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March 2005 Tax-efficient marital dissolution When divorce involves a high-income couple or complex assets, the parties and their attorneys should resist the temptation to “get it over with” until the tax consequences are carefully considered Financial anxiety is often a cause, and almost invariably a result, of divorce. Each party faces the prospects of a divided asset base and diminished income. In all but the most amicable marital dissolutions, strong legal representation is a must, and the attorney should lead the process. But effective tax planning is also essential, and taking advantage of all possible tax deductions and income-shifting opportunities can improve each party’s after-tax cash flow and, in many cases, ease a difficult financial situation. Spousal maintenance. The conventional tool to balance post-divorce Form 1040 income is spousal maintenance (often referred to as “alimony”). Barring provisions to the contrary, spousal maintenance payments are a deductible expense for the payor and taxable income to the recipient. However, tax laws allow divorcing parties to characterize any portion of an alimony or maintenance payment as non-deductible to the payor and non-taxable to the payee. This flexibility allows for optimal tax results, provided the marital dissolution decree contains the proper language. In the case of a lower income party with custody of children, there are significant tax credits and rebates that can be gained by carefully planning the mix of taxable and non-taxable payments to that person. By targeting certain income thresholds in the payee’s tax return, substantial child tax credit refunds and other tax savings can often be generated. Recent tax court cases have also imparted a few lessons regarding the requirements for achieving income-shifting in spousal maintenance agreements. Here are a few key points:
Property settlements. As of an effective date set forth in the dissolution decree, assets are generally split between the spouses. The laws assure that this division of assets is tax-free, but that does not make it immune to tax consequences. For example, Building A (which goes to husband) and Building B (which goes to wife) may each be worth $500,000. But if Building A has a depreciable cost basis of $400,000 and Building B is fully depreciated, what appears to be an equal split is actually anything but. In many cases, dissolution statutes do not take into account these differences of potential capital gain or future depreciation benefit. Similar disparities often exist among security investments and residential properties (a principal residence, for example, qualifies for tax-free sale while other secondary residences do not). Properly quantifying these tax disparities can assure a more accurate equalization of values. Tax laws also allow the transfer of portions of pension and other retirement plan accounts from one divorcing spouse to the other. Similarly, IRA accounts can be partially or fully transferred in a divorce, as can valuable unexercised stock options. When the recipient spouse later draws from these retirement plans or exercises the non-qualified stock options, such actions trigger ordinary income taxation, and if the income arises from stock options, there will also be payroll tax implications. Conclusion. In marital dissolutions involving high-income parties or complex assets, the parties and their attorneys should resist the temptation to “get it over with” until the tax consequences of each spousal maintenance and property settlement provision is reviewed by an experienced tax professional. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |