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

Posted by Joseph W. Cunningham, JD, CPA

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)

Read More “November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019”

October 2018 : Stock Redemptions

Posted by Joseph W. Cunningham, JD, CPA

View / Download October 2018 Article – PDF File

— With the Elimination of Taxable/Deductible Section 71 Payments Effective January 1, 2019, the Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations.

General

Section 71 payments have provided a means by which one spouse buys out the other’s marital interest in a business with pretax dollars. But, with the 2017 Tax Act’s repeal of the alimony deduction, this method will no longer be available beginning in 2019.

However, use of a stock redemption can be a “tax-smart” way to structure the buy-out. To do so, the owner spouse transfers stock to the non-owner, and it is then immediately redeemed by the corporation. The difference between what the non-owner receives and the owner’s carryover tax basis in the stock is taxed favorably as a capital gain or loss. Stock redemptions can be particularly suitable in the following circumstances:

  • The company has excess liquidity.
  • The stock has a relatively high tax basis (which is not uncommon if the company is an S corporation).
  • The spouse who will not end up with the business individually owns stock.
  • The owner spouse may not draw more compensation because of “reasonable compensation” tax constraints or legal restrictions.
  • The dilution, if any, caused by the redemption will not be problematic for the owner spouse.

Other than in a divorce context, this approach would be treated by the IRS as a step transaction—the non-owner spouse’s stock ownership would be considered merely transitory and lacking independent legal significance, which would result in a constructive dividend to the owner spouse. However, this technique is available in a divorce setting because of an expansive IRS interpretation of IRC 1041 incorporated in regulations the IRS issued in 2001. Treas Reg 1.1041-2.

Regulations and Illustrations

The following example explains the essential provisions of the regulations by way of illustration:

  • H and W each own 50 percent of ABC Company. They agree that H will continue to own and operate the company while W will tender her stock for redemption.
  • H has at no time assumed a “primary and unconditional obligation” to acquire W’s stock.
  • He has agreed, however, (1) to cooperate in his role as a corporate officer and shareholder so that the company implements the planned redemption and (2) to guarantee the company’s payment of the redemption proceeds.
  • Because H does not have a “primary and unconditional obligation” to acquire W’s stock before ABC redeems it, the redemption is not a constructive distribution to him.
  • Thus, W will be taxed at the long-term capital gain rate on the difference between the redemption proceeds she receives and her tax basis in the stock.

In the above illustration, both spouses own stock in the company. It is more common, of course, for the interest in the company to be owned by only one of the spouses. The regulations do not directly address the situation involving (1) one spouse—say, H—owning 100 percent of the stock and (2) a divorce settlement providing for the following transactions:

  • H’s transfer of 50 percent of his stock to W
  • W’s tender of the stock to the company for redemption of her newly acquired stock interest

Though not specifically addressed in the regulations, it appears that the tax treatment for this fact pattern would be the same as that which applies when both spouses initially own stock as follows:

  • The form of the transactions—(1) the nontaxable transfer under IRC 1041 of stock from, in our example, H to W, followed by (2) the redemption of W’s stock taxable at capital gains rates—will be honored provided H does not have a primary and unconditional obligation to pay W for her interest in the stock.
  • Alternatively, if there is such a primary and unconditional obligation, the redemption distribution would be deemed constructively received by H and taxed to him as a dividend.

To illustrate, assume that H is the sole owner of the company and that, as part of his divorce settlement with W, they agree he will transfer a 50 percent interest to her which she will tender to ABC in exchange for redemption proceeds. Though not expressly covered in the regulations, this fact scenario would appear subject to the following tax treatment:

• Provided H does not have a preexisting primary and unconditional obligation to pay W for her marital interest in the stock, the form of the two-step transaction will be honored for tax purposes.
• In effect, the transfer of the 50 percent interest from H to W as part of the divorce settlement will be tax free under IRC 1041, and the redemption distribution.

A principal reason to assume the above tax treatment will apply when one spouse owns all the stock is the following statement in the background section of the regulations:

“By enacting the carryover basis rules in section 1041(b), Congress has, in essence, provided spouses with a mechanism for determining between themselves which one will pay tax upon the disposition of property outside the marital unit. For example, assume Spouse A owns appreciated property that he or she wishes to sell to a third party. The spouses may agree that Spouse A will sell the property to the third party and recognize the gain. Any subsequent transfer from Spouse A to Spouse B of the sales proceeds will be nontaxable under section 1041. In the alternative, the spouses may agree that Spouse A will first transfer the property to Spouse B. This transfer is nontaxable under section 1041, with Spouse B taking a carryover basis in the transferred property. Spouse B will then recognize the gain or loss on the sale of the property to the third party because a sale to a third party is not covered by section 1041. In this latter scenario, the tax consequences of the sale are shifted to Spouse B.”

 

66 Fed Reg 40,659 (2001).

Viability of Redemptions in Divorce

Certainty of Tax Treatment. Provided there is no such primary and unconditional obligation, the parties may structure a divorce-related redemption with certainty of the tax treatment. Nonetheless, because things change, including the minds of divorcing parties, a savings clause appears advisable.

Guarantee Allowed. With the IRS’s clear statement that a primary and unconditional obligation does not include a guarantee
of another party’s performance, there should be no concern to provide that the remaining shareholder guarantee the corporation’s performance under the redemption agreement.

This is highly significant because, without a guarantee, it is conceivable, particularly where the remaining spouse would transfer a minority interest to the other spouse, that the remaining spouse would use his or her influence to obstruct the redemption, leaving the other spouse with a minority interest in a closely held company.

More Useful Post 2017 Tax Act. Though rarely used in the past, the redemption approach to a buyout will be the best alternative in many situations from a tax standpoint beginning in 2019. That said, redemptions are a good fit presently in some divorce settlements.

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… “Stock Redemptions”
View / Download October 2018 Article – PDF File

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

Read More “October 2018 : Stock Redemptions”

Aug / Sept 2018 : Calculation of an Equitable Award for the Non-Degreed Spouse Under the POSTEMA Decision

Posted by Joseph W. Cunningham, JD, CPA

View / Download Aug / Sept 2018 Article – PDF File

— Background on Postema

In 1991, the Court of Appeals set forth the divorce settlement remedy for a non-degreed spouse who made “sacrifices, efforts, and contributions” to enable the other spouse to attain an advanced degree and, often, professional training. Postema v. Postema, 189 Mich App 89 (1991) (“Postema”).

Prior to the Postema decision, there was a split among different Court of Appeals panels on the proper remedy for such a non-degreed spouse in cases in which a divorce prevents such spouse from sharing in the “fruits of the degree” after its attainment.

Some panels had decided that the non-degreed spouse is entitled to part of the “value of the degree” – that is, the present value of the difference between (1) projected earnings of the degreed spouse over his/her work life expectancy with the advanced degree and (2) projected earnings of such spouse without the advanced degree.

Other panels ruled that the non-degreed spouse was entitled to be reimbursed for sacrifices, efforts, and contributions
made, but not to a share of the value of the degree. To resolve the split, the Supreme Court ordered that the next case on the issue would become binding precedent on the appropriate remedy. That case was Postema.

The Court ruled in Postema that the purpose of an equitable award is to reimburse the “non-degreed” spouse for “sacrifices, efforts, and contributions” made to enable the other spouse to attain a professional degree. However, this does include a share of future incremental earnings attributable to the professional degree.

The Court stated an equitable award applies in situations in which “the degree was the product of a concerted family
effort.”

Components of a Postema Award

Under Postema, there are generally four components to be considered in calculating an equitable award.

