Finance 101 For Family Law Practitioners
FINANCE 101 FOR FAMILY LAW PRACTITIONERS
Despite the misconception of many lawyers, family law practitioners need to be familiar with many different areas of law – such as contract, real estate, tax, bankruptcy, even basic oil and gas laws – as well as understanding the intricacies of the Texas Family Code. This paper will examine the financial side of the family law practice.
I. Valuation and Division of Assets in a Divorce
When I discuss division of marital property with a client, I advise them it is a 3-4 step process; we need to identify the assets and liabilities, characterize them, evaluate them and then divide them. All property of either spouse acquired during the marriage is community property, unless it was acquired by gift or inheritance or personal injury. Although characterization of property can be a challenging exercise by itself, the focus of this paper is the evaluation of assets.
TFC §6.711(a)(2) A proper valuation of the spouses’ community assets and liabilities is necessary for the court to properly exercise its discretion in making a just and right division of the community estate. Finn v. Finn, 658 S.W.2d 735, 746-47 (Tex.App.-Dallas 1983, writ ref’d n.r.e.). In other words, a proper valuation can not made unless a proper valuation is made. The value of a spouse’s separate property is also necessary if the spouse’s separate estate is significant enough that it could affect the court’s just and right division. Murff v. Murff, 615 S.W.2d 696, 699 (Tex. 1981).
Marital property is listed on inventories at Fair Market Value. Ricks v. Ricks, 169 S.W.3d 523, 527 (Tex.App.-Dallas 2005, no pet.); Yzaguirre v. KCS Res., 53 S.W.3d68, 374 (Tex. 2001). The term “Fair Market Value” refers to the price the property will bring when it is offered for sale by one who desires but does not need to sell, and is bought by one who desires but does not need to buy. R.V.K. v. L.L.K., 103 S.W.3d 612, 618. The determination of fair market value is easy for accounts at financial institutions – as we select a value of the account on a certain date. In the event that fair market value is not obvious, property can be valued using its “Intrinsic Value.” R.V.K., 103 S.W.2d at 618. Intrinsic value refers to the monetary value of the property’s use to the owner which can be a very subjective measure. The parties may rely on the other evidence to ascertain the “intrinsic value”, e.g. the property’s original purchase price, replacement cost, its uses, etc. In Taylor County v. Olds, the Court stated that “… the best evidence of value is the market price or market value. The next best evidence is evidence of real or intrinsic value. The third best evidence is evidence of cost of replacement, and the fourth best evidence is evidence of value to the person whose property has been destroyed or injured. 67 S.W.2d 1102, 1105 (Tex. Ct. App. – Eastland 1934, writ dism’d).
A. Valuing Real Property
The value of real property – whether residential, commercial, unimproved or mineral interest – is measured by its fair market value as of the date of dissolution. R.V.K. v. L.L.K., 103 S.W.3d 612, 618 (Tex.App. – San Antonio 2003, no pet.). Frequently, parties will turn to an expert, a real estate appraiser for the determination of fair market value. Here in Harris County, many lawyers will rely upon HCAD as it purports to list property at 100% appraised value. For a residential home, this is relatively straightforward. For unimproved property or property in rural areas, determining fair market value is more complicated. In the event that the real property has no ascertainable fair market value, the fact finder will look to evidence of the property’s intrinsic value. See Taylor Cty. V. Olds, 67 S.W.2d 1102, 1104 (Tex.App. – Eastland 1934, writ disim’d.).
Real Estate Appraiser
Three appraisal methods apply various methods to evaluating real property interests:
1. The comparable sales (market) approach is the preferred method for establishing the fair market value of real property. Estate of Sharboneau, 48 S.W.2d at 182; Duer Wagner & Co. v. City Sweetwater, 112 S.W.3d 628 (Tex.App. – Eastland 2003, no pet.). This approach is frequently used in calculating the fair market value of unimproved land, residential property, and commercial property. The comparable sales approach calculates fair market value by looking at data from sales of similar properties in a relevant market, then adjusting those sales price sup or down base on the differences in the property. Estate of Sharboneau, 48 S.W.2d at 182. If there are not enough comparable-sales figures, or if this method is otherwise inadequate to measure the property’s fair market value, the court can use the income approach or cost approach to determine fair market value.
2. The income approach is the appropriate method for establishing the fair market value of real property that produces income. This approach is frequently used in calculating the fair market value of mineral interest and property that generates rental income. Destec Props., L.P. v. Freestone Cent. Appr. Dist., 6 S.W.3d 601 (Tex.App. -Waco 1999, pet. Den.).
3. The cost approach is the appropriate method for establishing the fair market value of real property that has no comparable-sales data and does not produce income. The cost approach values property in determining what it would cost to reproduce or replace the property, minus the actual depreciation in its value.
