8 tax areas to factor into divorce negotiations

September 3, 2020 9:05 AM

Let’s face it: We marry for love, but when it comes to a divorce, the focus is solely on money. This article addresses eight “under the radar” tactics that your client’s spouse may try to use to affect their net worth, which will directly affect your client’s final financial settlement. Clients heading into a divorce need to be aware of these so that they can gain assurance that all aspects of their spouse’s financial assets are fairly and accurately valued and disclosed on their net worth statement. This will enable them and their attorney to properly and equitably split the couple’s joint assets as needed.

The eight categories below to be the least discussed items during a divorce proceeding, but they can also have the biggest impact on your client’s final settlement. When it comes to divorce, knowing all of the financial issues and how you address them will ensure that your client comes out of the marriage in strong financial condition.

P.S. 58 costs

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When an employer pays the premium on a life insurance policy for the benefit of an employee, the “P.S. 58 costs” are normally applied to determine the taxable benefit passing to the insured employee. Such costs are documented by a Form 1099-R, with a distribution code “9” marked on the 1099-R. The dollar amount of the 1099-R is usually immaterial, but it may translate to a large insurance policy.

Why is this important and what to be aware of:Many divorce agreements require that life insurance be held until certain conditions/terms are met. So, if there is an existing policy already in place with your client’s spouse’s employer, this will likely reduce the need for a new or additional policy. Also, depending on the type of underlying insurance policy that the employer purchased (e.g., term or whole life), the policy may have some cash value, which will be an additional marital asset to be split. Furthermore, if there is a policy in place, your client will want to confirm who is selected as a beneficiary on the policy. It is important to understand that the beneficiary elections on a life insurance policy work slightly differently than the beneficiary elections on a retirement account. For a retirement account, if your client is married, their spouse must select them as the primary beneficiary of the account. If they don’t select the spouse, then the spouse must agree to it in writing. Conversely, for a life insurance policy, anyone can be selected as the primary beneficiary. So, if your client’s spouse has a life insurance policy through work, they are not required to select your client as the beneficiary. Check it out.

$15,000 annual gift limit

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Presently, the annual federal gift limit is set at $15,000. This means that, each year, taxpayers can give up to $15,000 to anyone they want — without any income or gift tax implications. Keep in mind that the recipient will pay tax on any income they earn from this money in the future, but they do not have to pay any tax on the actual gifted money when they receive it. Your client’s spouse is excluded from this as unlimited gifting is allowed between spouses.

Why is this important and what to be aware of:As an example, if your client’s spouse gave a friend $25,000 — first, they likely excluded the full amount from their net worth statement and chances are that they also didn’t file a gift tax return — both are problems. Excluding the assets from their net worth is the big concern here, and it is critical that these funds are included and part of any settlement. So, chances are your client’s spouse has been giving money to their friends and family, in excess of the annual limit to reduce their net worth.

Applicable federal rates

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If you lend your nephew $100,000, you must include interest to make it stand up as a valid loan. In this instance, many people would use the IRS applicable federal rates which represent the absolute minimum market rate of interest a lender could consider charging a borrower in order to prevent unnecessary tax complications. There are three AFR tiers — short-term (for loans with a repayment term up to three years), mid-term (loans with a repayment term between three and nine years) and long-term rates (for loans with a repayment term greater than nine years).

Why is this important and what to be aware of:If your client’s spouse is claiming that someone has lent them money, this will directly reduce their net worth and they likely reported it as a liability on their net worth statement. Any loan they report on their net worth statement needs to have supporting documentation. So, the first thing to check is to see if the loan documents include an interest rate, at least at the minimum AFR rate corresponding to the term of the loan. If not, then this is not a valid loan, and the amount should be added back to their net worth statement and be deemed part of their assets.

Section 179

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This is the IRS section that allows a taxpayer’s business to deduct the cost of certain property as an expense when the property is placed in service. Generally, this applies to real property, improvements and tangible personal property such as machinery and equipment purchased for use in a trade or business. For example, if your client’s spouse owns a business and right before year end, the business purchases $50,000 of equipment, the tax laws allow the business to take an immediate tax deduction for this, as long the equipment was placed in service.

