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Dec 2019 : Ethical Responsibilities For Family Law Attorneys and Business Valuation Experts

View / Download December 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


At an American Academy of Matrimonial Lawyers (AAML) and Business Valuation Resources (BVR) conference earlier this year in Las Vegas (where else?), the respective ethical responsibilities of family law attorneys and business valuation (BV) experts were discussed.

It was stated that an attorney’s charge is to apply legal theory to a case and to diligently advocate on the client’s behalf. Doing so with diligence means being committed to the client’s best interests and being a zealous advocate for the client.

However, it was then noted that a BV expert’s charge is to assist the trier of fact. This is done by educating the court by providing an analysis based on observable data and facts performed with unbiased objectivity.

So, the attorney is a zealous client advocate and the expert is the issuer of an unbiased opinion of value.

Obviously, these are potentially conflicting roles.

The example used at the Conference was similar to the following:

Facts

• Attorney, representing H, engages Expert to value H’s business.
• Expert uses an earnings multiple of 4 arriving at a preliminary value of $400,000.
• After reviewing the preliminary value, Attorney strongly suggests reasons for using a multiple of 3, resulting in a value of $300,000. He exerts pressure on Expert to revise the preliminary value accordingly.

Query 1

What are Expert’s ethical responsibilities under these circumstances?

One of the five Fundamental Principles of the Code of Ethical Principles for Professional Valuers is as follows:

  • Objectivity – not to allow conflict of interest or un-due influence or bias to override professional or business judgement.”

Two of the “Threats” listed in the Code of Ethical Principles for Professional Valuers are as follows:

  • Advocacy threat – the threat that a professional valuer will promote a client’s or employer’s position to the point that his/her objectivity is compromised.”
  • Intimidation threat – the threat that a professional valuer will be deterred from acting objectively because of actual or perceived pressures, including attempts to exercise undue influence over the valuation opinion.”
    So, the Expert should carefully consider Attorney’s reasons for a lower multiple and then use the multiple that the Expert, in his/her professional judgment, believes is appropriate.

Query 2

What are Attorney’s ethical responsibilities under these circumstances?

Attorney should persuasively present his reasons for a different multiple to the Expert.

Having done so, Attorney should respect Expert’s obligation to independently use his/her professional judgment in determining the appropriate multiple and resulting value.

Observations

  • Because business values are often subject to compromise in divorce settlements, it is natural for the attorney for the business owner to want to start low and the attorney for the non-owner to start high.
  • But, the BV expert cannot ethically slant a value one way or another to suit the interests of a party.
  • It is important that both experts have access to the same data. Often, the expert for the business owner has access to more data. Sharing all data reduces the chances that the two experts will arrive at substantially different values.
  • Because business values are often subject to compromise in divorce settlements, it is natural for the attorney for the business owner to want to start low and the attorney for the non-owner to start high.
  • But, the BV expert cannot ethically slant a value one way or another to suit the interests of a party.
  • It is important that both experts have access to the same data. Often, the expert for the business owner has access to more data. Sharing all data reduces the chances that the two experts will arrive at substantially different values.

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… “Ethical Responsibilities For Family Law Attorneys and Business Valuation Experts”
View / Download December 2019 Article – PDF File

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

Nov 2019 : QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions

View / Download November 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


With the elimination of taxable/deductible Section 71 payments effective January 1, 2019, using a QDRO transfer of an interest in a defined contribution plan (e.g., 401(k), 403 (b) account) by which a business owner spouse buys out the other spouse’s marital interest is a good fit in many situations.

General

In the past, Section 71 payments provided a means by which one spouse could buy out the other’s marital interest in a business with pretax dollars. But, with the 2017 Tax Cuts and Jobs Act of 2017 repeal of the alimony deduction, this method is no longer available as of January 1, 2019.
However, use of a transfer of an interest in a defined contribution plan account via a QDRO can be a “tax-smart” way to structure a business buy-out.

Example

  • H, 45 years old, owns ABC Company (ABC) which has been valued at $250,000 for his and W’s divorce settlement.
  • However, there are not sufficient other suitable marital assets to award W to offset the $250,000 business value.
  • But, H has a 401(k) account with a balance of $400,000.
  • His tax savvy lawyer proposes that H use his half of the 401(k) account to buy out W’s $125,000 interest in the business.
  • He tells H that he has the (1) business and (2) many years to replenish his 401(k) account for his future security.
  • He adds that, by using the 401(k) account, He will not need to use his personal cash or that of ABC for the buy-out.
  • Further, he states, since W no longer has the business as part of her future security, receiving additional 401(k) funds is ideal for her.
  • Since the $250,000 business value is largely after-tax and the 401(k) account is 100% pre-tax, the transfer to W must be tax affected.
  • So, assuming W federal and state tax rate will be 20%when she draws the 401(k) in the future, H transfers via a QDRO $156,250 of his $200,000 share of the 401(k) to W, the equivalent of $125,000 after-tax.

Observations

  1. Avoiding using cash for the buy-out may be particularly beneficial if H has spousal and/or child support obligations.
  2. Use of part of a 401(k) can also be used to buy-out an alimony obligation, as follows:
    • The present value of the projected stream of spousal support payments is calculated.
    • Then, the 401(k) amount is tax affected at the recipient’s tax bracket to its after-tax equivalent similar to what was done in the example.
    • The recipient can access the transferred amount from the 401(k) without the 10% penalty regardless of either parties’ age.

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… “QDROs Present a Tax-Smart Option Following Elimination of Section 71 Alimony Deductions”
View / Download November 2019 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)

Aug / Sept 2019 : Bankruptcy Exemption May Not Apply To Retirement Benefits Received In Divorce – Lerbakken v Sieloff & Associates, PA, NO. 18-6018 (8th Cir. 2018)

View / Download Aug-Sept 2019 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal


Background

  • In his 2014 divorce settlement, Mr. Lerbakken (Mr. L) received half of his wife’s 401(k) account and 100% of her IRA.
  • He subsequently filed for bankruptcy protection. One of his creditors was Sieloff & Associates. The firm that handled Mr. L’s divorce and remained unpaid.
  • Mr. L claimed that the 401(k) account and the IRA received in the divorce were exempt from claims of creditors as retirement assets under 11 U.S.C. Section 522(d)(12).
  • The bankruptcy court disallowed Mr. L’s claimed exemption for the 401(k) and the IRA.
  • Mr. L. appealed to the 8th Circuit Court.

8th Circuit Court Ruling

  • The 8th Circuit Court (Court) upheld the lower court’s disallowance of the exemption.
  • The Court referred to a 2014 U.S. Supreme Court ruling that an inherited IRA did not qualify as a retirement asset qualifying for the bankruptcy exemption. Clark v Rameker, 134 SCt 2242 (2014).
  • In so ruling, the United States Supreme Court indicated that retirement funds for purposes of the bankruptcy exemption meant funds set aside to be available when one stopped working and, hence, did not apply to an inherited IRA.
  • The Court ruled that a retirement asset received as part of a property settlement does not qualify for the exemption either.
  • The Court was not swayed by Mr. L’s claim that his wife’s 401(k) and IRA were accumulated specifically for their joint retirement.
  • It was also noted that Mr. L had not rolled the assigned funds into his own retirement account. He could not even produce a QDRO indicating that he had accessed his as-signed share of the 401(k).

Comments on the Case

  • The Court seemed to narrowly construe the statute since, as Mr. L asserted, the funds in question were in fact set aside for his and his former wife’s retirement.
  • The division of the parties’ retirement assets is frequently done with the objective of providing each party with sufficient financial security for retirement years.
  • Where bankruptcy is a possibility, to lessen the chances of what happened to Mr. L, retirement funds received in a divorce should be accessed promptly and rolled into one’s own retirement account.
  • QDRO preparation and processing should be attended to forthwith after a divorce.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Bankruptcy Exemption May Not Apply To Retirement Benefits Received In Divorce – Lerbakken v Sieloff & Associates, PA, NO. 18-6018 (8th Cir. 2018)”
View / Download Aug-Sept 2019 Article – PDF File

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

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)