  1. Lost or Forgone Earnings – The non-degreed spouse’s 50% marital share of the difference between (1) what the degreed spouse could have earned, after-tax, during years of education and training and (2) his or her actual aftertax earnings during those years.
  2. Cost of Education – The non-degreed spouse’s 50% share of the out-of-pocket costs of the education and training paid with marital funds
  3. Subordination of Career Aspirations – Compensation to the non-degreed spouse for the cost of either (1) not pursuing career aspirations or (2) delaying such pursuit solely due to allowing the degreed spouse to do so. The non-degreed spouse’s share of such “make-up” compensation is 50% for years during the marriage and, possibly, 100% of the present value of lost future earnings.
  4. Intangible Sacrifices, Efforts, and Contributions – Compensation to a non-degreed spouse for intangible sacrifices, efforts, and contributions such as loss of companionship, and additional time devoted to household/parenting responsibilities in excess of the normal time spent doing so, occasioned solely by the degreed spouse’s time constraints due to pursuit of the advanced degree and training.

The Court also stated that the equitable award should be reduced by the non-degreed spouse’s 50% share of the degreed spouse’s incremental earnings after attaining the degree and training.

All amounts are converted to the value of current dollars since the award will be paid in current dollars.

Information Required to Calculate a Postema Equitable Award

The components of an equitable Postema award are, in the main, fact intensive. Thus, input from both parties is essential. Information required includes a timeline including:

  • Date of marriage;
  • Time periods of (1) advanced degree education and, if applicable, (2) professional training;
  • If applicable, time period working as a professional after attainment of the degree and training; and,
  • Dates of birth of children during marriage.

The following is a “Postema Information Request List” used by the author when performing a Postema award calculation.

Information Required to Determine an Estimated Equitable Award According to the Postema Case

  • Date of marriage; length of “courtship”
  • Birthdates of children of the marriage.
  • Detailed chronology (year by year) of attainment of advanced degree and professional training (e.g., for a doctor – medical school; internship; residency; board certification training; etc.)
  • Current résumé of the professional
  • Educational background and employment history of the degreed spouse prior to pursuit of the advanced degree. Provide his or her annual earnings from such employment.
  • Annual earnings of each party during years of the marriage – both before attainment of the advanced degree and professional training, and afterward.
  • Other sources of funds such as student loans, loans or cash gifts from family, inheritances, etc. Please indicate (1) the year in which such funds became available and (2) the party to which the funds are attributable.
  • The costs of the advanced degree and professional training, including tuition, books, fees, travel, additional housing, etc. Please specify the source of funds used to pay these costs. If financed by loans, please indicate the extent to which such loans have been repaid with marital funds.
  • An estimate of hours per week the non-degreed spouse devoted to household and other family responsibilities, including parenting, in excess of the hours such spouse would have devoted to such responsibilities if the other spouse were not pursuing the advanced degree and professional training.
  • Comments on the extent to which the normal companionship generally existing between spouses was unavailable due to pursuit of advanced degree and professional training.
  • Extent to which, if any, the non-degreed spouse subordinated his or her career aspirations to allow the other to pursue his or hers. Please specify the future plans regarding such postponed career aspirations, including the timetable for same.
  • Copies of federal income tax returns of the degreed spouse’s practice for each year since commencement of the practice.
  • If the degreed spouse did not start a practice immediately on being licensed to so, please provide his or her employment history, including annual income, since he or she became licensed to practice.

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… “Calculation of an Equitable Award for the Non-Degreed Spouse Under the POSTEMA Decision”
View / Download Aug / Sept 2018 Article – PDF File

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

Read More “Aug / Sept 2018 : Calculation of an Equitable Award for the Non-Degreed Spouse Under the POSTEMA Decision”