Why is this important and what to be aware of:If your client’s spouse is claiming that the business had lower profits last year and therefore their business is worth a lot less, they need to examine the business tax return. It is possible that their spouse took advantage of Section 179 depreciation, which reduced the business net taxable income. But their spouse may be trying to cheat them. Most business valuations look at earnings before interest, taxes, depreciation and amortization, so the value of the business likely should not change materially due to a Section 179 deduction. In fact, the business may likely be worth more — because they just added a key asset that will help the business grow faster or be more efficient.

Form 1099-MISC

The Form 1099-MISC, which is filed by a business to report payments from a business to independent contractors, is changing for 2020, to a new Form 1099-NEC. So, if a business engages independent contractors, be it for professional fees, rent or other services, and that independent contractor or entity is an unincorporated business, to “validate” the business deduction, the business will need to prepare and file a 1099-MISC form with the IRS. This lets the IRS know that the business incurred a business deduction (still subject to an audit by the IRS as to whether it was a valid expense, but this is a separate issue), and the recipient of the form should include it in their income.

Why is this important and what to be aware of: While doing due diligence on the records of their spouse’s business, if your client finds that payments were made and a 1099-MISC Form was not prepared, then their spouse is likely trying to reduce their business income with non-business expenses. These amounts should be added to the net income of the business and will likely increase the value of the business.

529 plans

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Contributions to 529 college savings plans are covered under the gift tax rules — the $15,000 annual maximum outlined above — with one exception. Individuals may contribute as much as $75,000 to a 529 plan in 2020, if they treat the contributions as if it were spread over a five-year period. Please keep in mind that if a taxpayer contributes $15,000 into a 529 plan for a child, they cannot then also gift more money to them outside of this, since they already hit the maximum gift for the year, or they must file a gift tax return.

Why is this important and what to be aware of:Legally, once the funds are deposited into the 529 account, the funds belong to the beneficiary, likely your client’s child. Many times the spouse thinks the funds are theirs and will try to withdraw the funds from the 529 account at a later date, without telling the child, and not use it for the child’s education — treating it as their own money. Your client needs to make sure that these accounts are tracked and that the funds are used for their original intent, to fund their child’s education.

1031 exchange

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Section 1031 allows a taxpayer to avoid paying capital gains taxes upfront when they sell an investment property, if they reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value. Simply put, this strategy allows an investor to defer paying capital gains taxes on an investment property when it is sold.

Why is this important and what to be aware of:It is critical to understand the correct tax basis of each property to ensure that assets are split equitably. For example, let’s assume you client owns two investment properties, each with a fair market value of $1 million. Both properties were purchased at a cost of $900,000. One property was recently purchased for cash and the second property was acquired using a 1031 exchange where your client deferred $500,000 of gain, from a property they owned for many years. If they sold the first property, they would have a taxable gain of $100,000. If they sold the second, their taxable gain would be $500,000. While these properties are equal in current fair market value, they are not equal in after tax fair market value — which is critical to a fair and equitable split of assets.

Equity-based compensation and awards

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Equity-based compensation comes in many forms, including stock options, restricted stock, stock appreciation rights and even partnership interests or shares in a professional corporation. Most equity-based compensation awards are made pursuant to some form of written plan. The plan will provide a full understanding of compensation, including the value and terms of the awards. Vesting rules and transferability limitations are also crucial. Vesting is, in effect, when the award is actually “owned” by the recipient. So, if the award is for $100, but the employee is only 25 percent vested, they really only own $25. The key issue is to understand when they “own” the other $75. Transferability refers to the rights and limitations around the ability to transfer the ownership of the award to others.

Why is this important and what to be aware of:Equity awards are complicated rights governed by multiple authorities. They can be a significant portion of the marital estate. Unfortunately there is no method of valuation of equity awards that is widely recognized and accepted — so, your client should be prepared for multiple rounds of information gathering and analysis. Just understand that many award-related actions have a taxable impact, many of which are very significant.