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)

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)

January 2019 : 2019 Federal Income Tax Rates & Brackets, Etc., and 2019 Michigan Income Tax Rate and Personal Exemption Deduction

View / Download January 2019 Article – PDF File

Federal Income Tax

In the Tax Cuts and Jobs Act, passed in December 2017, federal tax rates were reduced and the tax brackets were expanded effective for tax year 2018. Also, the standard deduction was almost doubled while the deduction for personal exemptions was eliminated, as were some itemized deductions.

The following are inflation adjusted tax rates and the standard deduction for 2019 as announced by the IRS:

2019 Federal Income Tax Rates & Brackets and Related Information

2019 Federal Income Tax Rates & Brackets and Related Information

Standard Deduction

  • Single $12,200; $13,850 if 65 Years Old
  • Married Filing Jointly $24,400; $25,700 if one spouse is 65, $27,000 if both are
  • Head of Household $ 18,350; $20,000 if 65

Personal Exemption

There is no personal exemption. It was eliminated by the Tax Cuts & Jobs Act.

Estimated 2019 Long-Term Capital Gain Rates

  • 0% for taxpayers in the 10% or 12% brackets.
  • 15% for:
    • Single filers with taxable income between $39,475 and $519,300
    • Married Filing Jointly with taxable income between $78,951 and $612,350
    • Head of Household with taxable income between $52,850 and $510,300
  • 20% for taxpayers with taxable incomes exceeding the high end of the above ranges

2018 Tax Forms – 2018 federal income tax forms are accessible at www.irs.gov


Michigan Income Tax

Tax Rate

The Michigan income tax rate remains unchanged at a 4.25% flat rate.

Personal Exemption

The number of personal exemptions a Michigan taxpayer could claim had previously been tied to the number claimed for federal tax purposes. With the elimination of federal tax personal exemptions, Michigan enacted Senate Bill 748 (Bill), signed by Governor Snyder on February 28, 2018.

Under the Bill, the reference to federal exemptions is removed and the Michigan personal exemption deduction is increased from the $4,000 2017 allowance as follows:

  • 2018 – $4,050
  • 2019 – $4,400
  • 2020 – $4,750
  • 2021 – $4,900

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… “2019 Federal Income Tax Rates & Brackets, Etc., and 2019 Michigan Income Tax Rate and Personal Exemption Deduction”
View / Download January 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)

November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019

View / Download November 2018 Article – PDF File

As previously reported in this column, the 2017 Tax Cuts and Jobs Act (Act), signed into law in December 2017, radically changes the tax treatment of alimony/spousal support beginning in 2019. The other changes made by the Act affecting divorce took effect January 1, 2018.

Thus, there is a small window within which to decide whether to have existing law – or the new law – apply to divorces that can be finalized this year or next.

The New Law

In a total reversal, alimony/spousal support will not be deductible by the payer or taxable to the payee for divorce and separation judgments and decrees entered on or after December 31, 2018.

This also applies to modified judgments of divorce or separation effective after 2018.

Additionally, it applies to divorce and separation decrees entered before December 31, 2018 if the parties elect to have
the new law apply.

The Act is Not Applicable to Divorce and Separation Decrees Entered Before December 31, 2018

For all existing divorce settlements and those entered by year-end, alimony will continue to be taxable/deductible.

Hence, a window of opportunity before year-end for the many situations in which the alimony payer is in a meaningfully higher tax bracket than the payee. This has set the stage for creative uses of “Section 71 payments” under which the disparity in tax brackets can be used to provide a tax subsidy. Examples include using Section 71 payments to:

  • Divide non-qualified deferred compensation on a taxable/ deductible basis.
  • Structure installment payments of a business buy-out of the non-owner spouse’s marital interest on a taxable/deductible basis.
  • Pay attorney fees on a taxable/deductible basis.

However, after 2018, these opportunities and similar others will no longer be available. In situations where there is significant disparity in brackets, using Section 71 payments in such circumstances may no longer be beneficial.

Effect of Judgment Amendments Post 2018

If a pre-2019 divorce or separation judgment or decree is amended on or after December 31, 2018, the new nontaxable/nondeductible law applies.

Query: Would this be the result even if the amendment does not pertain to spousal support? If the answer has not become clear by year-end, the distinct possibility of losing taxable/deductible status of spousal support payments must be considered before advising the post-2018 amendment of a pre-2019 judgment providing for taxable/deductible alimony.

Fundamental Change in the Dynamic of Alimony/Spousal Support

When the alimony deduction was enacted in 1948, the theory was that, if a former family’s income is split between the parties in some manner post-divorce, the tax treatment should correspond.

The result in many cases has been less combined tax paid on the payer’s income. Because of budgetary concerns—including the enormous cost of the Act—eliminating the alimony deduction became a revenue raising option to help alleviate the Act’s deficit-increasing effect.

This creates a new paradigm for divorce practitioners and alimony guideline providers. That is, we will need to think in terms of after-tax dollars for spousal support, similar to child support.

How to Avoid Paying Alimony with After-Tax Dollars Under the New Law?

One approach is to negate the adverse tax consequences of the new law by using 401(k) funds. As we know, more and more employees have 401(k) accounts than in years past.

Example

  • H, 40 years old, is a middle-management employee at a small company. He earns $60,000 a year. He has a combined 26% federal-state income tax bracket.
  • W is a stay-at-home mom who works part time and earns $10,000 annually. Hence, as head-of-household, her standard deduction offsets her income for federal taxable tax. Her income is subject to minimal Michigan tax.
  • The parties agree on alimony of $1,250 a month, i.e., $15,000 annually, for 5 years when their youngest child will be either working or in community college.
  • H has a 401(k) balance of $150,000, which is split evenly with W receiving $75,000 and H receiving $75,000.
  • In addition to W receiving her $75,000 share, the parties agree that H will transfer his $75,000 share of the 401(k) to W in lieu of spousal support. She can withdraw $15,000 annually, paying approximately $2,000 in tax. H will pay W $2,000 per year to reimburse her for the taxes she will pay on her withdrawals. Thus, W will have $15,000 per year, which is $1,250 a month after-tax spousal support.
  • While W ends up with $15,000 a year after tax either way, using the 401(k) account saves H tax as follows:
Not Use 401(k) Use 401(k)
Payments Over 5 Years:
Payments $75,000 $10,000
Tax at 26% to Provide Funds $26,000 $3,500
401(k) Funds 0 $75,000
Total Cost to H $101,000 $88,500

Observations

  1. The example shows that, in relatively modest circumstances, use of a 401(k) account can result in considerable tax savings.
  2. It provides a means of using pre-tax dollars to fund aftertax obligations – an advantage where there is disparity in brackets.
  3. In the example, the tax on H’s $75,000 share of the 401(k) was shifted to W – at her lower bracket – incident to satisfying his after-tax spousal support obligation.
  4. At 40, H has ample time for his 401(k) account to be replenished.
  5. Using 401(k) funds for a spousal support obligation as shown in the example requires that the plan allow for annual withdrawals, Many plans do not do so. But, a small business plan, as in the example, often does.
  6. A 401(k) account can be used for other purposes, such as buying out the other spouse’s marital interest in (1) a business or (2) a cottage up north.

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… “Beware: Spousal Support Tax Treatment Changes January 1, 2019”
View / Download November 2018 Article – PDF File

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