The divorce statistics in the U.S. are sobering. According to the Census Bureau, in 1989 there was one divorce for every two marriages. In some states, however, recent results show a decline in the divorce rate. The apparent decline may not be realistic if economic conditions and court backlogs are considered. It not only takes longer to get through the court system, but there have been more battles over asset values and marital property distributions because of the downturn in the economy since 1988.

Because of the frequency of divorce and the magnitude of the distributions, it is possible that more wealth is transferred today through divorce than through inheritance.

DIVORCE IN A NUTSHELL

In lay terms, divorce is a legal action where the parties to a marriage seek to have the marriage dissolved on grounds permitted under the state of jurisdiction's domestic relations laws. The result is a court judgment dissolving the marriage, distributing marital property, and establishing maintenance and child support.

There is an important role for the CPA when marital property is to be distributed. The nature and extent of the marital property must be established. The assets and liabilities must be valued and an agreement must be reached on how they should be distributed. While CPAs assist in all phases, the focus of this article is the planning and analysis of how the marital estate should be distributed. Because of varying needs and perspectives of the parties, splitting assets down the middle is rarely the right answer.

For purposes of illustrating issues, it is assumed the divorce occurs in a state such as New York, which has equitable distribution laws and the valuatin of net worth and equitable distribution are already complete. The parties to the divorce are attempting to agree on the what, when, and how, for distributing the marital estate and for payments.

SELECTION OF ASSETS FOR DISTRIBUTION

A married couple may be owners of significant gross assets, but the attempt to partition these assets upon termination of the marriage is often beset by four problems--they might not be liquid, they might not be income-producing, they might be seriously debt-encumbered, and there may be tax consequences after distribution.

The selection of which assets are to be given to each party is difficult when assets have value but are not usable for current cash needs. When there are existing debts to be repaid and daily expenses to be covered, the transfer of a highly valued residence, for example, may not enable a recipient spouse to pay overdue bills.

The division of high value, non-income producing marital assets, liquid or not, may also be a problem. Appreciated investments that do not provide a current return also present a difficulty. If sold, there would be a capital gains tax reducing the amount currently available for reinvesting.

But I Thought I Was Wealthy!

Assuming a 28% federal capital gains tax and approximately 7% for state income tax, a spouse receiving and then selling $500,000 in securities, which originally cost $350,000, would net $446,750. Assume further that this spouse needs to pay $100,000 for expenses related to the matrimonial action and $46,750 for other debts incurred between the time of the divorce action and its settlement. This spouse is then left with $300,000. If the spouse wishes to remain liquid and invest in vehicles of minimal risk, the $300,000 might earn an average of $15,000 per year. Having chosen liquid investment vehicles involving the least price fluctuations, if this was also taxable income, the spendable amount would be somewhere between $9,000 and $12,000 depending on the tax bracket of the recipient.

The situation might also arise when an asset is encumbered and the recipient spouse assumes the debt or takes the asset subject to the debt. If the asset is not disposed of, the recipient may have temporary enjoyment of the asset without means to continue paying for the privilege.

The award of highly valued assets upon termination of the marriage could leave the recipient in an undesirable and unexpected financial situation unless there is professional advice rendered.

Creating Cash Flow and Tax Liabilities

Creating Cash Flow and Tax Liabilities. According to Sec. 1041, the actual transfer of property between spouses, or to a former spouse incident to a divorce, is not a taxable event. The transfer is treated as a gift and the transferee assumes the transferor's adjusted basis in the property.

But, providing cash flow from assets received from a high net worth but non-liquid estate can have immediate tax consequences upon disposition, seriously diminishing the original funds. Payment of income tax and potential tax penalties can greatly reduce available capital and income of the recipient spouse. Two examples are the marital residence and retirement plans.

