Aug / Sept 2019 : Bankruptcy Exemption May Not Apply To Retirement Benefits Received In Divorce – Lerbakken v Sieloff & Associates, PA, NO. 18-6018 (8th Cir. 2018)

View / Download Aug-Sept 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Background

  • In his 2014 divorce settlement, Mr. Lerbakken (Mr. L) received half of his wife’s 401(k) account and 100% of her IRA.
  • He subsequently filed for bankruptcy protection. One of his creditors was Sieloff & Associates. The firm that handled Mr. L’s divorce and remained unpaid.
  • Mr. L claimed that the 401(k) account and the IRA received in the divorce were exempt from claims of creditors as retirement assets under 11 U.S.C. Section 522(d)(12).
  • The bankruptcy court disallowed Mr. L’s claimed exemption for the 401(k) and the IRA.
  • Mr. L. appealed to the 8th Circuit Court.

8th Circuit Court Ruling

  • The 8th Circuit Court (Court) upheld the lower court’s disallowance of the exemption.
  • The Court referred to a 2014 U.S. Supreme Court ruling that an inherited IRA did not qualify as a retirement asset qualifying for the bankruptcy exemption. Clark v Rameker, 134 SCt 2242 (2014).
  • In so ruling, the United States Supreme Court indicated that retirement funds for purposes of the bankruptcy exemption meant funds set aside to be available when one stopped working and, hence, did not apply to an inherited IRA.
  • The Court ruled that a retirement asset received as part of a property settlement does not qualify for the exemption either.
  • The Court was not swayed by Mr. L’s claim that his wife’s 401(k) and IRA were accumulated specifically for their joint retirement.
  • It was also noted that Mr. L had not rolled the assigned funds into his own retirement account. He could not even produce a QDRO indicating that he had accessed his as-signed share of the 401(k).

Comments on the Case

  • The Court seemed to narrowly construe the statute since, as Mr. L asserted, the funds in question were in fact set aside for his and his former wife’s retirement.
  • The division of the parties’ retirement assets is frequently done with the objective of providing each party with sufficient financial security for retirement years.
  • Where bankruptcy is a possibility, to lessen the chances of what happened to Mr. L, retirement funds received in a divorce should be accessed promptly and rolled into one’s own retirement account.
  • QDRO preparation and processing should be attended to forthwith after a 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… “Bankruptcy Exemption May Not Apply To Retirement Benefits Received In Divorce – Lerbakken v Sieloff & Associates, PA, NO. 18-6018 (8th Cir. 2018)”
View / Download Aug-Sept 2019 Article – PDF File

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

May 2019 : Food for Thought on Treatment of Appreciation in Value of a “Separate” Business During Marriage

View / Download May 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Background

This article considers the treatment of appreciation in value during marriage of a business enterprise that was owned by one party at the time of marriage.

Many seem to consider appreciation during marriage of value of a “separate” business as either 100% active – thereby marital – or 100% passive – thereby separate (assuming no commingling, etc.).

This “either/or” characterization seems overbroad and generally based on little or no analysis of the factors driving the increase in value. It is also out of sync with the equitable nature of divorce and the corresponding objective of address-ing the unique circumstances of each case as they are versus a “one size fits all” basis.

In previously writing on this issue, I presented an example similar to the following;

  • A and B own identical rental property management companies – with one exception – which they operate as LLCs.
  • The exception – A manages his company and draws a $50,000 salary. B has always used a full-time manager who is paid $50,000 a year by the company. B works at a machine shop earning $50,000 annually.
  • At the time of A’s and B’s respective marriages, their companies were each worth $100,000; and, at the time of their divorces each was valued at $250,000. The growth of both is attributable to (1) pay down of debt, (2) inflation, and (3) increase in market values exceeding inflation.
  • Both companies have always been owned separately by A and B, respectively. Company income was always de-posited in their separate accounts from which funds were drawn solely to pay taxes on company income.
  • Though A and B had essentially the same earnings, business values, and appreciation during the marriage, arbitrary application of “either/or” active/passive characterization results in the $150,000 appreciation treated as marital in A’s divorce but separate in B’s divorce.

Why this anomalous result? Because 100% of the appreciation of A’s company is attributed to her activity as the rental property manager notwithstanding that she brings no particular “value-adding” skills to the job. As noted, the appreciation in value is due to other factors, which are “passive” (except arguably income used to pay down debt).