Any expert real estate appraiser will indicate in his or her report which approach he or she is using.
B. Valuing Personal Property
Evaluating personal property is a more difficult endeavor. Evaluation of certain property such as automobiles, boats and publicly traded securities is easier – reliance upon web based sites is reliable as an “established market”. If the item does not have an ascertainable fair market value, then the personal property can be valued according to its intrinsic value. Beavers v. Beavers, 675 S.W.2d 296, 299 (Tex.App. – Dallas 1984). Intrinsic value is most commonly used to value household goods, clothing and personal effects. Wendlandt v. Wendlandt, 596 S.W.2d 323 (Tex.App – Houston [1st Dist.] 1980, no writ). However, intrinsic value does not include value for sentimentality. Evaluation of certain items such as collectibles or jewelry often requires extensive research by an expert and is highly subjective.
C. Valuing Business Interests
The evaluation of closely held business present unique circumstances for the family law practitioner. Similar to any other type of property, closely held business present issues of characterization and value. In addition, closely held business also present unique issues such as valuation discounts, divisibility of good will, restrictions on transfer, etc. It is always preferably to employ an expert, when you have identified business interests that are part of the marital estate. The business valuation expert will play a critical role in the evaluation and presentation of your case.
1. Characterization of the Business Interest and Property
A spouse’s ownership in a business entity will be characterized as either separate or community property. The inception of title to an ownership interest (shares of stock) in a corporation occurs on the date of incorporation. For partnerships, the inception to title to an ownership interest (the right to receive a share of the profits and surpluses from the partnership) occurs on the date the partnership was created or the completion date of a condition precedent to the partnership’s formation. Harris v. Harris, 765 S.W.2d 798, 802 (Tex.App.-Houston [14th Dist.] 1989, writ de.) Generally, a business formed during the marriage will be community property. However, a business that is capitalized entirely with separate property will be characterized as separate property, and a business capitalized with mixed funds will be characterized in proportion to the amount each estate contributed to the capitalization. See Allen v. Allen, 704 S.W.2d 600 (Tex.App.-Fort Worth 1986, no writ); Hunt v. Hunt, 952 S.W.2d 564 (Tex.App.-Eastland 1977, no writ).
The property of the corporation or partnership is owned by the business entity, and not the individual shareholders or partners, and thus is not characterized as a separate or community property. TBOC §152.101 However, the property of a sole proprietorship includes everything that makes up the business, such as furniture, fixtures, machinery, cash, etc., and will be characterized as either separate or community property. Zeptner v. Zeptner, 111 S.W.3d 727 (Tex.App. – Fort Worth 2003, no pet.).
2. Valuation Methods
The goal of the business valuation is to evaluate the business and assign a value to the community property interest in the business. Just like with any other type of property, using a fair market approach to value the business is the preferred valuation method in Texas. However, if a party can present persuasive evidence that there is no comparable market for the business interest, the party can introduce evidence of the actual value (or intrinsic value) to the owner.
As with other types of appraisals, the business appraiser will use various appraisal methods to establish the value of the business. All methods are based on some form of expected economic income and/or asset values, and all depend to some extent on market data. (Pratt, p. 81) There are generally three types of methods used by business appraisers:
a. Asset Based Approach. The value of the business is determined by the value of the assets of the business minus liabilities. This approach is useful for business that are relatively easy to start up, or where the business derives income mainly from the assets themselves, rather than the personal efforts of the owners and employees. Finally, of the assets themselves are likely to be sold off by the buyer, rather than being retained for operations, the potential sale value of the assets is important to the valuation.
b. Income Approach. The value of the business is determined on the basis of some form of economic stream. The prospective purchaser will be looking at how much income and/or cash flow will be delivered to the purchaser in exchange for buying the company. This approach is most useful where the business will be transferred as a going concern. However, it is important to be cautious against “double dipping.” If the value takes into account the future efforts of the spouse, and then payments for support are ordered out of the earnings from the spouse’s efforts, the spouse’s future income has been counted twice. (Pratt, p. 348)
c. Market Approach. The value of the business is determined by comparing the subject to similar businesses, business ownership interests or securities that have been sold.
Generally, business appraisers will use two or more appraisal methods to maximize the reliability for the final result (Pratt, p. 81) Each of the appraisal methods outlined above has procedures unique to that method.
3. Exclusions & Discounts
Often, the most financially significant aspect of the business valuation is not the basic value of the entity, but the discounts that should or should not be applied at either the entity or the shareholder level. Specifically, the practitioner needs to be aware of the following issues that will result in an overall net reduction in the value of the business:
a. Whether the value of the business is dependent upon the future efforts of the professional individual?
