Aug / Sept 2020 : Property Settlement – Court of Appeals Upholds Trial Court’s Property Settlement Decision. Gappy v Gappy, Mich App No. 342861 (9/19/19) (Unpublished)

View / Download Aug-Sept 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Facts

  • H and W, who married in 2007, were both attorneys and maintained separate legal practices.
  • They also maintained separate bank accounts during their marriage.
  • In 2016, they purchased the marital home for $375,000. W paid the purchase price with funds from her account.
  • However, H arranged for $100,000 to be transferred to W’s account in connection with the purchase.
  • Both parties’ names were on the deed.
  • In addition to his law practice, H spent 15 hours or so a week working at his father’s business without getting paid. However, his father provided H with rent-free space.
  • W claimed that, citing Hanaway,1 some value of the father’s business should be imputed to H in the division of the marital estate.
  • The trial court treated the marital home as a marital asset and rejected W’s claim about the father’s business.
  • W appealed.

Court of Appeals Decision

  • The Court affirmed the trial court’s division of property.
  • In so ruling, the Court noted that the money in W’s account used to purchase the home consisted of her earnings during the marriage.
  • In this regard, the Court stated “that funds earned during a marriage are to be considered marital property.”
  • And, further, that “regardless of the parties’ intentions with their separate bank accounts, they agreed to jointly purchase the home by combining their separate funds and to hold the home in both of their names.”
  • On the other issue, the Court ruled that, unlike in Hanaway, H did not own a legal interest in his father’s business.
  • The Court also noted that H had testified that when his father died, his estate would pass to H’s mother and, further, that one of his brothers had special needs and that another had loaned money to the father over the years.
  • The Court said the trial court did not err in refusing to impute value to H of an asset in which he had no legal interest.

Comments on the Case

  • As the Court stated, money earned during marriage is marital regardless how disproportionately between the parties or whether it is deposited in a separate bank account.
  • However, a written separation agreement may provide that, as of a specified date, future earnings are no longer marital.
  • Regarding the other issue, there are cases involving family businesses owned by a parent but are essentially run by one of the parties who will clearly inherit the business.
  • If this has occurred during much of a long-term marriage, equity often screams that the business should be taken into account in a divorce settlement.
  • Should the mere fact that a party does not currently own a legal interest in a business of which he/she is CEO and certainly in line for future ownership be the overriding factor in fashioning an equitable divorce settlement in a long-term marriage?
  • That is the current state of the law which clearly frowns on any degree of speculation on what might happen going forward, despite how probable and significant it may be.
  • Of course, in “amicable” divorce settlements, provisions can be made to assure equitable results in such cases.

Endnote

1 Hanaway v Hanaway, 208 Mich App 278; 527 NW2d 792 (1995).


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… “Property Settlement – Court of Appeals Upholds Trial Court’s Property Settlement Decision. Gappy v Gappy, Mich App No. 342861 (9/19/19) (Unpublished)”
View / Download Aug-Sept 2020 Article – PDF File

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

May 2020 : “Double Dipping”

View / Download May 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Similar to Michigan law, the Ohio Court of Appeals rejected the arbitrary limiting of owner spouse’s income in determining spousal support to avoid “double dipping.” Kim v. Kim, 2020-Ohio-22 (1/8/2020).

Background

So-called “double dipping” occurs if these four conditions are met:

  1. The business or professional practice (enterprise) owned by one spouse (owner spouse) is valued by capitalizing excess earnings (or cash flow).
  2. Part of such excess earnings results from reducing owner spouse’s actual compensation from the enterprise to a “market” – or, “normal” level, reasonable compensation.
  3. The capitalized value of the enterprise is included in the marital estate divided between the parties.
  4. The total amount of the owner spouse’s compensation is included in determining income available for spousal support.

Example: H owns 100% of ABC Company (ABC). His average compensation from ABC is $200,000 annually. Reasonable compensation for his services, based on industry statistics, is $100,000.

If H’s actual compensation of $200,000 is used for determining spousal support, “double dipping” occurs since $100,000 of his actual compensation has been incorporated in the $1,200,000 value of ABC included in the marital estate divided between him and W. To avoid double dipping, H’s income for determining spousal support would be limited to $100,000.

Kim Case

Facts

  • H owns and works at two businesses from which his average compensation is $520,000 annually.
  • In calculating the value accepted by the trial court, H’s expert determined H’s “reasonable” or “market” compensation at $416,000.
  • The trial court used H’s total compensation – $520,000 – in determining spousal support.
  • It stated that, based on the circumstances of the case, equity does not require limiting H’s income for support purposes to avoid double dipping. In this regard, the court noted various factors indicating that H was in a much stronger financial position than W.
  • H appealed the court’s decision.

