Oct 2019 : Taking Taxes Into Account In Property Settlement Involving “Pre-Tax” Assets – Huggler v Huggler, Mich App. No. 343904 (6/25/19)

View / Download October 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Facts

  • Of their marital estate of around $800,000, the parties agreed as follows:
W H Total
Real Estate, Investments, Bank Accounts, and Personal Property 71,488 384,929 456,417
Retirement Assets – Pre-Tax 273,896 71,488 345,384
  • Because W was to receive a disproportionate amount of pre-tax assets, they further agreed that (1) H would pay W $154,618 of “Non-Retirement Assets” and (2) W would assign to H via a QDRO $101,204 from her retirement assets.
  • This would result in the following equal division of pre-tax retirement benefits:
W H Total
Real Estate, Investments, Bank Accounts, and Personal Property 226,106 230,311 456,417
Retirement Assets – Pre-Tax 172,692 172,692 345,384
  • Notwithstanding this agreement, H and W disagreed as to how the $154,618 balancing payment would be made. W wanted to receive the $154,618 in non-retirement assets. But H wanted to pay her $54,618 in cash and net the other $100,000 against the $101,204 retirement transfer due him from W.
  • W objected because it would leave her with a disproportionate share of pre-tax assets, as follows:
W H Total
Real Estate, Investments, Bank Accounts, and Personal Property 126,106 330,311 456,417
Retirement Assets – Pre-Tax 272,692 72,692 345,384
  • W claimed that she intended to access the $100,000, which in doing so would result in both income taxes and a penalty tax leaving her considerably less than what she had coming per the agreement.
  • She stated that she would “incur predictable and foresee-able tax penalties to cash in the retirement funds.”
  • The trial court ruled in H’s favor ruling that it would not consider the tax consequences of the division of assets be-cause “it would be forced to speculate when – or even if – she would cash in the accounts.”
  • W appealed.

Court Of Appeals Decision

The Court upheld the trial court decision, ruling in part that W “had not established that the tax consequences were reasonably likely to occur and were not merely speculative.”

Comments On The Case

1. General Practice in Michigan—Michigan family law judges do not typically reduce the value of assets by future tax unless the tax is imminent or otherwise not subject to speculation.

Nor are they required to, as the Court stated, under Nalevayko v Nalevayko, 198 Mich App 163 (1993).

2. Pre-Tax Assets – But, certain assets – employee benefits such as 401(k) accounts, IRAs (other than Roth IRAs), bonuses, and various forms of incentive pay – (1) are certain to be taxed and (2) generally provide no benefit to the employee spouse until he or she squares off with Uncle Sam and pays the tax.

Thus, unlike other investments, real property, and closely-held businesses, the various forms of retirement benefits and employee/executive compensation are generally tax affected for divorce settlement to the extent they are not divided equally.

Not to do so would result in an inequitable settlement to the party receiving more than half of pre-tax benefits, such as W in Huggler.

Simple Example – If one party receives a $10,000 bank account and the other a $10,000 pre-tax IRA, the divi-sion is not equal. Before the IRA funds can be converted to spendable cash, a tax must be paid resulting in a net amount of considerably less than $10,000.

3. Calculation of the Tax – The calculation of the tax can, however, be subject to dispute.

One approach is to allocate a portion of the total tax on a pro rata, or proportional, basis – the Average Tax method.

Another is to calculate the tax resulting from adding subject benefits on the tax return – the Marginal or Incremental Tax method. This calculation usually involves (1) calculating tax with the benefits included and (2) running the calculation without them. The difference is the tax attributable to the benefits.

The theory supporting the Average Tax method is that who is to say what component – or layer – of income is taxable at the lower rates on the tax rate schedule and which are taxable at higher rates. Hence, using an aver-age rate is fair – treating all dollars of income the same. It seems the average rate approach is better suited to elements of income routinely received by and taxable to the taxpayer spouse – such as a bonus received each year.

Correspondingly, the marginal approach seems more apt for items not part of the annual pay package, such as stock options issued periodically or, certainly, severance pay.

Illustration

Taxable Income Assuming:
Basic Comp Only Add Non-Recurring Incentive Pay Total
Taxable Income 100,000 50,000 150,000
Federal Tax (Rounded) 35,500
Average Tax Rate 23.7%
Marginal Tax Rate 28%
Tax Affected Value of $50,000:
– Less average tax: 50,000 – (23.7% x 50,000) = 38,150.
– Less marginal tax: 50,000 – (28% x 50,000) = 36,000.

And, of course, the difference is more dramatic if larger non-recurring benefits result in taxation at the top rate of 37%, vs. 28% in the example.


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… “Taking Taxes Into Account In Property Settlement Involving “Pre-Tax” Assets – Huggler v Huggler, Mich App. No. 343904 (6/25/19)”
View / Download October 2019 Article – PDF File

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

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 2015 : Overview of the Division of Retirement Benefits in Divorce – Part 2

Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

The following is a continuation of the materials presented in the March 2015 Tax Trends column.

III. Defined Contribution (DC) Plans

  1. A DC plan–such as a 401(k) plan – provides for separate account for each participant.
    1. E.g.–W’s account balance under the XYZ 401(k) plan was $50,000 on December 31, 2014.
    2. Other types of DC plans include pro t-sharing plans, money purchase pension plans, and 403(b) annuities.
  2. Division of DC plan accounts is also accomplished either by the o set method or by deferred division using a QDRO/EDRO.
  3. Offset method – Valuation
    1. The present value of the DC plan interest is generally considered its account balance as of the valuation date. See above for an example.
    2. As with the present value of pensions under DB plans, it is typically appropriate to tax affect the value of the account balance.
    3. It is important to specify a valuation date, generally close to when other assets will be divided.
    4. If there is a plan loan, the account is (1) valued net of the loan and (2) responsibility to repay the loan is assigned to the participant.
      Example:

      • The total pre-tax value of W’s 401(k) account is $50,000 – $40,000 of plan investments and (2) a $10,000 loan she drew from the plan.
      • Equal division under the offset method:
        (Table shown in PDF)
  4. Deferred division method – QDROs/EDROs

Continued in PDF file below… “Overview of the Division of Retirement Benefits in Divorce – Part 2”
View / Download May 2015 Article – PDF File

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