This example does not address whether the income from the separate property is separate or marital or, correspondingly, as noted, whether the reduction of debt by use of such income is separate or marital. Rather, the purpose is to illustrate the fiction that, if the owner is actively involved, 100% of the appreciation in value is attributable to his/her efforts and thereby marital.

Michigan Case Law on the Issue

The following discussion focuses on pertinent decisions of Michigan Court of Appeals (Court) regarding the subject issue.

Hanaway, 208 Mich App 278 (1995)

The principal issue regarding the family business (Company) was whether Ms. Hanaway (W) contributed to its “acquisition, improvement, or accumulation.” The trial court ruled that she had not, apparently focusing on “direct” contribution. The Court ruled, essentially, that W, did in fact, contribute by tending to the household and the parties’ four children thereby enabling Mr. Hanaway (H), “the company president,” to devote “himself to the business, working long work weeks.” This case established the principle that “contribution” could be indirect as well as direct in the family partnership.

The Court stated that although H received the business as a gift from his father, “… the increased value of that interest necessarily reflected defendant’s investment of time and effort in maintaining and increasing the business, an investment that was facilitated by plaintiff’s long-term commitment to remain home to run the household and care for the children.”

The Court ruled that the appreciation was marital.

Observations
  • The Court made no attempt to identify factors for the increase in value other than H’s intensive efforts as the Company’s CEO who worked long hours in this capacity.
  • Also, the apparent demanding role served diligently by W – which was front and center as the prime issue of the case – likely had some effect on the ruling on appreciation in value.

Reeves, 206 Mich. App. 490 (1997)

In this case, Mr. Reeves (H) owned a minority interest in a shopping center before his marriage to Ms. Reeves (W). H also owned a condominium that he and W lived in and two rental properties that he purchased in both parties’ names while they co-habited before marriage.

The Court ruled that appreciation in value of the shopping center was separate because H’s interest was “wholly passive.” In so ruling, the Court noted – “[i]t cannot be stated, as was done in Hanaway, supra at 294, that the property appreciated because of defendant’s efforts, facilitated by plaintiff’s activities at home.”

Observations
  • In Reeves, the Court did not need to parse reasons for the increase in value because H had no involvement whatsoever. All appreciation was obviously due to passive factors.
  • The Court’s use of the term “wholly passive” described H’s relationship to the shopping center investment which supported its ruling.
  • Thus, because H had no involvement whatsoever in the asset at issue, this case sheds no light on a situation where there may be some involvement by the owner, however minimal.
  • The Court included as marital the appreciation during marriage of the value of the jointly owned rental properties.

Dart, 460 Mich. 573 (1999)

The principal issue in this Michigan Supreme Court case was jurisdiction involving enforceability of an English judgment.

The Court also addressed a claim by W that she was entitled to share in the appreciation in value during marriage of a large family company, Dart Container Corporation (Dart), at which H was employed. H also had a beneficial interest in a trust to which substantial gifts of Dart stock had been made. The English court had rejected W’s claim.

The Court noted that it was possible “that plaintiff might have shown a nexus between defendant’s work at the company and the underlying trust assets.” … “However, we conclude that the possibility of prevailing was remote.”

The Court also noted that, apparently under general separate property principles, “[t]he trust income from the Dart Container Corporation was never marital property.”

Observations
  • Though the Court did not need to decide whether H’s active involvement at Dart was sufficient to include appreciation during marriage, the fact that it stated that there needs to be a “nexus” between the two is significant. Though not an express statement to this effect, it indicates that it may take more than active involvement to result in active appreciation.
  • The Court’s statement regarding trust income from Dart is noteworthy since there is little definitive law on the status of separate property income that is not commingled.

Uygur, Mich. App. No. 258207 (6/8/2006)

H was an executive at Giffels, a large company. He owned Giffels stock before his marriage to W. The Court ruled that, despite H’s active, high level involvement, appreciation in value during the marriage of his pre-marital Giffels stock was passive, hence, his separate property.

In supporting its decision, the Court stated:

“The value of defendant’s stock rose and fell based on the net worth of Giffels. The success of the company, and thus its stock value, rested on all of the company’s employees, of which defendant was only one. Because defendant worked for the company, his performance necessarily affected the company’s success to some degree. However, we cannot conclude that defendant’s employment caused the stock values to appreciate. Because the defendant’s ability to affect the company’s stock value was limited, the nexus between defendant’s employment and the company’s success was necessarily attenuated.” (Emphasis added.)