The Marital Residence. A marital residence purchased for $400,000 in 1980, worth $1,000,000 today, with a mortgage balance of $280,000 and an outstanding home equity loan balance of $200,000, requires mortgage payments of $35,000 and equity loan interest payments of approximately $25,000 per year. The divorce settlement must leave the recipient spouse able to make $60,000 in annual payments in addition to real estate taxes, property maintenance, and other personal living expenditures. If the spouse will not have sufficient cash flow available then the residence may have to be sold.

If the house is sold for $1,000,000 and selling expenses are $70,000, the seller will receive $450,000 after repaying the first mortgage and the home equity loan. According to IRC Sec. 1034, in order to not pay capital gains tax on the sale of a principal residence, the seller would have to buy a new residence within two years of the date of sale for at least $930,000, the adjusted sales price of the old residence. Considering that the residence is being sold because of financial inability to carry it, he or she would not likely buy a new home of the same value to save taxes, even if there were some possible savings from a more advantageous new mortgage.

As an alternative, the recipient spouse could pay approximately $188,000 in federal and state income taxes on the $530,000 gain on the sale of the former residence and be left with $262,000 to divide between investing in a new home and income-producing vehicles. If a new house cost $400,000, with a $100,000 down payment and closing and moving costs estimated at $22,000, a cash balance of $140,000 would remain. The mortgage payments would be approximately $28,000 per year. Lower real estate taxes and property maintenance costs would provide additional savings, and the cash balance could be invested in liquid funds yielding $4,000 of after-tax monies with minimal risk.

These results vary if the recipient spouse buys a new home at a cost somewhere between the adjusted selling price and the adjusted basis of the old home. The capital gain on the sale of the former residence would be partially taxed currently and the remainder rolled over to reduce the basis of the new residence. Considering the liquidity problems, cash flow, and tax ramifications of prospective distributions differing in each scenario, it would be appropriate for a CPA to be involved in the settlement process to aid in understanding what the future financial picture will be like. In addition, the CPA's construction of illustrative alternatives could assist the matrimonial attorney in negotiating a more equitable settlement.

Pension and Other Retirement Fund Assets. The distribution of retirement plan monies presents a problem for the high net worth marital estate when the recipient requires a current income stream and liquidity not provided by other sources. A retirement plan, in the form of a Keogh, other pension, IRA, or deferred compensation account such as a Sec. 401(k), often represents a significant amount of unencumbered liquid assets in the marital estate. If a distribution is made to a non-participant spouse pursuant to a divorce, the assets in question will only retain tax-exempt status if the plan has a provision for such distribution and the payment is made by way of a qualified domestic relations order (QDRO). The term domestic relations order (DRO) is defined in IRC Sec. 414(p)(1)(B) as "any judgment, decree, or order (including approval of a property settlement agreement) which relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant, and is made pursuant to a state domestic relations law." To be classified as qualified, the domestic relations order must specify certain information such as the names and addresses of the participant and alternate payee (e.g., the recipient spouse), the dollar amount or the percentage of benefit payments to be paid to the alternate payee, and the number of payments or periods over which payments are to be made.

An IRA transfer does not specifically require a QDRO document and therefore is easier to effect. IRAs allow for a transfer to an IRA account in the name of the alternate payee. Some other plans allow for a transfer to an IRA account. In the event that this type of transfer is not or cannot be rolled over to a retirement account for the benefit of the alternate payee, the distribution becomes a taxable event. If after a rollover the alternate payee withdraws monies before retirement age, this withdrawal would be a taxable event. Therefore, if the recipient spouse currently needs money, a distribution or withdrawal will be taxed as ordinary income and will be subject to the 10% penalty for early withdrawal and the 15% excise tax for any excess distribution in the calendar year. The excise tax is reduced by the 10% early distribution penalty attributable to the excess distribution IRC Sec. 4980A(6). Therefore, a distributive award from a high net worth marital estate can have costly consequences. Again, it is essential that the CPA involved in the negotiating process apprise the client of the tax and financial planning implications inherent in distributing retirement funds, taking into account each possible scenario. For example, an early distribution of $500,000 from a rolled over IRA would net the recipient spouse less than $240,000 after federal and state income tax, early withdrawal penalty, and excise tax. If withdrawn for current use, this money would forego the $40,000 per year it could earn on long-term investments if it remained in a tax-exempt retirement account.