The value of the business that is attributable to “personal goodwill” is not part of the community estate, and should be excluded from the value of the community property interest in the business. See Nail v. Nail, 486 S.W.2d 761 (Tex. 1972) The distinction between “personal goodwill” and “commercial goodwill” is important. In Geesbreght v. Geesbreght, 570 S.W.2d 427 (Tex.Civ.App. – Fort Worth 1978, writ dism’d.), the Court recognized that the business can have goodwill, that is distinct from “personal goodwill.” When goodwill is not attached to the person of the professional man or woman, it is property that may be divided as community property. In Salinas v. Rafati, 948 S.W.2d 286 (Tex. 1997), the Supreme Court overturned a jury verdict for $1,428,000. Finding that the award in a medical partnership dissolution proceeding consisted entirely of personal goodwill of the two remaining partners, and that personal goodwill was not an asset of the partnership to be divided. To determine whether the goodwill is “professional” or “commercial”, the court should consider whether the goodwill attaches to the person of the professional man or woman as a result of confidence in his or her sill and ability; whether it possess a value or constitutes an asset separate and apart from the professional’s personal, or from his ability to practice his profession; and whether it would be extinguished in the event of the professional’s death, retirement or disablement. Rathmell v. Morrison, 732 S.W..2d 6 (Tex.App. – Houston [14th Dist.] 1987, no writ).
b. Whether there is a buy-sell agreement between the owners and/or the company?
A buy-sell agreement is a contract between an owner and the company, or between two or more owners, describing the conditions under which one party may (or must) sell his or her interest to the other. (Pratt, p. 338) A buy-sell agreement may effectively limit the value of the community property interest in the business by restricting the marketability of the interest. The buy-sell agreement may also operate to reduce the value of the interest by excluding commercial goodwill from the community property estate. In Finn v. Finn, 658 S.W.2d 735 (Tex.App. – Dallas, 1983, writ ref’d n.r.e.), the Court found that the law firm had significant commercial goodwill. However, the Court found that the partnership agreement did not provide any compensation for a partner who ceased practicing with the firm, and provided no mechanism to realize the value of the firm’s goodwill. Therefore, the value of the commercial goodwill was not divisible in a divorce. In a later case, the Court held that a buy-sell agreement restricting the partner’s interest with respect to death or withdrawal of the partner was not necessary be determinative of a spouse’s interest in the ongoing partnership as of the time of trial in a divorce. Keith v. Keith, 763 S.W.2d 950 (Tex.App. – Fort Worth 1989, no writ).
c. Whether there is a covenant not to compete, restricting an owner from entering into a competing business?
A covenant not to compete is a contract preventing an individual (or group of individuals) from competing with a given entity or person. The covenant usually enhances the value of the entity by reducing the risk of certain individuals taking away business. To determine the value of the personal goodwill, consider the value of the business with a covenant not to compete and the value without one. See Geaccone v. Geaccone, 2005 W.L. 1774964 (Tex.App. – Houston [1st Dist.] 2005, no pet.)
d. Whether the ownership interest is a minority interest?
The minority shareholder discount is designed to reflect the decreased value of shares that do not convey control of a closely held corporation. (Pratt, p. 313, citing Estate of Andrews v. Commissioner, 79 T.C. 938 (1982). A minority interest usually is worth significantly less than a pro rata share of the value of the entity as a whole. A control owner can make many decisions that a minority owner can’t. Therefore, if the valuation methodology produces a controlling interest value, and the interest being valued is minority, a minority interest discount usually would be applied. Also, since minority interests usually are harder to sell than controlling interests, the minority interest discount might be compounded by subtracting a discount for lack of marketability. (Pratt, p. 344)
e. Whether the ownership interest is in a closely held business entity?
The lack of marketability discount is designed to reflect the fact that there is no ready market for shares in a closely held corporation. (Pratt, p. 313, citing Estate of Andrews v. Commissioner, 79 T.C. 938 (1982). The amount of the discount has reached 40%. (Pratt, p. 312) This discount can apply, even when valuing a controlling interest. (Pratt, p. 314)
f. Whether the business depends on a key person?
Dependence on a key person introduces a risk of the consequences of the loss of that person’s services in a case of death, disability or resignation. This risk is sometimes recognized through a separate discount for the key person factor. Pratt, p. 315 (Estate of Furman v. Commissioner, T.C. Memo. 1988). (Tax Court allowed a key person discount of 10%).
D. Stock Options & Restricted Stock Units
A “Stock Option” is a right to buy a designated stock within a designated period at a determinable price, if the holder of the option so chooses. Stock options can be granted to employees as a benefit or as compensation for part or present services, and/or as an incentive for future services. Stock options exist in various forms, such as: Incentive Stock Option Plan, Nonqualified Stock Option Plan, Restricted Stock Plan, and Employee Stock Purchase Plan.