May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2018 Article – PDF File

— Facts

  • During the parties’ 11 year marriage, H operated a successful business of which he was the sole corporate shareholder.
  • W was a stay-at-home mom tending to the parties’ two young children.
  • At the time of the divorce, W was earning $11,000 annually for part-time work at a charter school. She testified she was seeking a full-time job.
  • H drew $43,216 from the business in the most recent year.
  • During the pendency of proceedings, H paid W $500/month spousal support and paid all household/family bills pursuant to a status quo order.
  • H incurred substantial debt (1) to make the required support and status quo payments, (2) to pay his and W’s attorney fees, and (3) to pay business expenses. At the time of divorce, the business owed $108,000 including rent in arrears and tax deficiencies.
  • The trial court imputed $20,000 earnings to W and $40,000 to H.
  • The trial court awarded no spousal support to W because:
    • She had a Bachelor’s Degree in Fine Arts while H had just a high school education.
    • H had paid all family expenses during the pendency by incurring substantial business debt.
    • Since W benefitted from this, she was “partially responsible” for such debt.
    • Because H was assuming full responsibility to repay the debt, the trial court viewed this as a “favorable outcome” for W.

Court of Appeals (Court) Decision

  • The Court stated that the trial court failed to make a determination (1) “as to the origin of the debts” of H’s business and (2) “who was responsible for their creation.”
  • Further, the Court noted that W had little, if anything, to do with H’s business and, hence, likely had little, if anything, to do with incurring the debts.
  • The Court remanded the case for reconsideration of (1) W’s responsibility, if any, for the debts after thoroughly reviewing the origin of the debts and (2) the lack of a spousal support award to W.

Comments on the Case and on Treatment of Debts in Determining Money Available for Support

  • The Michigan Child Support Formula Manual (Manual) provides in Section 2.01(B):

    “The objective of determining income is to establish, as accurately as possible, how much money a parent should have available for support. All relevant aspects of a parent’s financial status are open to consideration when determining support.”
    (Emphasis added.)

  • Thus, if H in Bockart had to incur debts to pay family expenses, money used to make payments on the debts is simply not “available for support.”
  • If a business is required to pay on business loans incurred in the ordinary course of business, such as working capital loans or equipment purchase installment payment loans, then the money used to make payments is not available for support.
  • Such payments are not deductible in determining business net income and so must be separately identified when determining money available for support.
  • This is the flip side of adding back deductible depreciation (1) above straight line on personal property or (2) on real property – that is, converting net income to money available.
  • The Court’s focus on the “origin” of the debt seems misplaced. Whether W had any “responsibility” for creation of the debts should not be a deciding factor. Neither should whether the debts were incurred by H or by his company.
  • Rather, of significance is whether the funds from the debts were used for marital purposes. If so, they are debts of the marriage, however incurred.
  • This may not apply to debts to provide for payment of divorce attorney fees. Responsibility for such fees is generally separately considered in divorce settlements.

Concluding Comments

  • Like so many matters in divorce, determining money available for support is a case specific exercise.
  • This is particularly so if one party owns a business or professional practice – both (1) to ensure all items of “indirect” income (excessive perks, etc.) are identified and (2) that legitimate debt payments are excluded from money available for support.
  • Often balance sheets need to be reviewed in addition to income statements.

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 Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”
View / Download May 2018 Article – PDF File

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

Read More “May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”

April 2018 : 2018 Presents a Window of Opportunity for a Tax Smart Method for a Buyout of a Business Interest

Posted by Joseph W. Cunningham, JD, CPA

View / Download April 2018 Article – PDF File

— A business (or professional practice) owned by a divorcing party may present tax problems in structuring a property settlement. The business is often the parties’ largest marital asset and will usually be retained by the owner spouse. If other marital property is insufficient to balance the settlement, some form of installment payments is generally used to buy out the nonowner spouse’s marital interest in the practice.

It is sometimes appealing to a divorcing business owner to have the company make payments buying out the other spouse’s marital interest in the business on a tax deductible basis. Attempts to do this include labeling such payments for the ex-spouse’s consulting services or administrative assistance.

If examined by the Internal Revenue Service (IRS), however, the deduction is likely to be disallowed if the other spouse did not in fact provide services commensurate with payments received. Rather, the IRS would treat the payments as step transactions (1) constructive dividend distributions to the business owner spouse followed by (2) nondeductible property settlement payments to the other.

