Divorce

Apr 2023 : Holder’s Interest Value to the Owner Cuts Both Ways

Posted by Joseph W. Cunningham, JD, CPA

View / Download April 2023 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

The Michigan Court of Appeals has ruled in a number of cases that, if is a business providing personal services is worth more to the owner than the price at which it could be sold, the value for divorce purposes is value to the owner – sometimes called “holder’s interest value” – on a going concern premise unless there is reason to believe the enterprise will be sold or discontinued.

But what about the reverse situation – the sale value – that is, fair market value (FMV) – is higher than the value to the owner?

Premise of Value to Owner

If there is no intent to sell or discontinue a business or professional practice, it should be valued for divorce based on its intrinsic value to the owner on a going concern basis. The financial benefits from that value are what have been conferred on the family while intact and will be conferred solely on the owner post-divorce.

Support – Kowalesky, 148 Mich App 151 (1986) and several other Court of Appeals (COA) cases.

Logic – If there is no intent to sell, under what rationale should any value other than the value based on current financial benefits provided by the business be used in a divorce settlement?

No other value is relevant to this family or, hence, to this divorce.

However, Value to Owner Cuts Both Ways

Value to Owner Higher than FMV – The value of a neurosurgeon’s practice – dependent solely on established referral sources to this particular doctor – is worth much more assuming the doctor will continue the practice than to sell it. According to the COA, the higher value applies in divorce if there is no reason to believe the practice will be sold or discontinued.

FMV Higher than Value to Owner – Several years ago consolidators were “rolling up” funeral homes to add value via economies of scale – synergistic value. But, if a family-owned funeral home intended to remain as such and had no intention of “going corporate”, would it make any sense to use the higher potential sale value which is, essentially, irrelevant to this family, this divorce?

Logic – What possibly supports applying value to owner if higher, but not if lower? Either way, should not the value to this particular family be used?

Clawback Provision

If potential sale value is significantly higher than value to owner, the non-owner can be protected by use of a clawback provision which provides that, in the event of sale within a certain time frame, the non-owner will receive some percentage of net sale proceeds in excess of the value used in the divorce.

Depending on the circumstances, a declining percentage may be appropriate – e.g. 50% of the excess if the sale occurs within a year of divorce, 40% within two years, and so on.

Such a provision should be considered particularly if there is reason to believe a sale may occur in the near term.

It is not a failsafe method for safeguarding the non-owner, but does afford some measure of protection.

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… “Holder’s Interest Value to the Owner Cuts Both Ways”
View / Download April 2023 Article – PDF File

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

Read More “Apr 2023 : Holder’s Interest Value to the Owner Cuts Both Ways”

Feb 2023 : Tax Return Filing Status and Related Matters

Posted by Joseph W. Cunningham, JD, CPA

View / Download February 2023 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

At this time of year, parties who have recently divorced or are in the process of obtaining a divorce must consider how to file their federal income tax return.

The following present the options available, the rules regarding filing status, and planning opportunities.

Options

The filing options are, essentially:

  • Joint tax return at the lowest rates.
  • Single tax return with higher rates
  • Head of Household with rates between the joint and single rates.
  • Married filing separately with the highest rates.

For example, the tax on $60,000 taxable income in 2022 and the 2022 standard deduction are as follows:

As this shows, the difference between filing jointly and married filing separately is considerable, particularly at higher income levels. But, even at lower levels, the difference in the standard deduction is significant – a 100% higher joint vs. married filing separately.

Rules

Parties Divorced in Prior Year

How parties may file is determined by whether they were divorced as of December 31 of the prior year. If they were, the parties cannot file a joint return. Rather, they must file as single taxpayers or, if certain qualifications are met, as head of household.

Parties Not Divorced in Prior Year

If parties were still married at December 31, they may file a joint return for the prior year or may file married filing separate returns – at the steepest rates.

However, one (or possibly both) of them may qualify as married head of household as follows:

  • Must provide more than half the cost of maintaining a household;
  • Have a qualifying child or dependent who lived in the household more than six months of the year; and,
  • At the end of the year must be considered unmarried.

“Considered unmarried” though still legally married requires that a party satisfy the head of household requirements and, in addition, that the other spouse did not live in the home during the last six months of the year.

Planning Considerations

Joint or Separate Return?

If a divorce process is in the latter part of a calendar year, it is generally advisable to “run the numbers” both ways – that is, joint filing and separate return filing – especially if one spouse may qualify as head of household – to determine which way yields the lower overall tax.

In general, joint filing will typically result in lower overall tax if one party has significantly more income than the other. Because of this, it is not uncommon in such cases to finalize the divorce in all respects but to postpone filing the judgment until early January so a joint return can be filed.

However, there are instances where one party suspects the other of fraudulent or highly aggressive tax positions and does not want to be subject to the potential “joint and several” liability that applies to joint return filers. Further, awareness of such tax positions may preclude a claim of “innocent spouse.”