There are, of course, scenarios in-between the $240,000 and $500,000 whereby the recipient spouse could rollover the entire distribution to an IRA account and withdraw only necessary funds each year. The result might be a combination of high risk but higher returns in the retirement plan and a lower tax rate on an individual income tax return for the annual withdrawals. There would, however, still be the 10% penalty on all early withdrawals. One way to avoid this is to provide for annuity payments from the IRA based on the life expectancy of the alternate payee IRC Sec. 72(q)(2)(D). These could be withdrawn before retirement age without penalty and provide a good planning opportunity for the recipient spouse who needs additional monies before retirement age. TABULAR DATA OMITTED

THE COMPLETE PICTURE

Using the previous examples, assume the recipient spouse received $500,000 in securities, the residence with a net equity of $520,000, the retirement rollover of $500,000, and an additional $3,000 from a savings account. As illustrated in Exhibit 1, the net value of the marital estate is $4,730,000 and the equitable distribution to the recipient spouse is 50% of the marital residence and 30% of all other assets. The recipient spouse has been hypothetically awarded less than 50% of certain assets after considering such features as the duration of the marriage and direct and indirect contributions to the marriage and its property. The payor spouse's closely held business is included in marital assets but because ownership is to be left intact the distribution of monetary values is shifted to the other assets. The $750,000 for the business is replaced by $260,000 net worth in the residence, and an additional $350,000 and $140,000 in securities and retirement assets respectively. The total value to the payee spouse is $1,523,000.

In the worst scenario, if all items were liquidated, the spouse would have $993,000 for investment in a new residence and income vehicles. There would be $300,000 from securities after paying bills and taxes, $450,000 from the residence before taxes, $240,000 from the IRA after taxes, and $3,000 cash.

In the foregoing example, total liquidation is probably not the answer. Considering individual assets separately is also inappropriate; assembling a complete package is critical for evaluating settlement options. Without proper planning, one or both of the parties could be left disadvantaged.

PROPERTY SETTLEMENT DISGUISED AS TAXABLE ALIMONY

Before the Tax Reform Act of 1984, alimony was a continuing obligation to support the former spouse because a marital relationship obligated that support. The amendment to IRC Sec. 71 redefines alimony. Alimony now appears as maintenance to rehabilitate the former spouse while that person proceeds to a new and separate life and seeks employment, continues education, and prepares to be self-supporting, if possible, upon termination of the marriage.

The alimony requirements of Sec. 71 do not put limitations on the original source of funds for payments but to qualify as alimony, payments must be in cash IRC Sec. 71(b)(1)(A). This enables the divorcing parties to structure a financial settlement where an agreed upon property settlement could be disguised as maintenance payments and be paid out as alimony for tax purposes. This creates a bargaining stage for the parties and is a popular planning technique for non-liquid marital estates where the payor spouse is expected to continue earning a high salary that enables regular payments to be made to the recipient.

A recipient spouse could receive a larger total amount for agreeing to include in taxable income what would otherwise be a nontaxable transfer of property according to Sec. 1041. The income tax ramifications of affording a payor spouse a Sec. 215 deduction for alimony payments is significant for high net worth individuals.

Timing of payments is an important consideration. For example, a payee spouse may more readily agree, to include higher payments as alimony income if the bulk of the entitlement is received over as few years as possible, even though the original preferred option would have been to receive the entire amount tax-free upon termination of the marriage.

