Tax considerations when dividing property in divorce

The emotional aspects of a divorce often interfere with planning for the efficient distribution of the marital estate. The shock and ill feelings may create a barrier between spouses that prevents even discussing issues. Tax practitioners need to know how to explain to a divorcing client the tax realities, to avoid any post-divorce tax surprises. Mistakes in property division or fraud can produce consequences that the tax practitioner may be unable to reverse.

OPPORTUNITIES FOR CPAs

Divorce engagements can require CPAs to act in either or both of two roles. One role is that of a forensic accountant in locating all assets and liabilities for marital division. The other role requires the CPA to apply his or her tax expertise to separating marital assets and payments.

In the forensic role, the CPA investigates and analyzes financial evidence and interviews parties to ensure all marital assets are included to prevent fraud. This forensic examination may be used as evidence at trial. Many states require forensic accountants to register as private investigators. The tax adviser role of a CPA helps divorcing couples make an orderly division of marital assets with the least tax burden.

Since divorcing spouses may have competing interests, CPAs with clients in divorce must take care to avoid professional conflicts of interest or their appearance. Generally, this means that although tax advisers may have represented both spouses in the past, they should represent one party but not both, or else obtain conflict-of-interest releases. The same consideration should extend to other family members who, as a result of the divorce, may have competing interests (see AICPA Code of Professional Conduct Rule 102, Integrity and Objectivity, especially Interpretation 102-2.03, Conflicts of Interest). Rule 102 provides examples of situations in which an AICPA member’s objectivity could be impaired. One is “a member has provided tax or personal financial planning (PFP) services for a married couple who are undergoing a divorce, and the member has been asked to provide the services for both parties during the divorce proceedings” (see also the sidebar, “Divorce Issues Checklist”).

DIVISION OF MARITAL ASSETS

For wealthy couples, particularly, the distribution of property often is the most important aspect of a divorce or separation agreement. Unless they meet the requirements of Sec. 1041 or Sec. 2516, property transfers included in a divorce decree are subject to income taxes or gift taxes, respectively.

Property acquired by the spouses during their marriage (e.g., family home, retirement plan assets) generally qualifies as marital property. With the exception of qualified retirement plan assets covered under the Employee Retirement Income Security Act (ERISA), state laws ultimately govern the division of marital assets in a divorce, and state laws differ radically on who gets what when the marriage ends. The division of assets differs according to whether the divorce takes place in an equitable distribution (common law) state or in a community property state. Currently, nine states (listed below) are community property states, and the remaining 41 are common law states.

EQUITABLE DISTRIBUTION STATES

In the 41 equitable distribution states, the courts decide what is a fair, reasonable, and equitable division of assets. A court may decide to award a spouse anywhere from none to all of the property value. The courts focus on factors such as how long the marriage lasted, what property each party brought into the marriage, the earning power of each spouse, the responsibilities of each spouse in raising their children, the amount of retraining needed to make a spouse employable, the tax consequences of the asset distribution, and debt allocation. If the couple signed a prenuptial agreement or an agreement during the marriage, they have more control over how the property is divided. Additional aspects of an equitable distribution that should not be overlooked include:

• Every asset acquired during the marriage and not covered by an agreement is subject to division.
• The name on the asset title or the source of the money used to acquire assets is not controlling.
• The parties to the divorce have the burden of identifying and proving the existence of assets.
• One spouse may prove to the satisfaction of the court that the other spouse transferred assets with divorce in mind and have an equal amount of assets awarded to him or her.
• Each spouse is responsible for any debts incurred during the marriage.

Thus, equitable distribution is considered a fair, but not necessarily equal, distribution of marital property.

COMMUNITY PROPERTY STATES

Community property is a form of concurrent ownership between a husband and wife created by statute in nine states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin (Alaska also allows a full or partial community property election). Community property laws, however, also are important for individuals residing in non-community-property states because property acquired in community property states and brought into non-community-property states ordinarily remains community property for state law and tax purposes. In addition, the separate property of each spouse brought into a community property state remains separate property, as long as it is properly segregated and identifiable. However, some states, such as California, may treat the property as community property for purposes of division during a divorce if it would have been community property had it been acquired in the community property state (see Cal. Fam. Code §125). The earnings of the divorcing couple are considered community property and thus are equally divided between the spouses. The same is true for assets bought by one spouse during marriage with funds earned during marriage.