Observations
  • The Court ruled that the appreciation was passive notwithstanding that H actively worked at the Company at a high level and, further, that his work “necessarily affected the company’s success to some degree.”
  • Also, the Court indicated that there must be a nexus between the owner’s activity and the success – that is, increase in value – of the company.
  • Thus, according to this court, simply being actively involved does not automatically result in “active” appreciation.
  • This case is significant for the acknowledgement that factors other than the owner spouse’s active involvement may be responsible for increase in value.

Henderson, Mich. App. No. 295765 (6/9/11).

H was actively involved on a day-to-day basis in a management capacity at a family company founded by his father.
In this regard the Court stated:

“Plaintiff worked a regular schedule and maintained an office at the company. He oversaw multiple departments and performed necessary functions.”

H’s counsel relied on Uygur in support of his claim that the appreciation was passive. The Court did not consider Uygur, in large part, apparently, because it is an unpublished opinion.

The Court noted that, unlike with the shopping center in Reeves, H’s position at the company was not “wholly passive at all times.” And, further, that he “was not merely one of several employees at BNP. As co-CEO, the record demonstrates that plaintiff bore responsibility for many of the company’s major functions.”

Thus, the Court reversed the trial court decision saying that the “trial court clearly erred in finding that the appreciation was passive and could not be classified as marital property.” The case was remanded for further proceedings.

Observations
  • This appears to be an excellent case for allocating increase in value to various factors, one of which is H’s active involvement. The Court did not expressly rule that all of the appreciation was marital.
  • The Court’s reference to “wholly passive” from Reeves is unfortunate since it is not at all clear that the court in Reeves intended anything more by that phrase than to describe the undisputed lack of any involvement of Mr. Reeves in the shopping center.

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… “Food for Thought on Treatment of Appreciation in Value of a “Separate” Business During Marriage”
View / Download May 2019 Article – PDF File

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

April 2019 : IRC Section 529 Plans Expanded to Include K through 12 Public, Private, and Religious School Tuition

View / Download April 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Section 529 Plans – Prior to 2017 Tax Cuts and Jobs Act Changes (Tax Reform Act)

Internal Revenue Code Section 529 allows states to establish a tax-advantaged savings program that permits a person to contribute to an account for a designated beneficiary’s qualified higher education expenses (QHEE).

Distributions from such accounts – including earnings – are not taxable provided such distributions do not exceed the
beneficiary’s QHEE.

QHEEs include tuition, fees, books, supplies, and equipment – including technology equipment – required for attendance at a qualified institution of higher education (as defined in the 1998 Amendment to the Higher Education Act of 1965 – generally, any public college or university).

Distributions for QHEE are limited to $10,000 per beneficiary annually. If there is more than one Section 529 account for a beneficiary – e.g., one maintained by each set of grandparents – the $10,000 limit applies to distributions from all accounts on a combined basis.

Funds in a Section 529 account can be rolled into another Section 529 account for another beneficiary. So, if an account’s
funds exceed a beneficiary’s QHEE at time of graduation, the excess funds can be transferred to another beneficiary.

Grandparents, as well as parents, often use Section 529 plans to fund future educational expenses of loved ones.

Tax Reform Act Changes to Section 529 Plans

Under the Tax Reform Act, effective in 2018, tuition – and only tuition – for kindergarten through high school qualifies for the tax benefits under Section 529.

Further, this expansion applies to public, private, and religious school tuition for K through 12.

The definition of qualified expenses remains broader for post-secondary education.

Michigan Education Savings Program

Michigan has established the Michigan Education Savings Program (MESP) – a Section 529 program. Some features of the MESP:

  1. Investment Options – The MESP offers many investment options for differently aged beneficiaries. The investment risk level options include Aggressive, Moderate, and Conservative.
  2. Tax Benefits – A person filing as single can deduct up to $5,000 in MESP contributions annually for Michigan income tax purposes. The limit is $10,000 for a couple filing a joint Michigan income tax return.
  3. So, at Michigan’s 4.25% tax rate, every $1,000 of contributions saves $42.50 in Michigan taxes.
  4. Of course, the primary tax saving is the exclusion from federal income tax of the earnings in the account.
  5. Fees – There are no enrollment or account maintenance fees. There is a modest program management fee and a fee on underlying investments.
  6. Not Restricted to Michigan Educational Institutions – Distributions for QHEE can be for an educational institution
    outside Michigan

Relevance to Divorce

Provision for educational expenses – particularly K-12 private school and post-secondary education – is often an objective in divorce settlements. Use of Section 529 may offer a tax-advantaged way of doing so – particularly now for K-12 private school tuition.


