Marital Income

Mar 2023 : Tailored Installment Payments to Balance the Scales without Breaking the Bank

Posted by Joseph W. Cunningham, JD, CPA

View / Download March 2023 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

The value of a closely held business or professional practice often dwarfs the value of other marital assets. If there are not sufficient suitable assets to award the non-owner spouse, installment payments are frequently used to balance the settlement.

In structuring the payments, two objectives often compete with one another:

  1. Don’t Kill the Golden Goose – It is important not to impose an undue strain on the owner’s cash flow, part of which may also be required for spousal and/or child support.
  2. Don’t Make Me Wait ‘Til I’m Old and Gray – On the other hand, it is generally not fair to require the non-owner spouse to wait a long period of time to receive his or her share of the marital value of the business.

Tailoring payments around other divorce obligations is a way to achieve both objectives.

Example

As part of their divorce settlement, H and W have agreed that he will pay her $200,000 for her one-half marital interest in his business. He will also pay combined transitional alimony and child support for their youngest child totaling $30,000 for each of the next 3 years.

H receives an annual salary of $60,000, supplemented by a bonus depending on company profit. He proposes that he pay the $200,000 by transferring a sufficient amount of his 401(k) plan to net W $50,000 after tax and that the $150,000 balance be paid over 15 years with interest at 4%, resulting in monthly payments of $1,110.

W responds that this is unacceptable; that it is unreasonable to expect her to wait so long for her share of the marital value of the business. She demands payment over 7 years, resulting in monthly payments of $2,050, almost twice what H proposed.

However, H claims he cannot afford to pay that much since the business has not been able to pay bonuses of late and the near future looks no brighter. In particular, he’ll be tight over the next few years with the alimony and child support obligations.

The attorneys meet with their joint CPA expert and work out the following payment terms to achieve both objectives.

No payments of principal and interest for three years. Adding the $18,000 of unpaid compound interest brings the principal to $169,655 as of the beginning of the fourth year.

  • Years four and five – $1,500 per month
  • At end of year five – $50,000 balloon payment
  • Years six and seven – $2,000 per month
  • At end of seven years – $55,500 balloon payment.

Tailored to Fit – The above indicates the way in which payments can be tailored to accomplish both objectives. The use of balloon payments enables the non-owner spouse to receive his or her share within a reasonable time frame. It also gives the owner spouse ample time to make arrangements to fund the balloon payments.

Related Matters

Provide for Acceleration – It is generally advisable to provide for acceleration of the balance due in the event the owner sells his interest in the business or the company receives a substantial influx of cash available to the owner, such as from refinancing.

Restrictions May Be in Order – In addition to normal security provisions, it is sometimes advisable to place restrictions on (1) the amount of compensation and/or distributions to the owner spouse and (2) the investment of business funds in non-operating assets (e.g., cabin up north or Florida condo “used for business”). Usually this can be done only if the owner spouse has a controlling interest.

Provide for Prepayment Option – Finally, it is often appropriate to provide for prepayment of the obligation at the option of the owner spouse.

Saving the Interest Deduction

The IRS has taken the position that interest paid on a divorce-related obligation from one ex-spouse to the other is “personal” interest and, hence, non-deductible. This results in a tax “whipsaw” since the payee ex-spouse receiving the interest must report it as taxable income notwithstanding that the payer cannot deduct it.

There have been a couple tax cases in which, under the circumstances of the case, the IRS position was rejected and the interest deduction was allowed as investment interest expense. However, the IRS has not acquiesced with these decisions and, further, investment interest expense can only be deducted to the extent of investment income (e.g., interest, dividends, etc.).

Aware of the IRS’s position, H’s CPA in the above example suggests that there is a way to avoid the loss of the interest deduction.

  1. This method is to “impute” interest at a rate approximating the after-tax equivalent of the agreed-on interest rate. The IRS and U.S. Tax Court have ruled that the imputed interest rules otherwise applicable to below market or no interest loans do not apply to divorce related obligations between ex-spouses. Under this approach, there is no loss of interest on the payee’s death.

So, H’s CPA proposes using 2.75% unstated, “baked in” interest rate as the approximate after-tax equivalent of 4.00%. This is done by running the amortization schedule with 2.75% as the interest rate to determine the payments. And, in the settlement agreement, the obligation to make the resulting payments is stated without reference to any interest rate.

Substituting 2.75% for 4% on the $150,000 obligation results in the following changes – within the target seven year period:

A prepayment provision with unstated, “baked in” interest would include a prepayment discount equal to the unstated rate of interest (2.75% in this case) applied to the outstanding balance at the time of prepayment over the period during which the balance was otherwise scheduled to be paid.

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… “Tailored Installment Payments to Balance the Scales without Breaking the Bank”
View / Download March 2023 Article – PDF File

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

Read More “Mar 2023 : Tailored Installment Payments to Balance the Scales without Breaking the Bank”

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)”

Mar 2022 : ROBACH VS. ROBACH

Posted by Joseph W. Cunningham, JD, CPA

View / Download March 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

This Month’s Column: Court of Appeals distinguishes McNamara vs. Horner in ruling that allocation of appreciation between a pre-marital employee benefit account balance and contributions during marriage is acceptable where information to do so is available. Robach vs. Robach, Mich App Docket No. 352077 (12/16/21) – Unpublished.