Separate property in community property states may include property owned before marriage and, in some states, property acquired during the marriage with proceeds from the sale of separately owned assets. State law also may permit each spouse to inherit or receive by gift property that will not become community property.

FULL DISCLOSURE REQUIRED TO DIVIDE MARITAL ASSETS

Almost all states require the parties to disclose all material information needed to allow them to negotiate and agree upon a division of marital property. For example, California law states that because married couples are subject to the fiduciary rules imposed on persons in a confidential relationship (Cal. Fam. Code §721), this creates an obligation for a spouse to “make full disclosure to the other spouse of all material facts and information regarding the existence, characterization, and valuation of all assets in which the community has or may have an interest” (Cal. Fam. Code §1100(e)).

To ensure clients comply with the full-disclosure requirement, tax advisers should recommend that the divorcing couple inventory all property, including intangible assets such as advanced degrees, goodwill, and patents, that can result in substantially increased income in future years. Consideration of intangible assets in property settlements is becoming more important as courts express an increased willingness either to classify the intangibles as property subject to distribution or to require spouses to pay for reimbursement.

SEPARATION AGREEMENT AND DIVORCE DECREE

If the parties present their separation agreement to the court and the court issues a decree dissolving the marriage, the court may incorporate the agreement in the divorce decree, usually referred to as a merger. According to Section 306(d)(1) of the Uniform Marriage and Divorce Act (UMDA), merger occurs when the decree sets forth the terms of the separation agreement and orders the parties to perform its terms as an enforceable contract with enforcement as a judgment. Section 306(e) of UMDA provides for enforcement as a judgment, as well as contract remedies, if the separation agreement is in the divorce decree. A court order that specifically modifies an original divorce or separation instrument relates to the ending of the marriage and thus is incident to the divorce (with tax implications described later), even if it is issued many years after the divorce.

TRANSFERS DURING MARITAL DIFFICULTIES

A transfer of property by one spouse during a period of marital strife, whether or not divorce is imminent, might not be considered made unconditionally and is subject to additional scrutiny. All states give each spouse certain legal rights to share in the family’s assets if there is a divorce, but the scope of those rights varies significantly from state to state. In most states, the nondonor spouse may have set aside—as a fraudulent transfer—a gratuitous transfer of property made after the marriage has begun to deteriorate. Any unwritten custody arrangements where one spouse transfers property to a custodian for safekeeping with the understanding of a future repossession is highly suspect when the other spouse has no knowledge of the transfer.

TRANSFERS OF PROPERTY: ASSET DISSIPATION

The judicial doctrine of fraud on marital rights or dissipation of marital assets is an attempt to balance the transferor’s right to freely transfer his or her own property against the need to protect the legal entitlement of the transferor’s spouse to property. In most states, the law invalidates lifetime transfers if they are made with intent to deprive the transferor’s spouse of marital property rights, or if the transfers are made under circumstances where it would be unfair to permit them to stand.

To determine whether a spouse has attempted in a divorce situation to remove assets from the claims of the other spouse, courts look at all the relevant factors including:

• Whether consideration is involved;
• Size of the property transferred versus the transferring spouse’s total wealth;
• Time elapsing between the transfer of property and the divorce;
• Relations between the spouses at the time of transfer;
• The source of the property transferred; and
• Whether the transfer is revocable or illusory (i.e., the transferring spouse retains rights in or powers over the transferred property).

TAX CONSIDERATIONS

It is usually important that any property transfers between the divorcing spouses occur under circumstances that do not produce taxable gain or gift tax liability. Since no estate tax marital deduction is allowed for transfers to a former spouse, the transferor also will not want the transfer to be includible in his or her taxable estate.

Taxable gain. Under the general rule of Sec. 1041(a), a transfer of property to a former spouse incident to divorce will not cause the recognition of gain or loss. A transfer of property is incident to a divorce if the transfer occurs within one year after the date on which the marriage ceases or is “related to the cessation of the marriage,” which requires that the transfer:

• Is pursuant to a divorce or separation instrument, and
• Occurs not more than six years after the date on which the marriage ceases.

A divorce or separation instrument includes a modification or an amendment to the decree or instrument (Temp. Regs. Sec. 1.1041-1T(b), Q&A-7).