Generally, stock options have various restrictions places on them, such that they are not readily transferable. They may be vested or unvested. The ability to exercise the options may be dependent on various contingent factors, such as continued employment, date certain, and the stock reaching a certain price.
While stock options may be complicated to value and to characterize, they are nevertheless a contingent property interest and a community asset subject to division upon divorce. Hendershot v. Hendershot, WL 4445648 (Tex.App. – Fort Worth 2008); Kline v. Kline, 17 S.W.3d 445, 446 (Tex.App. – Houston [1st Dist.] 200, pet. denied); Charriere v. Charriere, 7 S.W.3d 217, 219 (Tex.App. – Dallas 1999, no pet.); Bodin v. Bodin, 955 S.W.2d 380, 381 (Tex.App. – San Antonio 1997, no pet.); Demler v. Demler, 836 S.W.2d 696, 699 (Tex.App. – Dallas 1992, no writ). In a divorce decree, the court shall determine the rights of both spouses to stock options and other employer plans in the nature of compensation or savings. TFC §7.003
1. Characterization Issues
Section 3.007 of the Texas Family Code was amended in 2009. Subsections (d) and (e) address the characterization of stock options and restricted stock. With these sections, the Texas legislature overturned the inception of title rule for such benefits and adopted the rule of proportionality based on the service performed by each marital estate. See Charriere v. Charriere, 7 S.W.3d 217, 219 (Tex.App. – Dallas 1999, no pet.). The rule of proportionality will apply to each component of the benefit requiring varying periods of employment. (Sampson & Tindall’s Family Code Annotated, Comment to §3.007).
Option/Stock granted before marriage:
The # of days from The # of days
Grant Date until following date of
Date of Marriage + Dissolution until
Exercise Date x (option/stock) = Separate Property
The # of days from Grant Date until
Option/Stock granted during marriage:
The # of days from Date of Dissolution
until Exercise Date x (option/stock) = Separate Property
The # of days from Grant Date
until Exercise Date
2. Valuation Issues
While the statute, as revised, sets forth a proper method for determining the character of the stock option/restricted stock, there is nothing in the code or case law with regard to the proper method of stock option valuation. Boyd v. Boyd, 67 S.W.3d398 (Tex.App. – Ft. Worth 2002). Employee stock options are generally governed by an agreement with the employer. These agreements typically provide various restrictions, including time restrictions (vesting period during which the options cannot be exercised), contingencies on the exercise of the stock (usually future job performance and stock performance), and restrictions on transferability. See Charriere v. Charriere, 7 S.W.3d 217 (Tex.App. – Dallas 1999, no pet.)
There are three basic methods used to value options:
(1) annual-percent growth method. The annual-percent-growth method that values stock options by taking the annual growth rate of a company’s stock and using this value to estimate the future value of the options. For example, assume a stock is trading at $100. If an annual percent growth of 12% were applied to the stock, in two years it would be worth $125.44.
(2) Intrinsic-value method. The intrinsic-value method simply calculates the amount that would be gained if the option were exercised immediately. If options are issued to the employee at the stock’s market price, there is no immediate intrinsic value.
(3) Black-Scholes method. The Black-Scholes method estimates the present value of an option based on several assumptions, including (1) the future volatility of the stock, (2) the risk-free rate of return of a U.S. Treasury security, (3) the future dividend yield, and (4) the expected length of time until the option is exercisable. Market and accounting professionals generally use the Black-Scholes method when valuing options to purchase a publicly traded stock. But the Black-Scholes method does not apply to options to purchase stock from a closely held corporation and ignores many of the restrictions on selling employee stock options, such as continued employment, vesting, and requirements for exercise.
E. Mineral Rights
Mineral rights are real property, and the characterization of such interests are governed by general marital property rules. In re Marriage of Read, 634 S.W.2d 343 (Tex.App. – Amarillo 1982, writ dism’d.).
1. Delay rentals are revenue from the mineral rights, and are deemed to be community property. McGarraugh v. McGarraugh, 177 S.W.2d 296 (Tex.App. – Amarillo 1943, writ dism’d.).
2. Royalty income is separate property. The court in Norris v. Vaugham, 152 Tex. 491 (1953) held that a royalty payment is compensation for the extraction or waste of the separate estate, as opposed to income from the separate estate. See also Welder v. Welder, 794 S.W.2d 420 (Tex.App. – Corpus Christi 1990, no writ).
3. Lease bonuses are not considered income, and are separate property. Lessing v. Russek, 234 S.W.2d 891 (Tex.App. – Austin 1950, writ ref’d n.r.e.).
