Marital Property

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)”

Jun/Jul 2022 : Divorce-Related Professional Fees May Be Added to the Tax Basis of Property Received or Retained in a Divorce

Posted by Joseph W. Cunningham, JD, CPA

View / Download June/July 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

For years prior to 2018, divorce-related professional fees were deductible as miscellaneous itemized deductions if they were incurred (1) for tax advice or (2) the procurement of taxable spousal support.

However, the 2017 Tax Cuts and Jobs Act eliminated miscellaneous itemized deductions and, correspondingly, the deduction of otherwise qualifying divorce-related professional fees.

But, as under prior law, some divorce-related professional fees may be added to the tax basis of assets received or retained in a divorce, hence reducing taxable gain on disposition.

This was the holding in Gilmore v United States, 245 F Supp 383 (ND Cal 1965), which involved the protection of a business interest from claims of the nonowner spouse.

The portion of the fees that may be capitalized as additional tax basis is that which is attributable to services related to the protection, preservation, or acquisition of the business or investment property. In general, this portion is that part of the fees associated with the property settlement. The example at the end illustrates the determination of the addition-to basis component of legal and accounting fees.

It should be noted that for spouses who retain no assets, fees allocable to property settlement may nonetheless be an addition to the basis of marital assets transferred to the other spouse (who takes a carryover tax basis, increased by the fees, under IRC 1041).

Whenever there is a rational basis for allocating a fee, or part of a fee, to a particular asset (e.g., a fee for the valuation of a closely held business), that fee should be specifically allocated to the asset it relates to. Other fees that qualify as additions to a basis for a spouse are allocated among assets awarded
to that spouse pro rata their respective FMVs.

The IRS accepted this method of allocation in Spector v Commissioner, 71 TC 1017 (1979), rev’d and remanded on other grounds, 641 F2d 376, cert denied, 454 US 868 (1981); Treas Reg 1.212-1(k). The portion of the fees. However, the IRS maintained that a ratable portion of the fees had to be allocated to cash (which can never have a basis in excess of its face value) as well as to noncash properties. The Tax Court upheld the IRS position, thus eliminating any tax benefit of the fees allocated to the cash. The same applies to retirement benefits. That is, a portion of fees should be allocated to them but cannot increase their tax basis.

Similarly, with the large exclusion of gain available on most sales of principal residences, the allocation of fees thereto will often provide no tax saving benefit.

Contemporaneous Documentation

Whenever a divorce-related professional fee qualifies as an addition to basis, it is important that the tax benefit portion of the fee be specifically allocated to the related work. McDonald v Commissioner, 52 TC 82 (1969); Hall v United States, 78-1 US Tax Cas (CCH) ¶9126 (Cl Ct 1977), adopted, 78-1 US Tax Cas (CCH) ¶9420 (Cl Ct 1978). Rev Rul 72-545 stressed the importance of clearly establishing “a reasonable basis for allocating to tax counsel a portion of the legal fees incurred in connection with the divorce proceedings.” Some attorneys issue separate invoices for tax benefit work. Regardless of how such work is invoiced, it should be described in appropriate detail. Moreover, it is clearly preferable that the actual detail be provided when an invoice is submitted, rather than a year or more later when a client is being examined by the IRS concerning the estimated deductible portion of the fee.

Practice Pointer

Counsel should, at the close of every case, determine whether any of the professional fees incurred qualify as additions to tax bases of assets his or her client received. Also at that time—not later—counsel should include the results of the determination in a letter to the client and suggest it
be given to the client’s tax advisor. Not only is this a moneysaving service to the client, it is in counsel’s “enlightened self interest,”
since it will often reduce the client’s cost of paying the attorney fees.

Allocation of Fees to Tax Basis

  • $2,000 property settlement legal fee – Allocable to property awarded to client pro-rata to their respective values.
  • $500 legal fee consulting with valuation expert – Allocable to assets valued by the expert, pro-rata to their respective values.
  • $2,500 accountant’s fee – Allocable to assets valued by the accountant pro-rata to their respective values.

It should be noted that allocating fees as described above will provide minimal benefit in the many cases where the assets consist, in the main, of retirement benefits and equity in a home. However, it is important to be aware of the potential for benefit in every case and then take advantage where there is the opportunity to do so.

The author once worked on behalf of a woman who had inherited a large stock portfolio. Her divorce attorney billed her $50,000 – largely to protect her inheritance. Post-divorce, she married a stockbroker who promptly sold and reinvested the entire portfolio. $45,000 of the $50,000 divorce lawyer fee was added to the basis of the stock sold, hence reducing the taxable gain by same amount and saving substantial federal and state income taxes.

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… “Divorce-Related Professional Fees May Be Added to the Tax Basis of Property Received or Retained in a Divorce”
View / Download June/July 2022 Article – PDF File

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

Read More “Jun/Jul 2022 : Divorce-Related Professional Fees May Be Added to the Tax Basis of Property Received or Retained in a Divorce”

Feb 2022 : Sale of Marital Residence in a Divorce Context – Taxation of Gain

Posted by Joseph W. Cunningham, JD, CPA

View / Download February 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

As is generally known, prices of homes in Michigan have increased substantially in the last couple years. Sellers are frequently receiving multiple offers above their asking price.

So, most homes sold in these conditions will result in considerable gains over what the seller paid for the house.

Because of the recent surge in home sale prices, the following summarizes how the gains on residential sales are treated for tax purposes in a divorce context.

General Rules of Taxation on Principal Residence Sale

There is an exclusion for tax purposes of gain on the sale of a principal residence – up to $250,000 for qualifying single taxpayers and $500,000 for qualifying married taxpayers who file a joint tax return.

To qualify for the exclusion, a single taxpayer must own and live in the home as a principal residence for two of the five years preceding the sale.

A taxpayer who fails to satisfy the use requirement due to a change of employment, health problems, or other unforeseen circumstances is allowed a percentage of the exclusion equal to the percentage that the two years ownership and use requirements are met.

For a married couple, one spouse must satisfy the two out of five years ownership requirement, but both must have lived there for two of the five years preceding the sale.

A taxpayer may use the exclusion each time a home is sold, provided two years have elapsed since the last sale.

As a practical matter, even with the recent increase in home prices, the lion’s share of gains will not exceed the exclusion. However, particularly for houses held for many years in upscale areas, gains might be higher than the exclusion.

Sale In A Divorce Context

Home Sold While Married

The marital status on the date of sale determines whether the parties are married for purposes of the exclusion.

If parties are married on the date of sale, the $500,000
gain exclusion is available provided:

  • The parties file a joint return for the year of sale. This means that the divorce does not occur in the year of the sale.
  • One of the spouses satisfies the two out of five years ownership requirement
  • Both satisfy the two out of five years use requirement.
  • Neither has used the exclusion within two years preceding the sale.

Special Rules Applicable to Divorce-Related Sales

  • Attribution of Ownership – When an interest (e.g., fifty percent) in the marital residence is transferred from one spouse to the other pursuant to the divorce, the transferor’s period of ownership passes with the property to the transferee.
    Example:

    • H and W agree that she will transfer her 50% interest in their home to him.
    • H decides to sell the house 2.5 years after the divorce.
    • W’s period of ownership is transferred to H with respect to the 50% interest she transferred to him.
    • Thus, he satisfies the two out of five years ownership requirement and, hence, qualifies for the $250,000 exclusion on the entire gain, not just the 50%.
  • Attribution of Use – If it is expressly provided in the divorce settlement that one spouse is entitled to remain in the home until it is sold (often when the youngest child is emancipated), that spouse’s use is attributed to the other (who is usually out of the house and would not otherwise qualify).
    Example: In their settlement, H and W agree that:

    • They will continue to jointly own the house;
    • W will live there with their child; and,
    • The home will be sold and proceeds divided in four years when their child graduates from high school.

Provided that the divorce settlement expressly provides for W’s right to remain in the home until it is sold, then her occupancy is attributed to H for purposes of the two years use requirement. Thus, the $500,000 exclusion is available.

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… “Sale of Marital Residence in a Divorce Context – Taxation of Gain”
View / Download February 2022 Article – PDF File

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

Read More “Feb 2022 : Sale of Marital Residence in a Divorce Context – Taxation of Gain”

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”