Transfer taxes. A transfer of marital property rights under a property settlement agreement that was incorporated into a divorce decree is not subject to gift tax. In Harris, 340 U.S. 106 (1950), the Supreme Court held that in such a case, the transfer would be pursuant to a court decree, not a “promise or agreement” between the spouses as required under gift tax law. However, subsequent decisions have limited the application of this rule to transfers that occur after the entry of a divorce decree.

If a transfer is not made under a property settlement agreement incorporated into a divorce decree, it may still not be subject to gift tax under Sec. 2516. Sec. 2516 provides that transfers of property or interests in property in settlement of marital property rights are treated as made for full and adequate consideration if the transfers are made pursuant to a written agreement and the divorce occurs within a three-year period beginning one year before the spouses enter into the agreement. Note that under Sec. 2516, the property transfer does not have to occur during the three-year period; the transfer may be made any time later, as long as it is “pursuant” to an agreement entered into during the three-year period.

Example. On Jan. 19, 2006, Mr. and Ms. Smith signed a separation and property settlement agreement to address contractual issues arising from the cessation of their marriage. The Smiths divorced in 2007. As part of the agreement, Mr. Smith transferred certain property to Ms. Smith. The agreement also provided:

Each party accepts the provisions herein made for him or her in lieu of and in full and final settlement and satisfaction of any and all claims or rights that either party may now or hereafter have against the other party for support or maintenance or for the distribution of property. However, each party has relied upon the representations of the other party concerning a complete and full disclosure of all marital assets in accepting the property settlement, and it is understood and agreed that this provision shall not constitute a waiver of any marital interest either party may have in any property owned but not fully disclosed by the other party as to existence or fair market value at the time this agreement is executed. Moreover, the failure of either party to disclose property shall constitute a material breach of this agreement, which shall give rise to whatever remedies at law or in equity may be available to the other party.

At some time after the parties signed the agreement, Ms. Smith began asking Mr. Smith whether all assets had been disclosed. She also hired an attorney to pursue claims arising from nondisclosure of assets. In 2011, Mr. Smith realized that he had inadvertently failed to disclose to Ms. Smith stock options ($16 million fair market value) that a court would consider marital assets. According to the terms of the agreement, Ms. Smith had not waived her marital interest in the stock options. Pursuant to a settlement (or an amendment to the original agreement), Mr. Smith paid Ms. Smith $6 million in 2011 in settlement of the claim that she had made regarding her interest in this property.

In considering this issue, Mr. Smith expressed concern that the transfer to Ms. Smith would exhaust his unified transfer tax credit and create a taxable gift transfer. However, because Mr. Smith made the payment pursuant to a written agreement relative to their marital and property rights, and Mr. and Ms. Smith divorced within the three-year period beginning one year prior to the signing of the agreement, under Sec. 2516, Mr. Smith was not subject to gift tax on the transfer and did not have to use his unified transfer tax credit.

Alimony. Sec. 71(b)(1) defines alimony as a transfer of cash made under a divorce or separation instrument to a spouse or former spouse under the following conditions:

• The divorce or separation instrument does not designate the payment as anything other than alimony (not for child support).
• The payments do not continue after the death of the recipient.
• The provisions of the instrument do not preclude a deduction by the payor spouse and the recognition of income by the payee spouse.
• Spouses who are legally separated under a decree of divorce or separate maintenance do not live in the same household when the transfer is made.

Certain payments to third parties on behalf of the spouse—for example, mortgage payments—qualify as payments in cash.

Alimony does not include child support payments (which are generally nondeductible by the payor and not included in the recipient’s gross income), noncash property settlements, payments that are part of the community income of the payee, payments to maintain the payor’s property for use by the payee, or the value of such use. If the parties are married at the end of the tax year and file a joint return, payments made during the year do not qualify as alimony.

Generally, alimony is deductible by the payor and included in the recipient’s gross income. Thus, there is inherent tension between property settlement and alimony. The payor may want a low property settlement and high alimony amounts for the tax deduction. The payee spouse, however, wants the reverse—that is, a property settlement not includible in income rather than taxable alimony.