II. Tax Ramifications of Divorce
Taxes -they are unavoidable. Understanding how they impact your client’s future is essential to being an effective advisor and advocate for your divorcing client. The purpose of this section is to provide a broad overview of the day-to-day tax issues that arise, as well as to alert you to more sophisticated tax planning matters that will require the advice of a tax professional.
A. Filing Status
Filing status is used in determining whether a tax return must be filed, the deductions and/or credits that can be claimed, and ultimately, the amount of tax to be paid. The filing status available to the taxpayer is determined partly according to the taxpayer’s marital status on the last day of the year. For federal tax purposes, a marriage means only a legal union between a man and a woman as husband and wife. A taxpayer who is still married as of the last day of the year will elect from among the following filing statuses: Married filing a Joint Return, Married filing a Separate Return or Head of Household. If the taxpayer is divorced by the last day of the year (i.e., the Court has rendered the divorce by December 31), then the taxpayer may file Single. A court can not require a party to file with a specific status. However, the court can enforce an agreement between the parties to file with a specific status. The court can also consider the impact that the filing status has on the marital estate in making a division of property. If the parties initially filed a joint return, they can amend the return and file separately. However, if a party initially filed a separate return, they can not amend the return and file jointly at a later date. In the absence of the agreement, the taxpayer will elect his or her filing status.
1. Married Filing Jointly
Filing a joint return typically results in a lower combined tax. The parties will include all their income, exemptions, deductions and credits on the return. In order for the return to be considered a joint return, both spouses must sign the return. By signing the return, both spouses become jointly and individually liable for the taxes that are due – even if the income was earned only by one spouse.
If a taxpayer has filed jointly, they may be able to apply to the IRS for relief from joint liability. Relief available includes: Innocent Spouse Relief, Separation of Liability Relief, and Equitable Relief. “Innocent Spouse Relief” is available if the taxpayer filed a joint return which included an understatement of tax directly related to the spouse’s erroneous items, the taxpayer establishes that he/she did not know and had no reason to know about the understatement, and it would be unfair to hold the taxpayer liable for the understatement of tax. To qualify for “Separation of Liability Relief”, the taxpayer must have filed a joint return and must meet one of the following requirements at the time of the requested relief: the taxpayer is divorced and legally separated from the spouse; the taxpayer is widowed; or the taxpayer has not been a member of the same household as the spouse during the 12 month period ending on the date relief is requested. Separation of Liability Relief provides for the allocation of the additional tax owed between the taxpayer and the spouse (or former spouse). “Equitable Relief” is available if the taxpayer does not qualify for the other two reliefs available, and who can show that it would be unfair to hold the taxpayer liable for the understatement or underpayment of tax.
2. Married Filing Separately
Married persons may elect to file separate returns. In that case, each spouse will report his or her share of the community income, exemptions, deductions and credits on their individual return. If one spouse itemizes deductions, the other spouse must also itemize their deductions (and not use the standard deduction). Each spouse is generally liable only for the taxes due on their own return. Filing separately typically results in a higher amount of tax owed because certain deductions and exemptions are not available.
3. Head of Household
Filing as head of household gives the taxpayer many more benefits than filing separately. It allows the taxpayer to include certain credits, exemptions and deductions that are generally not available to an individual filing separately. Also, it usually provides for a lower tax rate than married filing separately. However, in order to qualify for this filing status, the party must meet the following requirements: (1) be unmarried or “considered unmarried” on the last day of the year; (2) paid more than half the cost of keeping up a home for the year; and (3) had a “qualifying person” (i.e., child) live with the taxpayer for more than one-half the year.
For purposes of filing as Head of Household, a person is “considered Unmarried” if their spouse did not live in the home during the last six months of the tax year; the home was the main home of the qualifying dependent for more than one-half the year; and the taxpayer can claim an exemption for the child. In addition, the taxpayer must file a separate return.
B. Dependency Exemptions
Dependency Exemptions can be valuable for taxpayer. The general rule is that the parent with whom the child resides for the greater number of nights during the year is the “custodial parent” and entitled to take the exemption. If the decree is silent as to the dependency exemption, then the general rule under the Internal Revenue Code applies.
The divorcing spouses can, however, enter into agreements between them in the Decree regarding the dependency exemptions. The exemptions therefore frequently become a tool for negotiating. It is not unusual to allocate the tax exemptions between the parties.
The only enforceable way for a party to ensure that they will be entitled to take advantage of the dependency exemption is for the divorce decree to ORDER the other party to execute Form 8332, waiving their right to take the dependency exemption. Parties may agree to alternate years, or to divide children. It is important to note however that the parties can not agree to split the exemption – they can agree only to allocate who gets to take which dependents and in what years.