For such arrangements to withstand IRS scrutiny, the spouse receiving payments must in fact perform services. If the wife did not work for the practice during the marriage, such arrangements would generally be viewed as sham transactions.

And, even if the wife had previously worked at the practice, she must actually perform duties commensurate with the amount of payments. This is often unlikely in view of the strained relationship generally prevailing between the husband and the wife as a result of the dissolution of their marriage.

The Tax Court has upheld IRS disallowance of practice deductions for payments to the owner’s ex-spouse that in fact represented part of the divorce related buy-out of his or her interest in the company. [1]

For this article, it is assumed that H is the business owner.

For divorces completed before December 31, 2018, there is a better way to achieve the same result (i.e., the use of deductible payments by the company to buy out the W’s marital interest in the business). As indicated, however, this method is available only for divorces and separations finalized in 2018.

“Section 71 payments,” as they are sometimes referred to, resulted from the Tax Reform Act of 1984’s elimination of the requirement that payments must in fact discharge the payor’s obligation to support the payee. The subjective “support” requirement (which had given rise to an ever-increasing number of tax disputes) was essentially replaced by more objective strictures. First, payments must terminate on the payee’s death and, second, payments must not be excessively front-loaded (i.e., disproportionately bunched in the years immediately succeeding the divorce).

These changes opened a vista of planning opportunities for divorce practitioners. Payments in settlement of property rights or for legal fees of the other spouse may be made on a taxable/deductible basis provided the alimony requirements of Section 71 are satisfied. They are used as a means of dividing non-qualified retirement benefits to which QDROS do not apply. Such flexible uses of Section 71 payments are especially beneficial where the payer is in a considerably higher tax bracket than the payee.

But, the alimony deduction under Section 71 has been eliminated by the 2017 Tax Cuts and Jobs Act (Tax Act) effective for divorces and separations finalized after December 31, 2018. The Tax Act also provides, however, that the prevailing deductible treatment of alimony will be grandfathered for divorces finalized before December 31, 2018. Thus, 2018 is a “window” for using Section 71 payments to advantage, including one spouse buying out the other spouse’s marital interest in a business (or professional practice) on a taxable/deductible basis.

Example

Assume that H and W agree that he will pay her $25,000 annually for ten years in consideration of her marital property interest in his business and, further assume that H’s marginal tax bracket averages thirty percent, the W’s fifteen percent. In view of bracket disparity, H and W decide to share a “tax subsidy” provided by Uncle Sam.

Thus, as an alternative to the $25,000 nondeductible/nontaxable annual payments for ten years, they agree that the H will make taxable/deductible payments to W of $32,500 annually for ten years, subject to termination in the event of the wife’s death, which will qualify the payments under Section 71. H will draw additional salary from the business to fund his payments to W. By converting the payments to taxable/deductible, H and W each end up with $2,000 plus more per year after tax, compliments of Uncle Sam, as follows:

Husband Wife Uncle
Sam
Payments of $32,500 (32,500) 32,500 0
Tax Benefit (Cost) 9,750 (4,875) 4,875
After-Tax 22,750 27,625 4,875
Annual Benefit Via Section 71 Payments 2,250 2,625 4,875
Ten Year Benefit 22,250 26,250 48,750

So, by using Section 71 Payments, Uncle Sam effectively paid $48,750 of the $250,000 obligation – almost twenty-five percent.

Planning Opportunity

For 2018 divorces in which a business or practice owner is in a meaningfully higher tax bracket than the non-owner spouse, consider the use of Section 71 payments as a means of structuring buyout installment payments.

This tax saving technique will no longer be available for divorces entered after December 31, 2018.

Neither will other uses of Section 71 payments such as those noted above.

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.

Endnote

1 Greenwood v. Commissioner, 57 TCM 1058 (1989).

Download the PDF file below… “2018 Presents a Window of Opportunity for a Tax Smart Method for a Buyout of a Business Interest”
View / Download April 2018 Article – PDF File

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

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