The IRC, however, has front-loading rules that preclude a payor from having large alimony deductions which are actually a disguised property settlement. The CPA must be aware of all of Sec. 71(f) alimony recapture rules when assisting in negotiations of a divorce agreement. The rules are designed to avoid front-loading of property settlements disguised as maintenance in the first two post-divorce years. The disallowance of alimony deductions is calculated using excess payments in the first and second post-separation years where the first year is the calendar year in which the payor made the first maintenance payments and the second year is the succeeding calendar year IRC Sec. 71(f)(6). This provides the basis for another negotiating point: a larger total monetary payout in exchange for avoiding excess alimony in the early years.

A marital estate that is income-producing but not liquid, where it is agreed that the titled spouse will retain title, might be distributed in fixed cash payments spanning a specified period. An agreed-upon amount of distribution might also be negotiated as maintenance payments after considering tax ramifications and interest factors for accepting a payout over a longer period.

Circumstances Change

Another situation to consider where a property settlement might be disguised as alimony is when the circumstances of the payor spouse change between the date an action commenced and the settlement date. The current economic recession or other circumstances may have affected the liquidity and the value of the assets and/or the income of the payor. The agreement should consider ability to pay the distribution. For example, New York courts have discretion as to the selection of valuation dates. The valuation date or dates may be anytime from the date of commencement of the action to the date of trial NY DRL 236(B)(4)(b) (McKinney 1986). The courts have considered post- commencement events to achieve fairness and equity in distribution.

An agreement may be structured so payments can be calculated according to fixed portions of future income. As income fluctuates, so would payments. Payments could also be negotiated as maintenance, includible in income of the payee, and deductible from income by the payor as alimony. Although fluctuations in payments in the first two post- separation years are subject to front-loading rules, the agreement can avoid a potential tax problem if, for at least three years, there is a continuing liability to pay amounts fixed in relation to income from business or property, or from employment compensation or self- employment. Fluctuations in these payments, due to changes in the payor's income or compensation, are not subject to alimony recapture IRC Sec. 71(f)(5)(c).

Property settlements made in cash over a specified period may successfully qualify as alimony payments if they are designated as such in the final agreement. The recipient spouse would want the settlement amount to be secured with insurance on the life of the payor in the event payments are to cease upon the payor's death. However, one of the specific requirements of Sec. 71 is that alimony payments cease upon the death of the payee spouse IRC Sec. 71(b) (1)(D). Alimony payments are for the welfare of the former spouse and if the former spouse dies, there is no longer any reason to maintain that person. A chance therefore exists that the payee spouse will never receive the intended property share of the marital estate if that party should die.

Alimony Is Better

Because a high net worth payor would prefer the payments to be tax- deductible alimony, and the payee would expect compensation for both taxes and the death risk associated with alimony, calculation, negotiation, and bargaining become the order of the day. After all is said and done, the payee spouse may conclude that a lesser, non-taxable, secure property settlement is more desirable. The CPA's involvement is essential in order to construct models of financial alternatives in assisting the attorney in the settlement process.

Property settlements disguised as maintenance payments were discussed earlier. Some prospective payors in a divorce proceeding might decide to reverse the action and disguise maintenance payments as part of the property distribution.

Watch Out for Bankruptcy

Although the asset appraisals as of the valuation dates may have given a marital estate an appearance of high net worth, current financial conditions may, on the other hand, alert the payee spouse to signs of potential bankruptcy of the payor. If the payor spouse files for personal bankruptcy after the divorce is finalized by decree, marital property settlements will be discharged according to Secs. 727, 1141, or 1328(b) of the Federal Bankruptcy Code. Payments for alimony, maintenance, or child support will not be discharged to the extent the divorce decree or other legal agreement according to state law designates a liability as such, "unless such liability is actually in the nature of alimony, maintenance, or support" U.S.C. Sec. 523(a) (5)(B). Therefore, the payee spouse may be subject to losing not only entitled property amounts, but also amounts for maintenance that have been termed property in the divorce agreement.