C. Child Support, Alimony and Property Settlement Payments
Periodic payments can take many forms in a final decree of divorce. It is important to understand the tax consequences of these different periodic payments, as well as to the mindful of their ultimate enforceability.
1. Child Support
Child support is payable pursuant to statute – event thought the amount of child support may be reached by agreement of the parties, it can not be enforced as a contract. In Texas, the provisions for calculating the amount and method of child support can be found in the Texas Family Code Chapter 154. Child support is generally payable until the child graduates from high school or turns eighteen, whichever occurs later. A child support obligation does not terminate on the death of the obligee, but continues as an obligation to the child. If the obligor dies before the child support obligation terminates, the remaining unpaid balance of the child support becomes payable on the date the obligor dies and is a claim against the obligor’s estate. A child support obligation may be modified as a result of a material and substantial change in the circumstances of the parties or the child; the obligation is enforceable as a judgment and by contempt; and the obligation survives bankruptcy. Child support is a non-taxable event – the obligor does not deduct the amount of child support paid, and the obligee does not report the child support received as income.
2. Alimony or Spousal Maintenance
Since 1967, the courts have sanctioned the use of contractual alimony; however, it wasn’t until 1995, that the Texas Legislature enacted “spousal maintenance” in very limited circumstances. In 2011, the Texas Legislature broadened the applicability and duration of maintenance significantly. The new and improved provisions for maintenance can be found in Chapter 8 of the Texas Family Code. It is important to note that not all “spousal maintenance” award will qualify as alimony. In fact, as used herein, “alimony” has a very specific definition, which when satisfied, will allow the parties certain tax attributes regarding the payments made.
From a tax perspective, alimony can be a very advantageous means of providing support post-divorce. Under the Internal Revenue Code, a party can effectively reduce their tax bracket by making alimony payments to their ex-spouse. However, there are specific requirements that must be satisfied in order for the paying party to benefic from the deductions of alimony.
A payment to or for a spouse under a divorce or separation instrument is alimony under the following conditions:
1) the spouses do not file a joint return with each other;
2) the payment is in cash (not property);
3) the instrument does not designate that the payment is “not alimony”;
4) the spouses are not members of the same household at the time the payments are made;
5) there is no liability to make any payment (in cash or property) after the death of the recipient spouse; and
6) the payment is not treated as child support (i.e., payment will be child support if it is tied to a happening of a contingency related to a child – employment, marriage, leaving house, leaving school, reaching certain age)
Furthermore, if alimony payments decrease or terminate during the first three calendar years, the parties may be subject to the recapture rule. The recapture rule requires the payor to include in income in the third year part of the alimony payments that were previously deducted; and the payee deducts in the third year part of the alimony payments that he or she previously included in income.
Alimony can also be enforced by contempt. If it is an agreed order, the court can not enforce the obligation for any period beyond what the court could have ordered under Texas Family Code Chapter 8. Alimony may be withheld, subject to an income withholding order. Furthermore, the obligation to pay alimony to an ex-spouse survives bankruptcy if it qualifies as a domestic support obligation.
3. Property Payment Arrangements
Generally, there is no taxable event or recognition of gain or loss on the transfer of property between spouses, or between former spouses if the transfer is because of a divorce. The property transfer is treated as “gift” for determining the tax basis in the property. There may be occasions when one party wants to “buy out” the other party’s interest in property, and the parties reach an agreement on the terms of the buy out. For example, if Husband is taking a business that is worth $100,000, he and wife may agree that he will pay her $50,000 over a period of three years in monthly payments. The benefit the spouse receiving the payments is that this is generally a non-taxable event (always consult with a tax expert for exact ramification). There is a great deal of risk associated with such a transaction, however, because it is a debt that will not survive bankruptcy, and is generally not enforceable by contempt. Such an agreement should be negotiated with the assistance of a tax professional, and ideally will be secured by an asset in the event there is a default to minimize risk.
C. Tax Provisions in the Decree
There are many options for allocating tax liability between the spouses in a final decree of divorce. Determining which provisions to include will generally be based upon whether both parties were income earners, whether there was a great disparity in the income of the parties, and what the general goals are for the parties. It is highly recommended that the decree contain provisions addressing the following issues:
1. Tax Allocation Provisions for Years Prior to Divorce
2. Tax Allocation Provisions for Year of Divorce
4. Exchange of Information
5. Third Party Preparation
6. Tax Refund
7. Reserving Records
8. Payment of Taxes Not Income
III. Qualified Domestic Relations Order
A Qualified Domestic Relations Order, also referred to as a QDRO (pronounced Quadro), is a legal order required to divide the ownership interests in a qualified retirement plan as part of the division of marital assets in a divorce. The QDRO creates or recognizes the existence of an alternate payee’s right to receive, or assigns to an alternate payee the right to receive, all or a portion of the benefits payable with respect to a participant under a retirement plan.