Private or Religious Grade & High School Example:

  • Dad agrees to pay a child’s private school tuition of $10,000 annually.
  • Using a 529 plan to do so saves $425 of Michigan tax each year.
  • And, any earnings in the account are tax free if all used for qualified education expenses.

For public college and university expenses, it is advantageous to start when children are young and, hence, the savings horizon is long enough to establish significant funds for education.

College Example:

  • Contributing $250 a month for a 5 year-old child, invested at 2%, will result in over $44,000 at the child’s age 18.
  • The $8,000 earnings will be free of federal and state income tax if used for qualified education expenses.
  • And, the Michigan tax savings total $1,530 over the 13 years.

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… “IRC Section 529 Plans Expanded to Include K through 12 Public, Private, and Religious School Tuition”
View / Download April 2019 Article – PDF File

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

February 2019 : Tips on Providing for Joint Tax Refunds, Overpayments, and Estimated Taxes in a Divorce Context

View / Download February 2019 Article – PDF File

With the tax return filing season getting into high gear, the following are tax matters often overlooked in divorce settlements. Where applicable, simply providing a copy of this article to a client with the recommendation to consult with a tax advisor is a potentially valuable service.

Joint Tax Refunds

Address on Tax Return— Most divorce settlements provide for the division of a tax refund on the final joint return. The check will be sent to the address on the return and will be payable to both parties. Thus, delay in receipt of a refund may result if the principal residence is used on the return and the refund is sent after the marital home is sold and the effective “forwarding address” period has expired. If this is foreseeable, use another address on the return (e.g. in care of the CPA/tax preparer).

Notification and Documentation— It is advisable to provide that the party who receives the refund check must notify the other party, provide documentation of the refund, and make payment of the other party’s share within a specified time frame – e.g., one week.

Take Away— Consider potential logistical problems concerning receipt and division of a joint tax refund and make appropriate arrangements, and provide for notification, documentation, and payment.

Joint Tax Overpayments Applied to Estimated Tax

Advantage of Applying an Overpayment— Many taxpayers apply for extensions rather than filing by April 15. And most with income not subject to withholding – LLC income; S Corporation income; investment income – must make estimated tax payments due April 15, June 15, September 15, and January 15 each year.

An overpayment from a prior year is deemed received by the IRS as of the April 15 initial due date even if the return is filed six months later at or near the October 15 extended due date. Thus, it is often advantageous to apply an overpayment to the succeeding year tax liability, especially if a taxpayer realizes late in the year when the return is filed that preceding estimated payments are insufficient to avoid the underpayment tax liability. This can be done with the entire overpayment, or just part of it with the balance refunded.

Parties Can Each Apply Part of Overpayment— Parties are free to agree on the application of an overpayment on a joint return to the next year’s tax. If the amount so applied is allocated 100% to the husband, nothing needs to be done on either spouse’s succeeding year tax return. However, if the overpayment is to be divided equally, husband will need to make an after-tax payment to wife to square things off.

If any of the overpayment is to be applied to wife’s tax, she must enter husband’s SSN in the appropriate space on page one of her Form 1040 followed by “DIV”. If wife has remarried, she must enter ex- husband’s SSN at the bottom of Form
1040 page one, again followed by “DIV”.

Take Away— If either party relies on estimated tax payments and an overpayment is possible, make provisions in advance for potential advantageous use of the overpayment.

Estimated Taxes

New Requirement for Many— Many recipients of taxable spousal support provided in pre-2019 divorce settlements have never needed to make quarterly estimated tax payments. However, since no income tax is withheld on spousal support payments, estimated tax payments are generally necessary to avoid (1) a large April 15 payment and (2) corresponding underpayment of tax penalties. This applies to both federal and state income taxes.

The underpayment penalty may be avoided if the amount paid in – via wage withholding or estimated tax payments – exceeds the party’s hypothetical prior year tax based solely on his or her individual income and deductions. This often applies in the first year of receipt of spousal support, but not generally to subsequent years.

Take Away— Attorneys should advise clients awarded taxable spousal support to contact his or her tax advisor regarding estimated tax payment requirements.


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… “Tips on Providing for Joint Tax Refunds, Overpayments, and Estimated Taxes in a Divorce Context”
View / Download February 2019 Article – PDF File

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

December 2018 : 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

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)