Personal Financial Planning
Advisers must consider a number of issues when helping a client navigate through a divorce. Emotions are at their peak, but careful thought and planning must take place before the divorce agreement is finalized, to prevent future financial and legal headaches. This item discusses the five top issues that financial advisers and CPAs should consider throughout a client's divorce negotiations.
1. What Constitutes Alimony? Will It Be Tax-Deductible?
Sec. 215 grants a deduction for a taxpayer who pays alimony, but the definition of alimony and related requirements are contained in Sec. 71(b). Alimony must be in the form of cash and:
- Payments must be received by, or on behalf of, a spouse under a written divorce or separation instrument;
- The written document cannot designate that the payments will not be includible in gross income of the payee and not be deductible by the payer;
- The payer and payee cannot live in the same household;
- The payments must terminate upon death of the payee spouse; and
- The parties cannot file a joint return.
If any of these requirements are not met, the payments do not qualify as alimony. (Note that each payment or stream of payments as indicated in the divorce decree or separation agreement is tested separately for all alimony criteria.)
Even if the payments meet these requirements, they must not be excessively front-loaded as defined under Sec. 71(f). If there was a decline in the amount paid over the first three years, there may be recapture, which will affect the tax deduction. For the payer to properly deduct settlement payments as alimony, the parties must be willing to spread payments relatively evenly over the first three post-separation years.
To further complicate matters, alimony rules vary from state to state. Some states rely on a needs-based alimony statute, while others divide community property in favor of the lower-earning spouse to compensate for lack of alimony payments. Furthermore, in certain community property states (where the community does not terminate until the divorce or separation is finalized), the interim support may be only a division of community income. Thus, alimony treatment is inappropriate in this case.
A practitioner cannot rely on the mere fact that the payments are called alimony. A payment will be deemed to be child support if it is reduced when a contingency related to the child occurs or at a time that can be clearly associated with such a contingency (Temp. Regs. Sec. 1.71-1T(c)). If support payments are reduced within six months before or after a child attains age 18, 21, or the local age of majority, then the amount of the decrease can be determined to be child support. The same recharacterization can occur if payments are to be reduced on two or more occasions within one year before or after a different child of the payer spouse attains an age from 18 to 24. Beyond these bright-line tests, other contingencies may include reductions when the child gets a job, attends college, joins the military, or moves away from home. Even if the chance of the contingency is remote, the fact that there is a contingency may lead to the recharacterization of a portion of the maintenance as child support, which the payer may not deduct.
In some cases, the parties may not want to treat payments as alimony. In these cases, an election can be made for federal income tax purposes by stating in the applicable agreement or decree that the payments are not to be treated as alimony for tax purposes. This may be appropriate if the divorcing parties' tax brackets are similar; the payer does not realize a tax benefit from the deduction; the payments are purposely front-loaded; the payer has established an alimony trust; or an agreement cannot be reached to indemnify the payee for the tax that is due on the payments (when alimony is being used as a property settlement).
2. The QDRO: Is It Truly Qualified? Planning Opportunities Abound
A qualified domestic relations order (QDRO) is a tool to designate retirement benefits to an alternate payee. To be qualified, a domestic relations order (DRO) must meet the requirements of Sec. 414(p) and be submitted to the plan administrator for approval. Since DROs can be complicated, numerous drafts may need to be submitted before the DRO becomes qualified. It is therefore crucial that the QDRO be formally reviewed and changes made before the divorce is final, to ensure the document achieves the intended results.
Unfortunately, not all attorneys are well-versed in QDROs, and this could produce disastrous results. If it is later determined that the QDRO does not meet the requirements of Sec. 414(p), the participant spouse may be taxed on the distribution and subsequent payment to the nonparticipant spouse. Further, if the nonparticipant spouse dies, the benefits could go to the participant spouse instead of to the nonparticipant spouse's estate.
Multiple planning opportunities are available with a QDRO. A distribution under a QDRO to an alternate payee can be made before the participant spouse becomes eligible to take a distribution. This can allow for debts to be paid and add liquidity to a settlement when no other liquid assets are available to split. In addition, the after-tax value of the qualified plan might be greater in the hands of the nonparticipant spouse. Income could be shifted to a lower-taxed party without the same alimony limitations. Additionally, it is important that the QDRO specify that the nonparticipant spouse is treated as the surviving spouse. Otherwise, if the participant spouse dies before payments begin, there is no obligation to make payments to a former spouse.
The alternative payee's cash flow needs are another important consideration and should be assessed before rolling over QDRO distributions into an IRA, as the 10% penalty is not assessed on a distribution to an alternate payee pursuant to a QDRO, regardless of age (Sec. 72(t)(2)(C)). Once the funds are in an IRA, the 10% early withdrawal penalty applies if the alternate participant is under age 59½ and no other exception applies. Alternatively, if the plan allows, the funds can be held in a separate account with the plan trustee, especially if the alternate payee is under age 59½.
For more information regarding QDROs, see the U.S. Department of Labor's page with frequently asked questions, available at www.dol.gov.
3. Jointly Owned Primary Residence
A primary residence is often a divorcing couple's largest asset. Maximizing the Sec. 121 exclusion is therefore an important consideration. In some situations, it could make sense to sell the home in advance of the divorce to repay the mortgage and report the transaction on a joint return, taking advantage of the full $500,000 exclusion under Sec. 121 if the divorcing couple otherwise qualify. However, sometimes one or both parties to a divorce do not want to sell the home. One spouse could be emotionally attached to it or may want to wait until minor children are grown up. Alternatively, the home might be "underwater" (worth less than the principal amount of the mortgage), and the couple want to hold the property until the value rebounds enough to pay the debt.
If a client no longer lives in the home but the former spouse is using it, the nonresiding spouse may be able to qualify for the Sec. 121 gain exclusion even if his or her own usage does not meet the two-year rule. Sec. 121(d)(3) allows the former spouse who gave up the use of property to count the period that the resident spouse is using it. This is allowed as long as the usage and ownership requirements were followed pursuant to a divorce or separation instrument.
If a client is using the property and remarries, the new spouse could also qualify for the Sec. 121 exclusion. The new spouse would have to meet the usage requirement. In contrast, a new spouse of the nonresiding former spouse would not qualify since he or she would not meet the usage test.
How are mortgage payments and property tax payments on a home treated when the home is owned jointly? It depends. If the client is required by the instrument to make the full mortgage and property tax payments as maintenance and holds joint title to the home, the full amount of the payments would not be maintenance, since half of the payments would be considered payments for his or her own property. The half deemed paid on behalf of the spouse would be deductible as alimony, and the half that is considered the payer's share of qualified mortgage interest and property taxes could be deductible on Schedule A, Itemized Deductions. (The resident spouse may deduct the other half.) When the home is eventually sold, the proceeds are usually reduced accordingly for the spouse who lived in the home but did not pay the mortgage and property taxes post-divorce.
If both spouses are making payments, the mortgage interest and property tax deductions generally are attributed to the spouse who makes the payment. If the couple reside in a community property state and pay the mortgage and property taxes from a community checking account, then the deduction will generally be split equally between the spouses. (Note that most states differ in their treatment, so planners should consult proper counsel prior to advising clients.)
4. Life Insurance and Securing Future Payments
In addition to providing tax planning, advisers can help clients reduce risk and ease their fears about the future. The client may be concerned that the other party to the divorce will be unable to pay a property settlement or that maintenance payments will be insufficient to provide economic security. These issues should be addressed before the divorce is final.
Life insurance: This can be a cost-effective tool to secure future payments if the payer dies before his or her obligation is met. A term policy can cover a period of time; a whole life policy provides the ability to pull from the cash surrender value for urgent cash flow needs. There are many variations in between, so a trusted insurance expert should be consulted before providing recommendations to a client. The following issues need to be considered:
- Who should own the policy, and who should pay the premiums? For payments to be considered maintenance, the recipient spouse needs to be the policy owner, not the insured. It is often best to have the recipient spouse make the payments to avoid a situation where the payee spouse suddenly decides to stop making payments, causing the policy to lapse.
- A client should be advised to request that the other spouse apply for life insurance in advance of the final settlement. Waiting until after the judgment has been finalized can be disastrous if the spouse applying for the insurance is uninsurable. In this case, other options can be considered before the divorce is final.
- Not all life insurance is equal. If the payer is merely designating the former spouse as the beneficiary on an employer-provided plan, the policy might not be maintained if the payer loses his or her job or the employer decides to stop carrying the coverage.
Disability insurance: If the payer spouse is still employed, disability insurance is another useful tool to ensure cash flow when faced with a disability.
Annuities: An annuity can be a great way to simplify and secure payments, but this can be expensive with certain products. If the annuity is owned by the payer, the taxable income would be offset by the alimony deduction. This can help address any concerns about smoothing out support payments, since the annuity will pay out a fixed amount of income.
5. Planning Before and After the Divorce Is Final
The case is not over when the divorce is finalized. Without proper planning, clients can get lost in the details and be caught off-guard as assets are distributed and sold. Cash flow needs can be an issue if the spouse's finances are not thoroughly analyzed. Even though a client has legal representation, the full financial and tax picture might not have been analyzed and considered. For instance, will a client receive mostly liquid or illiquid assets? Will there be a tax impact if the client needs to sell an asset for cash? Does the settlement agreement consider after-tax effects and provide for equitable treatment between spouses? Has the client considered that all assets are not created equal from a risk standpoint? Although the fair market value of two assets may be the same before settlement, it might not be months afterward.
As trusted advisers, CPAs can help clients better understand the divorce process and final settlement before it's too late. Legal terms are difficult for clients to understand, especially when emotions and stress are at their peak. If possible, CPAs should meet with a client throughout divorce negotiations to be sure that pertinent areas are being considered, including:
- Insurance and risk management;
- Spousal employee benefits;
- Investment management;
- Tax impact of receiving or paying alimony;
- Cash flow before and after the divorce;
- Business or property valuations;
- Retirement planning; and
- Estate planning.
Once the judgment has been finalized, the client's financial picture is likely to change dramatically. It is prudent to revisit the will, beneficiary designations, budgeting, financial plan, and future goals. The client may need a referral to a new team of professionals and will often look to his or her CPA as a trusted adviser and competent guide through these murky waters.
EditorNotes
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