Federal bankruptcy laws take precedence over state laws in distinguishing between property and support. The payee spouse becomes a creditor who must prove to the Bankruptcy Court that a debt labeled as a property settlement is maintenance or the debt may be discharged.

An example of this problem is the decline in maintenance payments at an age when the payee spouse is to begin receiving payments from a pension award. The pension asset is a distributive property right and yet there may be an additional portion of the asset attributed to the recipient substituting for actual maintenance payments. The financially dependent payee spouse bears that burden of proof in Bankruptcy Court.

Deductibility of Professional Fees

Professional fees incurred in the divorce process of a high net worth individual could be for services of accountants, attorneys, appraisers, economists, and other consultants. It is ironic that so much money is spent for obtaining a divorce while often neglecting the timing and tax deductibility of those payments.

Expenses incurred in accordance with IRC Sec. 212 are deductible on Schedule A of Form 1040 if they are for the production or collection of income Sec. (212(1); the management, conservation, or maintenance of property held for the production of income Sec. (212(2); or the determination, collection, or refund of any tax Sec. (212(3). Professional fees paid for the negotiation of alimony would fall under sec. 212(1). Since alimony is for the recipient spouse's maintenance, it is likely that expert witness fees for assisting in determining the payor spouse's earning capacity would be deductible.

Fees incurred for property settlements, including those for equitable distribution, are covered under Sec. 212(2). However, these fees are only deductible according to the original nature of the claim for the deduction. Although the spouse with title to the property may be trying to protect the property for the purpose of generating future income, the fee is originally incurred as a result of a severed marital relationship. A marital relationship is of a personal nature and, according to U.S. v. Gilmore, 372 U.S. 39 (1963), and U.S. v. Patrick, 372 U.S. 53 (1963), the fees would not be deductible even though paid in connection with property held for the production of income. This interpretation of the law is consistent with IRC Sec. 262 that disallows deductions for expenditures of a personal nature.

The payment of fees under Sec. 212(3) for tax advice rendered to either spouse in the divorce process could represent a sizable deduction. Divorce agreements, particularly of high net worth individuals, involve extended discussions, negotiations, and resolutions of tax consequences for alimony and property matters. The deductibility of any item is, of course, ultimately subject to question by IRS and must be supported by documentation.

Because a final agreement probably involves negotiations for both alimony and property, the legal fees may have to be allocated to deductible and nondeductible portions. (Legal fees for child support and the actual divorce are not allocable.) A reasonable basis for apportionment may be according to the nature of the receipts. One method of allocation fixes a deductible percentage of legal fees for each year in which they are paid. A second method allows a deduction for legal fees in the year of payment related to the nature of receipts for that particular year. This method is similar to the familiar allocation of Sec. 212 investment expenses relative to taxable and tax- free income.

Exhibit 2 shows the results of the first method. The present value of the total receipts for all years is $2,000,000, of which 25% is alimony and 75% is for property. There would be a corresponding deduction for 25% of legal fees in each year in which the fees are paid.

In Exhibit 3, the second method shows payments for legal fees over two years. The spouse receives $100,000 as alimony income in each year. The property distribution is $900,000 in Year 1 and $400,000 in Year 2. The spouse may allocate 10% and 20% of legal fees paid to deductible items in Years 1 and 2, respectively.

Assume that the total unallocated legal fees are $60,000. The recipient spouse pays $20,000 in Year 1 and $40,000 in Year 2. According to Exhibit 2, 25% of the fees will be deductible in any year of the fees will be deductible in any year of payment. Five thousand dollars will be deductible in Year 1 and $10,000 in Year 2, for a total of $15,000. According to Exhibit 3, 10%, or $2,000, is deductible in Year 1, and 20%, or $8,000, in Year 2, for a total of $10,000.

Present value calculations make the first method more difficult but, depending on the circumstances, it could lead to greater benefit. If nothing else, these examples obviate the need for planning the timing of payments for professional fees.