A. Retirement Plans requiring a QDRO
QDROs apply only to employee benefit or pension plans subject to the Employee Retirement Income Security Act of 1974 (ERISA), the Federal law governing private sector pension plans, Not every retirement plan requires a QDRO. Examples of plans not requiring a QDRO include the following: State and Municipal retirement plans (e.g., teacher, fireman or police), Federal Retirement Plans (CSRS, FERS &TSP), IRAs (Traditional, Roth, SEP, SIMPLE and Keogh) and most Deferred Compensations Plans. While many of these plans do not require a QDRO, they will have other requirements for transferring ownership. The most common plans requiring a QDRO are a 401k or private pension plan.
Just as retirement plans may be “qualified” (under ERISA) or non-qualified, they may also be defined benefit plans or defined contribution plans. A defined benefit (or pension) plan calculates benefits using a fixed formula that typically factors in final pay and service with an employer, and the payments are made from a trust fund specifically dedicated to the plan. In a defined contribution plan (e.g., 401k), the payout is dependent upon both the amount of money contributed into an individual account and the performance of the investment vehicles used. Some type of retirement plans, such as cash balance plans, combine features of both defined benefit and defined contribution plans.
Qualified plans receive favorable tax treatment. Therefore, qualified plans have special requirements when the interests are transferred to an “alternate payee” in order to maintain the favorable tax treatment. Not following the rules for transferring the interests can result in serious tax consequences, including penalties. It is recommended that even “form” QDRO’s from employees be reviewed by an expert to determine if it accomplishes the anticipate goal.
B. A Divorce Decree is not sufficient to Divide Retirement Plan Interests
For many types of property, the divorce decree can serve as muniment of title – it is evidence of the ownership of the asset by virtue of its inclusion in the decree. Certain property is awarded to Husband; Certain property is awarded to Wife. By virtue of the statements contained in the decree, the property is effectively divided. This is not true for qualified retirement plans. In fact, in order to divide the property, the order must meet specific requirements as set forth in ERISA and the Internal Revenue Code.
While there is nothing ERISA or the Internal Revenue Code that requires that a QDRO be issued in a separate order, practically speaking, the requirements of the QDRO are such that it makes sense to draft the QDRO as a separate order. The QDRO can be sent to the plan administrator for approval before or after it is signed by the judge (best to do before hand). The assets are then divided.
If, however, the QDRO is not signed, and is not approved, the assets are not transferred. The only documents that can divide up the pension plan is the QDRO. If the plan participant dies, and the QDRO has not been entered, the ex-spouse takes nothing – even though the decree awarded her fifty percent of the husband’s pension plan. The pension plan becomes part of his estate, and she is deprived of her interests in the plan.
The moral of the story is: don’t put off getting the QDRO completed. Once the division of qualified retirement plan is agreed upon, retain the assistance of a QDRO expert to get the QDRO prepared so it can be entered simultaneously with the decree, or shortly thereafter.
C. A QDRO is not a Neutral Order
A QDRO is an advocating document – it is drafted to benefit one side, at the expense of the other. While every QDRO must contain certain provisions, such as the names and addresses of the participant and alternate payee and the name of the plan, the specific content of the rest of the QDRO will depend upon the type of retirement plan, the nature of the participant’s retirement benefits, the purposes behind issuing the order, and the intent of the drafting parties.
1. Dividing the Defined Contribution Plan (401k)
When dividing a defined contribution plan, the issue will be identifying the assets to be divided, the dates for determining the interests in the plan and the value of the plan, and how the assets will be divided. Specifically, the alternate payee generally can choose whether they will transfer the amount to a rollover IRA, create a separate account with the plan, or take a lump sum distribution. One unique benefit for the alternate payee of a defined contribution plan is that the alternate payee can get cash from his/her share of the plan without incurring the 10 percent early distribution penalty. In order to take the penalty-free distribution, the request must be submitted with the QDRO for approval. In other words, the alternate payee can not have the assets transferred to a rollover IRA, and then withdraw from the IRA.