Facts

  • H & W were married in 2011 and divorced in 2019.
  • H had various stock options, stock grants, and additional shares of stock in the company at which he worked.
  • Most of these stock interests were acquired before the marriage though some did not vest until after.
  • H claimed that his stock options and grants were not received “on account of service credit accrued during marriage” (emphasis added) and, accordingly, were not part of the marital estate under MCL 552.181(1).
  • Further, he hired an expert to allocate the appreciation on his retirement account between growth attributable to (1) their pre-marital balances and (2) contributions during marriage.
  • The expert was able to do so because H had Fidelity account statements for the entire period of the marriage.
  • The trial court agreed with H and his expert, and, correspondingly, awarded his company stock and appreciation allocated to his pre-marital retirement account balances to him as his separate property.
  • W appealed.

Court of Appeals Decision

  • W claimed that because the expert relied on statements provided by H the expert’s analysis was unreliable.
  • She further claimed that, pursuant to the published case of McNamara vs Horner, 249 Mich App 177 (2002), contributions during marriage were commingled with premarital funds in the retirement account and, hence, could not be separately identified for the allocation.
  • The Court ruled, essentially, that it had not been demonstrated that the account statements used by the expert were unreliable.
  • It also upheld the expert’s allocation of appreciation during marriage because the expert was able to specify preand post-marital funds in the Fidelity statements.

Comments on the Case

  • As readers of this column may recall, the decision in McNamara vs. Horner has been criticized as arbitrarily narrow with its strict application often resulting in gross unfairness.
  • Where sufficient documentation is available – as in the Robach case – it is quite possible to allocate appreciation during marriage between a pre-marital retirement account balance and (2) contributions during marriage.
  • Having all the statements for the subject period is certainly ideal. But, if a few are missing, interpolating between statements is sometimes possible.
  • While the published McNamara vs. Horner case remains the law in Michigan, the unpublished Robach decision indicates that a common-sense result may be attained where sufficient information is available.
  • As a matter of full disclosure, the author hereof was the expert in Robach.

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… “ROBACH VS. ROBACH”
View / Download March 2022 Article – PDF File

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

Read More “Mar 2022 : ROBACH VS. ROBACH”

May 2021 : Court of Appeals Reverses Trial Court Ruling on the “Marital/Separate” Property Character of a Business Interest Received by Gift before Marriage Wolcott v Wolcott, Mich App No. 351918 (March 11, 2021) Unpublished

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2021 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Facts

  • In July 1999, W’s father gave her a 10% interest in a closely-held business (Company) at which she was not employed.
  • The parties married a month later in August 1999.
  • During the entire marriage, the parties maintained separate bank accounts.
  • W deposited any distributions she received from the Company into her separate bank account.
  • The trial court ruled that W’s interest in the Company was her separate property.
  • H appealed.

Court of Appeals Decision

  • In an unpublished decision, the Court reversed the trial court’s ruling.
  • In doing so, the Court noted that the distributions W received from the Company – though deposited into her separate bank account – were commingled with her marital income deposited into the same account.
  • Further, the Court stated that W had testified that she used some of the distributions from the Company to pay marital expenses and household bills.
  • The Court ruled that W’s conduct with regard to distributions from the Company indicates that her interest in the Company was marital property.

Comments on the Case

  • The Court’s decision seems unfair to W.
  • The parties evidently, from the outset of their marriage, intended to keep their respective property interests separate, including the distributions W received from the Company.
  • That the distributions were incidentally “commingled” with marital funds does not necessarily indicate an intent to convert them – and certainly not the Company – to marital property, nor does use of some of the funds to pay marital expenses – particularly if other funds were temporarily insufficient.
  • The Court used these two factors to convert a pre-marital gift into marital property.
  • Treating the commingled distributions as marital seems reasonable. But, to treat the entire value of W’s interest in the Company as marital seems excessive.
  • The obvious upshot of the case is, if a party wants to keep separate property separate, then such party:
    1. Should deposit any income from such property in a separate account into which no marital funds are deposited; and,
    2. Should not use such funds to pay marital expenses. If such is necessary because marital funds are insufficient, make a documented loan of the separate funds to pay the expenses, and be sure that the loan is repaid.

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 Reverses Trial Court Ruling on the “Marital/Separate” Property Character of a Business Interest Received by Gift before Marriage Wolcott v Wolcott, Mich App No. 351918 (March 11, 2021) Unpublished”
View / Download May 2021 Article – PDF File

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

Read More “May 2021 : Court of Appeals Reverses Trial Court Ruling on the “Marital/Separate” Property Character of a Business Interest Received by Gift before Marriage Wolcott v Wolcott, Mich App No. 351918 (March 11, 2021) Unpublished”