To maximize potential tax benefits of deductible professional fees, the limitation of usefulness of the deduction should also be considered. The amount of deductible fees paid, plus other miscellaneous itemized deductions, must exceed 2% of the taxpayer's adjusted gross income (AGI). Itemized deductions may be further reduced by 3% of AGI above $105,250 (adjusted for inflation). Without planning, fees may be allowable but not usable to reduce AGI.

Even though professional fees for protecting or establishing ownership may be currently nondeductible, due to the personal nature of their origin, they may be capitalized. Fees related to defending properties of the titled spouse may be allocated based on each property's individual proportion to the total value of the properties remaining after settlement. The portion of fees allocated to cash accounts, however, cannot increase the basis of those accounts because the basis of cash may not be more than its face value. The fees related to the acquisition of property by the non-titled spouse can also be added to basis.

In New York, for example, when dividing property, consideration is given to each party's contribution to the marital relationship "including joint efforts or expenditures and contributions and services as a spouse, parent, wage earner, and homemaker" NY DRL 236(B)(5)(d)(6). The professional expert fees for valuing these contributions should also be capitalized as part of the basis of appropriate items such as real estate investment properties.

Alimony Trusts

An alimony trust provides maintenance to a former spouse in accordance with conduit rules so that taxable income generated by trust corpus is taxable to the beneficiary spouse, while tax-exempt income and distributions from corpus remain tax-free. The payor no longer has income or alimony deductions generated by the assets now in trust.

According to IRC Sec. 1041(b)(2), transfers to a trust, incident to divorce, will leave the basis in the property the same as the transferor's. One exception to this concerns the transfer of installment obligations to the trust. In this situation, the transferor recognizes gain or loss in accordance with Sec. 453B(g). The basis of the transferred property is adjusted for recognized gain or loss, and the gross profit percentage is recalculated.

The other exception to the Sec. 1041(b)(2) rule is for transfers in trust where liabilities exceed basis according to Sec. 1041(e). A gain would be recognized by the transferor in this situation and the trust's basis in the transferred property would be increased by the amount of gain recognized. If there is more than one property transferred, then the total basis and total liabilities rather than individual items would be subject to the gain recognition computation. Thus, a planned transfer of assets could avoid tax consequences to the payor spouse.

There are additional items beyond the scope of this article that may also be considered. For example, there are gift tax consequences if the payor spouse does not retain the reversionary interest and the remainder is transferred to other than the payee spouse in settlement of property rights related to divorce. Also, alimony trust income for child support is taxable to the grantor.

Another negotiating consideration is whether the trust should be funded with assets producing tax-free income. If the assets remain individually owned, the payor spouse would have the benefit of an alimony deduction in addition to tax-free income, but the payee spouse would have taxable alimony income. On the other hand, if the assets are transferred to the trust, the payee spouse would not be taxed on alimony income, but there would be no personal alimony deduction. The tax bracket of each party should be reviewed for maximum benefits.

The alimony trust can be especially useful to assuage post-divorce emotional factors. It could alleviate the possible bitterness a payor spouse may feel by eliminating the need to personally write alimony checks. It would give the payee spouse a sense of security in knowing that the source of maintenance money is segregated. It could also help regulate the spending patterns of a former spouse where there is concern for someone who has no experience living on a fixed budget.

CONSIDER THE ALTERNATIVES

The divorce process should include cost-benefit considerations. The financial and emotional aspects can best be served by a negotiated settlement of the parties rather than a lengthy litigious contest. Alternative structures for agreements are not likely to be as fully explored or beneficially resolved as they can be unless utilizing the services of a CPA able to assist the clients, attorneys, and ultimately the judge. Regardless of whether the high net worth marital estate is $1 million or $30 million, the aspects of potential bankruptcy, alimony trusts, and timing of cash needs for items such as divorce costs should be an integral part of planning for the parties to go forward upon termination of the marriage.