the other spouse to attain an advanced degree and, often, professional training. Postema v. Postema, 189 Mich App 89 (1991) (“Postema”).

Prior to the Postema decision, there was a split among different Court of Appeals panels on the proper remedy for such a non-degreed spouse in cases in which a divorce prevents such spouse from sharing in the “fruits of the degree” after its attainment.

Some panels had decided that the non-degreed spouse is entitled to part of the “value of the degree” – that is, the present value of the difference between (1) projected earnings of the degreed spouse over his/her work life expectancy with the advanced degree and (2) projected earnings of such spouse without the advanced degree.

Other panels ruled that the non-degreed spouse was entitled to be reimbursed for sacrifices, efforts, and contributions
made, but not to a share of the value of the degree. To resolve the split, the Supreme Court ordered that the next case on the issue would become binding precedent on the appropriate remedy. That case was Postema.

The Court ruled in Postema that the purpose of an equitable award is to reimburse the “non-degreed” spouse for “sacrifices, efforts, and contributions” made to enable the other spouse to attain a professional degree. However, this does include a share of future incremental earnings attributable to the professional degree.

The Court stated an equitable award applies in situations in which “the degree was the product of a concerted family
effort.”

Components of a Postema Award

Under Postema, there are generally four components to be considered in calculating an equitable award.

  1. Lost or Forgone Earnings – The non-degreed spouse’s 50% marital share of the difference between (1) what the degreed spouse could have earned, after-tax, during years of education and training and (2) his or her actual aftertax earnings during those years.
  2. Cost of Education – The non-degreed spouse’s 50% share of the out-of-pocket costs of the education and training paid with marital funds
  3. Subordination of Career Aspirations – Compensation to the non-degreed spouse for the cost of either (1) not pursuing career aspirations or (2) delaying such pursuit solely due to allowing the degreed spouse to do so. The non-degreed spouse’s share of such “make-up” compensation is 50% for years during the marriage and, possibly, 100% of the present value of lost future earnings.
  4. Intangible Sacrifices, Efforts, and Contributions – Compensation to a non-degreed spouse for intangible sacrifices, efforts, and contributions such as loss of companionship, and additional time devoted to household/parenting responsibilities in excess of the normal time spent doing so, occasioned solely by the degreed spouse’s time constraints due to pursuit of the advanced degree and training.

The Court also stated that the equitable award should be reduced by the non-degreed spouse’s 50% share of the degreed spouse’s incremental earnings after attaining the degree and training.

All amounts are converted to the value of current dollars since the award will be paid in current dollars.

Information Required to Calculate a Postema Equitable Award

The components of an equitable Postema award are, in the main, fact intensive. Thus, input from both parties is essential. Information required includes a timeline including:

  • Date of marriage;
  • Time periods of (1) advanced degree education and, if applicable, (2) professional training;
  • If applicable, time period working as a professional after attainment of the degree and training; and,
  • Dates of birth of children during marriage.

The following is a “Postema Information Request List” used by the author when performing a Postema award calculation.

Information Required to Determine an Estimated Equitable Award According to the Postema Case

  • Date of marriage; length of “courtship”
  • Birthdates of children of the marriage.
  • Detailed chronology (year by year) of attainment of advanced degree and professional training (e.g., for a doctor – medical school; internship; residency; board certification training; etc.)
  • Current résumé of the professional
  • Educational background and employment history of the degreed spouse prior to pursuit of the advanced degree. Provide his or her annual earnings from such employment.
  • Annual earnings of each party during years of the marriage – both before attainment of the advanced degree and professional training, and afterward.
  • Other sources of funds such as student loans, loans or cash gifts from family, inheritances, etc. Please indicate (1) the year in which such funds became available and (2) the party to which the funds are attributable.
  • The costs of the advanced degree and professional training, including tuition, books, fees, travel, additional housing, etc. Please specify the source of funds used to pay these costs. If financed by loans, please indicate the extent to which such loans have been repaid with marital funds.
  • An estimate of hours per week the non-degreed spouse devoted to household and other family responsibilities, including parenting, in excess of the hours such spouse would have devoted to such responsibilities if the other spouse were not pursuing the advanced degree and professional training.
  • Comments on the extent to which the normal companionship generally existing between spouses was unavailable due to pursuit of advanced degree and professional training.
  • Extent to which, if any, the non-degreed spouse subordinated his or her career aspirations to allow the other to pursue his or hers. Please specify the future plans regarding such postponed career aspirations, including the timetable for same.
  • Copies of federal income tax returns of the degreed spouse’s practice for each year since commencement of the practice.
  • If the degreed spouse did not start a practice immediately on being licensed to so, please provide his or her employment history, including annual income, since he or she became licensed to practice.