To make property payments deductible, the payor spouse may try to disguise the payments as alimony. For example, the payor may make large “alimony” payments shortly after the divorce, followed by smaller alimony payments in subsequent years. Sec. 71(f) prohibits excessive front-loading of alimony payments and requires the payor spouse to recharacterize (or “recapture”) part of the alimony payments as nondeductible property transfers if there is excessive front-loading. Tax advisers can help their divorcing clients by reviewing any nonuniform payment schedule to make sure it does not violate the anti-front-loading rules.

ENSURING SAFETY

In planning for the division of assets and the obligations of the parties, safeguards can be put into place to avoid failed expectations. For example, parties may contractually decide that new life insurance is needed to fulfill the payor’s alimony and child support payment obligations in the event of death. The parties may contract to leave the ex-spouse as beneficiary (hanging beneficiary) on life insurance policies and retirement plans to ensure that the ex-spouse receives his or her bargained-for interests. If the beneficiary is designated as “my current spouse” and the owner spouse remarries, the ex-spouse no longer receives his or her interest when death or retirement occurs.

Safeguards also may be needed when a payor spouse has cyclical income business interests or illiquid business interests; the spouses may agree that an alimony trust or maintenance trust (Sec. 682 trust) is the best solution. An alimony trust can protect the payee (ex-spouse) from the death or financial insolvency of the payor before all of the payments have been made.

EMERGING WHOLE

Spouses in divorce situations must disclose all property, and this property must be distributed to the proper party. When fraud, errors, or omissions occur, a CPA needs to be capable of helping his or her client avoid the negative tax consequences of transfers or payments made in connection with the divorce. The client’s objective is to emerge from the divorce economically whole while minimizing taxes.  

Divorce Issues Checklist

Among the many tax practice resources the AICPA makes available to Tax Section members (see Resources box at the end of this article) is an eight-page checklist of tax considerations for CPAs representing clients who are divorcing or recently divorced. Some of its points are:

• Determine which party to represent and prepare a new engagement letter, privacy disclosure notice, power of attorney, and similar documents.
• Consider obtaining conflict-of-interest releases where indicated.
• Review any prenuptial agreement.
• Consider the effect of joint liability for any taxes owed.
• Determine responsibility between spouses for payment of taxes, allocation of estimated tax payments, tax refunds, carryovers, and potential recapture.
• Consider the need for (or, if completed, obtain a copy of) a qualified domestic relations order for any individual retirement accounts and other retirement plans.
• If there are children with investment income, reevaluate “kiddie tax” implications.
• For a property settlement, obtain or prepare a schedule of assets with tax considerations for each asset.
• Consider the effect of divorce on insurance coverage, beneficiary designations, mortgages and other debts, financial and estate planning, etc.

Source: Divorce Issues Checklist, AICPA Tax Section.

EXECUTIVE SUMMARY

CPAs can provide forensic services and/or tax advice concerning identification and division of marital property for a client going through a divorce. Since divorcing spouses are likely to have competing interests, however, CPAs providing these services should take care to avoid conflicts of interest.

In the nine community property states, property is owned concurrently between spouses. In the rest, referred to as common law states, courts must determine an equitable distribution of the spouses’ property between them.

Property transfers by a spouse during a period of marital strife may be subject to heightened judicial scrutiny in an equitable distribution of property. A court may invalidate transfers made to deprive the other spouse of assets by fraud or dissipation.

A transfer incident to divorce from one spouse to the other generally will not result in taxable gain or loss. However, divorcing couples should be made aware of requirements in the Code and regulations for a transfer to be considered incident to divorce. Similarly, alimony typically entails tax planning.

Ray A. Knight (knightra@wfu.edu) is a visiting professor of accountancy, and Lee G. Knight (knightlg@wfu.edu) is the Hylton Professor of Accountancy, both at Wake Forest University in Winston-Salem, N.C.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

AICPA RESOURCES

Publications

• Divorce Issues Checklist, available to AICPA Tax Section members with many other tax practice guides and other resources at tinyurl.com/b7k4g98 after logging in. To join the Tax Section, see below.
• Divorce: The Accountant as Financial Expert (#091055)
• Forensic Accounting for Divorce Engagements: A Practical Guide, Third Edition (#091029)

CPE self-study

• Family Law (#154110)
• Forensic Accounting: Fraudulent Reporting and Concealed Assets (#731958)

For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.

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