Court of Appeals Decision

  • The Court of Appeals (Court) upheld the trial court decision.
  • In so ruling, the Court stated that it agreed with the analysis made in another Ohio case that the statute “precludes an outright prohibition of double dipping” and that the trial should, “in the interest of equity,” consider the effects of double dipping.
  • In Kim, the Court noted that the trial court cited circumstances that were “overriding the unfairness of double dipping.”

Relevance to Michigan

Ohio, like Michigan, is an “equitable distribution” state. As we know, equitable distribution does not mean equal distribution to divorcing parties. Rather, trial courts have considerable discretion in tailoring a settlement to the equities of a case.

Double Dipping in Michigan – Loutts v. Loutts, Mich App No. 297427 (9/4/12)

  • The Michigan Court of Appeals (COA) published decision in Loutts is consistent with the Ohio Kim decision and COA decisions in four previous Michigan unpublished decisions on “double dipping.”
  • Essentially, the COA ruled that:
    • The effect of “double dipping” can be taken into account in determining spousal support to achieve a proper balancing of incomes and needs.
    • Hence, arbitrary limiting of the owner spouse’s income to avoid double dipping on a “bright line” basis is improper pursuant to MCL 552.23 and case precedents on using formulaic approaches to determining spousal support.
    • However, if not needed to achieve a proper balancing of incomes and needs, double dipping should be avoided.

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… “Double Dipping”
View / Download May 2020 Article – PDF File

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

Jan 2020 : State of Michigan Tax Exemptions for Divorce Related Transfers of Real Property

View / Download January 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


General

For most Michigan transfers of ownership of real property, there are two tax adverse consequences:

  1. The Michigan Real Estate Transfer Tax imposes a tax of $3.75 for every $500 of value transferred. Additionally, the county transfer tax rate is $.55 for every $500 of value transferred.
    .
    So, the total transfer tax on $50,000 of property transferred is $2,150.
  2. Transfers of Ownership result in the “uncapping” of the taxable value of the transferred property.
    .
    This can be significant since the annual increase in taxable value for property tax purposes is otherwise limited by law to 5% or the rate of inflation, whichever is lower.
    .
    So, for property held for several years which has appreciated significantly in value, a transfer will likely result in a substantial increase its taxable value for property tax purposes.

Exemptions Applicable to Divorce Related Transfers

The following are exemptions that avoid both (1) imposition of a transfer tax and (2) the uncapping of taxable value.

  1. Transfers pursuant to a judgment provided no money is ordered by the court to be paid as consideration for the transfer are exempt. MCL 207.526(l); MCL 211.27a(7)(h)
  2. Transfers between spouses creating or disjoining a tenancy by the entireties are also exempt. MCL 207.526(j); MCL 211.27a(7)

Observations

  1. Apparently, a divorce related transfer occurring after divorce–when the parties are no longer spouses–for which money consideration is paid–does not fall within either exemption.
    .
    In such an instance, no consideration should be specifically provided for the transfer.
  2. And, if relying on the “pursuant to judgment” exemption, it seems advisable to provide for the transfer in the divorce judgment instead of, or in addition to, the property settlement agreement.

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… “State of Michigan Tax Exemptions for Divorce Related Transfers of Real Property”
View / Download January 2020 Article – PDF File

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

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)

June / July 2019 : Oldie But Goodie – Tailored Installment Payments To Balance The Scales Without Breaking The Bank

View / Download June-July 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


In a recent case in which I was involved, the problematic settlement issue was how the business owner could afford to pay the other spouse’s marital interest in the company within a reasonable time frame.

As in that case, it is not uncommon that the value of a closely held business or professional practice dwarfs the value of other marital assets. If there are not sufficient suitable assets to award the non-owner spouse to offset the business value, the problem is how to make the settlement work.

Usually in such situations, installments payments are used to balance the settlement. In structuring such 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 sup-port.
  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-own-er spouse to wait a long period of time to receive his or her share of the marital value of the business.

As noted years ago in this column, tailoring installment 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 half 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 three years.

H receives an annual salary of $70,000, 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 seven 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. And, he’ll be strapped for cash 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 $19,655 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 illustrates how 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 time to make arrangements to fund the balloon payments.

Practice Pointers

  • 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 only done 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.

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

Use “imputed” interest at a rate approximating the after-tax equivalent of the agreed upon 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.

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:

2.75% 4%
Payments years 1-3 0 0
Payments years 4 and 5 1, 500 1,500
Ballon at end of year 5 40,000 50,000
Payments years 6 and 7 2,000 2,000
Ballon at end of year 7 40,219 55,500

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… “Oldie But Goodie – Tailored Installment Payments To Balance The Scales Without Breaking The Bank”
View / Download June-July 2019 Article – PDF File

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