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… “Calculation of an Equitable Award for the Non-Degreed Spouse Under the POSTEMA Decision”
View / Download Aug / Sept 2018 Article – PDF File

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

Read More “Aug / Sept 2018 : Calculation of an Equitable Award for the Non-Degreed Spouse Under the POSTEMA Decision”

May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2018 Article – PDF File

— Facts

  • During the parties’ 11 year marriage, H operated a successful business of which he was the sole corporate shareholder.
  • W was a stay-at-home mom tending to the parties’ two young children.
  • At the time of the divorce, W was earning $11,000 annually for part-time work at a charter school. She testified she was seeking a full-time job.
  • H drew $43,216 from the business in the most recent year.
  • During the pendency of proceedings, H paid W $500/month spousal support and paid all household/family bills pursuant to a status quo order.
  • H incurred substantial debt (1) to make the required support and status quo payments, (2) to pay his and W’s attorney fees, and (3) to pay business expenses. At the time of divorce, the business owed $108,000 including rent in arrears and tax deficiencies.
  • The trial court imputed $20,000 earnings to W and $40,000 to H.
  • The trial court awarded no spousal support to W because:
    • She had a Bachelor’s Degree in Fine Arts while H had just a high school education.
    • H had paid all family expenses during the pendency by incurring substantial business debt.
    • Since W benefitted from this, she was “partially responsible” for such debt.
    • Because H was assuming full responsibility to repay the debt, the trial court viewed this as a “favorable outcome” for W.

Court of Appeals (Court) Decision

  • The Court stated that the trial court failed to make a determination (1) “as to the origin of the debts” of H’s business and (2) “who was responsible for their creation.”
  • Further, the Court noted that W had little, if anything, to do with H’s business and, hence, likely had little, if anything, to do with incurring the debts.
  • The Court remanded the case for reconsideration of (1) W’s responsibility, if any, for the debts after thoroughly reviewing the origin of the debts and (2) the lack of a spousal support award to W.

Comments on the Case and on Treatment of Debts in Determining Money Available for Support

  • The Michigan Child Support Formula Manual (Manual) provides in Section 2.01(B):

    “The objective of determining income is to establish, as accurately as possible, how much money a parent should have available for support. All relevant aspects of a parent’s financial status are open to consideration when determining support.”
    (Emphasis added.)

  • Thus, if H in Bockart had to incur debts to pay family expenses, money used to make payments on the debts is simply not “available for support.”
  • If a business is required to pay on business loans incurred in the ordinary course of business, such as working capital loans or equipment purchase installment payment loans, then the money used to make payments is not available for support.
  • Such payments are not deductible in determining business net income and so must be separately identified when determining money available for support.
  • This is the flip side of adding back deductible depreciation (1) above straight line on personal property or (2) on real property – that is, converting net income to money available.
  • The Court’s focus on the “origin” of the debt seems misplaced. Whether W had any “responsibility” for creation of the debts should not be a deciding factor. Neither should whether the debts were incurred by H or by his company.
  • Rather, of significance is whether the funds from the debts were used for marital purposes. If so, they are debts of the marriage, however incurred.
  • This may not apply to debts to provide for payment of divorce attorney fees. Responsibility for such fees is generally separately considered in divorce settlements.

Concluding Comments

  • Like so many matters in divorce, determining money available for support is a case specific exercise.
  • This is particularly so if one party owns a business or professional practice – both (1) to ensure all items of “indirect” income (excessive perks, etc.) are identified and (2) that legitimate debt payments are excluded from money available for support.
  • Often balance sheets need to be reviewed in addition to income statements.

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 Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”
View / Download May 2018 Article – PDF File

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

Read More “May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”