Thus, it may be advisable for the suspecting party to consider filing a separate return.

Or, if a joint return is filed, for him or her to secure a “hold harmless” provision regarding any tax deficiencies, penalties, and professional fees attributable to fraudulent or highly aggressive filing positions taken by the other spouse.

Estimated Tax Payments; Tax Refunds & Overpayments

Another important consideration for a divorce related tax return filer is the area of estimated tax payments; tax refunds & overpayments. Below is the August 2022 column regarding this matter.

Estimated tax payments made – and/or taxes withheld – during the year of divorce are generally a marital asset. Tax refunds or, overpayments applied to next year’s tax, attributable to tax payments made during marriage are also a marital asset.

And, it may cut the other way – that is, estimated tax payments and/or taxes withheld may be less than the actual tax on marital income received and shared during the year of divorce.

In this regard, note the following:

  1. Separate Returns for Year of Divorce – Whether divorcing parties can file a joint return or must file separate returns depends on their marital status as of December 31. If divorced as of that date, they must file separate returns for their respective separate incomes and deductions.
  2. Estimated Payments Automatically Are Credited to the Husband – Since the husband’s social security number (SSN) is generally listed first on joint estimated payment vouchers (Form 1040ES) made during marriage, such payments will automatically be credited to him unless there is a written alternative provision agreed on by the parties.
    The same applies to tax overpayments on the parties’ last joint return applied to the following year’s tax.
  3. Estimated Tax Payments and Tax Withheld During Marriage Are Marital Funds – Absent unusual circumstances, estimated tax payments and tax withheld during marriage are made with marital money – essentially half by each party.

The above matters are often not addressed in divorce settlements. The following presents (1) observations on such tax payments and (2) applicable tax law.

Tax Payments Made During the Year of Divorce

Example – Assume the following alternative facts for joint estimated tax payments made by – and/or withheld on behalf of H – during the year of a divorce for which the judgment is entered on December 30.

So, in Case #1, H will receive a windfall unless W’s attorney identifies the overpayment and makes an offsetting adjustment. Half of H’s $10,000 overpayment was made with W’s share of marital funds.

In Case #3, it is H’s attorney who needs to (1) identify that H will pay $10,000 of his own funds on income equally shared with W and (2) make an offsetting adjustment. When paying the $10,000, H will, in effect, be paying both his and W’s $5,000 shares of the tax on marital income.

Agreement to Apportion Joint Estimated Tax Payments

IRS Publication 504 – “Divorced or Separated Individuals” – provides that divorced parties may agree on the division of joint estimated tax payments made during marriage.

Because the IRS credits the account of the spouse who’s SSN appears first on the estimated tax voucher (Form 1040ES) – almost always the husband’s – if the other spouse (assume W) claims any of the joint estimated tax payments on a separate return, W should indicate the ex-spouse’s SSN on page one of his or her IRS Form 1040 in the designated space. If W has remarried, she should enter the current spouse’s SSN in the appropriate space and enter the ex-spouse’s SSN, followed by “DIV,” on the line at the bottom of page one, where estimated tax payment credits are claimed.

Tax Refunds and Overpayments Applied to Next Year’s Tax

It is common practice to provide for the division of tax refunds resulting from the parties’ final joint income tax return.

But, in some cases, parties filing a joint return will apply all or a part of any tax overpayment to the following year’s tax rather than having it refunded. This frequently occurs when a return is on extension and filed after April 15 and the prior year overpayment is needed to cover current year tax to avoid the underpayment penalty.

The IRS has ruled that it will abide by an agreement of spouses who are no longer married regarding the apportionment of an overpayment of tax on a prior year’s joint income tax return that the parties elected to apply to the following year’s tax liability. Rev Rul 76-140.

However, here, too, because the IRS credits the account of the spouse who’s SSN appears first on the tax return, if the other spouse claims any of the applied overpayment, the other spouse should indicate the ex-spouse’s SSN on page one of his or her IRS Form 1040 in the designated space. If the other spouse has remarried, he or she should enter the current spouse’s SSN in the appropriate space and enter the exspouse’s SSN, followed by “DIV,” on the line at the bottom of page one, where estimated tax payment credits are claimed.

Practice Pointers

  1. Discover Tax Situation – As part of discovery, the tax overpayment or underpayment status of the parties should be determined. This can often be provided by the parties’ tax preparer.
  2. Over Withholding – The owner of a closely-held business can arrange excessive tax withholding. If undetected, the money that should be in marital accounts to divide will instead accrue 100% to the owner as a tax refund. The excessive withholding can be done on the last day of the year. So, the fact that withholding was not excessive on a September 30 pay stub is not a reliable safeguard against withholding manipulation.

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… “Tax Return Filing Status and Related Matters”
View / Download February 2023 Article – PDF File

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

Read More “Feb 2023 : Tax Return Filing Status and Related Matters”

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)”

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”