2. Dividing the Defined Benefit Plan (Traditional Pensions)
There are many options to consider when dividing a traditional pension plan, which will be determined by the plan itself as well as Federal law.
a. Survivor Benefits. For example, Federal law requires all pension plans to provide benefits in a way that includes a survivor benefit for the participant’s spouse. If a participant and his or spouse become divorced before the payments begin, the divorced spouse loses all right to the survivor benefits unless otherwise specified in the QDRO. For example, a QDRO can require that the plan treat a former spouse of a participant as the participant’s surviving spouse. In that case, the former spouse will be entitled to the Qualified Joint and Survivor Annuity (QJSA), or the Qualified Pre-retirement Survivor Annuity (QPSA), as applicable, upon the death of the participant.
b. Separate Interest Approach. A QDRO that creates a “separate interest” divides the participant’s benefits into two separate parts” one of the participant and one for the alternate payee. Under a separate interest approach, the alternate payee can determine the form in which his or her benefits are paid and when benefit payments commence. Some of the issues to be determined in a QDRO include the following: Subsides, Future Increases in Participant’s Benefits.
c. Shared Payment Approach. Under this approach, the alternate payee receives payments only when the participant receives payments. In splitting the benefit payments, the QDRO may award the alternate payee either a percentage or a dollar amount of each of the participant’s benefit payments. If the QDRO awards a percentage, then the alternate payee generally will automatically receive a share of any future subsidy or other increase in the participant’s benefits.
d. Form of Alternate Payee’s Benefits Payments. Under the Separate Interest Approach, the QDRO may specify a particular form in which payments are to be made to alternate payee, or may provide the options available to the alternate payee. This may include a lump sum payment, or periodic monthly payment, among other choices.
e. Commencement of Benefit Payments to Alternate Payee. Under the Separate Interest Approach, the alternate payee may begin receiving benefits at a different time than the participant. Federal law provides that benefit payments to the alternate payee may begin as soon as the participant attains his or her earliest retirement age.
Each of these selections made in a QDRO may significantly impact the value of the benefit to be paid to the alternate payee, and to be paid to the participant.
3. Final Notes
When a retirement plan is part of the marital estate, the attorney representing either the participant of the alternate payee needs to understand the characteristics of the type of retirement plan they are dealing with. The first thing to do is to request a copy of the plan document, as well as any accounting records (e.g. statements, etc.). If the plan has a sample document, that is a great place to begin. If the plan is a qualified plan, or will require a document similar to a QDRO to divide, it is always a good idea to retain a QDRO expert at the beginning. The QDRO expert will be able to advise the attorney through the negotiation process, as to the specific elections that need to be made to maximize the benefits for the client.
However, in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was passed. Under BAPCPA, debtors can no longer discharge debts that are considered “domestic support obligations.” Moreover, a creditor can look to the debtor’s exempt property to satisfy the domestic support obligations.
Navigating financial issues in a family law case can cause a lot of anxiety for the family law practitioner. Hopefully, this article has provided a starting place for the analysis of many of the financial issues that frequently arise in such cases. Having professionals, such as CPA’s, QDRO Attorneys, Business Attorneys, Business Valuation Experts, and Real Estate or other Appraisers is critical for the family law practitioner. In the end, using experts in their field produces value and better results for the clients.
Information is derived from IRS Publication 504 (2010), Divorced or Separated Individuals
IRS Publication 504 (2010)
See Leftwich v. Leftwich, 442 A.2d 139 (D.C. Ct. App. 1980), “to sanction the trial court’s effectively ordering a spouse to cooperate in the filing of a joint return would nullify the right of election conferred upon married taxpayers by the Internal Revenue Code… Married individuals filing a joint return expose themselves to joint and several liability for any fraudulent or erroneous aspect of the return.”
See Johansen v. Johansen, 365 N.W. 859 (S.D. 1985)
See Wadlow v. Wadlow, 491 A.2d 757 (N.J. App.Div. 1985)
See IRS Publication 971, “Innocent Spouse Relief”
IRS Publication 555 (2010)
Internal Revenue Code§152(e)
Texas Family Code §154.124©
Texas Family Code §154.002. Note however, that the obligation to support a child may terminate earlier under the provisions of §154.006, or may be extended for an indefinite period if the child is disable under §154.001(s)(4)
Francis v. Francis, 412 S.W.2d 29 (Tex. 1967)
82nd Leg., ch. 486 (H.B. 901) §, eff. Sept. 1, 2011
Internal Revenue Code §71(a)
See TFC §8.101 et seq.
IRS Publication 504; IRC §1041
TFC §9.012; TEX. CONST. art. I, §18
“What you should know about QDROs” by The Institute for Certified Divorce Financial Analysis, published in divorcemag.com
See www.dol.gov, “FAQ’s About Qualified Domestic Relations Orders”
ERISA §205; IRC §401(a)(11) & 417
QJSA – when benefits are paid as a QJSA, the participant receives a periodic payment for the rest of the surviving spouse’s life upon the participant’s death.
QPSA – if a married participant with a non-forfeitable benefit under one of these types of plans dies before his or her annuity starting date, the plan must pay the surviving spouse of the participant a monthly survivor benefits.