Failing to understand financial pitfalls in divorce settlements lead to complications even after taxes have been paid by the party receiving a property.
By Andrew K. Hoffman, Financial Professional
Family lawyers who do not foresee financial pitfalls in divorce settlements lead to complications that tend to linger long after a divorce is finalized. In my divorce practice, I have found that the two top services lawyers want a Certified Divorce Financial Analyst® (CDFA) professional to perform are:
1) help them and their clients analyze the financial and tax implications of different settlement options, and
2) protect them from liability for financial errors in divorce settlements.
One of the most common mistakes I see with regard to divorce settlements is not taking the effect of taxes into account when dividing marital property. Failing to understand the tax basis of property can lead to settlements that are far from equitable after taxes have been paid by the party receiving the property. When I work with lawyers, I make sure that we review the tax basis of all property, and we ascertain whether the client intends to keep or sell the property post-divorce. One possible solution to this problem is to divide the marital property into tax assets of a similar tax basis and then divide these separate classes; this type of division helps to avoid the complexities or omission of tax affecting assets of different basic types. Documenting the discussions with the client about the tax basis of assets and the client’s final decision can be helpful later when taxes are payable; at that time, the client may have forgotten about the discussions and the decision he/she made and maybe furious about being hit with a huge tax bill. Being able to demonstrate that the client knew and agreed to this may help to defuse the situation.
Financial Pitfalls in Divorce Settlements and Retirement Plans
Many lawyers welcome assistance with retirement plans. A CDFA professional can help a lawyer understand the rules and requirements of each type of plan to create a settlement for the client. When negotiating this settlement, it’s crucial to find out what options are available before the settlement is final.
In terms of Defined Contribution Plans, for instance, it’s important to know whether the plan will allow distributions – an important consideration if some of the retirement funds will be used to generate liquidity or rolled over to another retirement plan or IRA. Keep in mind that every company you run across is different. Working with an experienced CDFA professional can help you avoid the problems that are caused when you and your client think that you roll over the money to an IRA, and then discover that the plan doesn’t allow distributions. Some plans do not allow distributions on certain investment choices while other plans have temporarily frozen funds in certain investment choices because of the downturn in the economy. CDFA professionals can help lawyers understand the timing of distributions to make sure the distributions are made at the right time to avoid unanticipated taxes. With more commercial annuities containing living benefits that are divided by contract, a CDFA professional can help lawyers and their clients understand whether any or all contractual benefits can be transferred in a divorce.
CDFA professionals can help their clients understand Defined Benefit pension plans – particularly whether there is cash that the participant or alternate payee can tap into or when there will be a future stream of income available. We can help determine whether it would be better to value the pension and offset the value with other assets, divide the future income, or combine these two approaches. When negotiating the division of a Defined Benefit Plan, a CDFA professional can make sure that the property settlement agreement does not require payments that the plan does not allow. A CDFA can help both client and lawyer understand the importance of survivor benefits, ensuring that the right to the pension is not lost by the early death of their ex-spouse; a CDFA can also explain what would happen to the benefit in the event of the client’s death.
In the current economy, many homes are worth less than the mortgage balance. Some homeowners are choosing to get out with a short sale. However, you should be aware that a short sale could result in a gain if the short sale value exceeds the homeowner’s basis – which could cause the homeowner to have taxable income if the Bank writes off a portion of its mortgage.
Spousal Support and Taxes
CDFA professionals can help lawyers understand how spousal support can be used as a tax-planning tool and make sure that spousal support is deductible from income by the payor spouse (IRC §215) and includible in income by the receiving spouse (IRS §71). We can help clients structure spousal support to avoid triggering recapture; the two main triggers are front-end loading of spousal support spousal or having support fluctuate or end within six months of a contingency related to one or more children of the marriage (examples include a child attaining a specific age or income level, dying, marrying, leaving school, or gaining employment). If you make a mistake in either of these areas, spousal support could be reclassified as child support, which is neither deductible by the payor nor taxable income to the recipient. Imagine what your client could end up owing in back taxes, penalties, and interest if he/she has been paying (and deducting) spousal support for 18 or 20 years when the IRS discovers the reduction and reclassifies the payments as non-deductible child support! The payor spouse will have to amend all his/her returns, but the recipient spouse can only amend and receive a refund on the last three years of tax returns.
Capital Loss Carry Forwards
With the downturn in the economy, we are starting to see more capital loss carryforwards on tax returns. This is a good time to review some of the rules of carryforwards. Carryforwards have value as a potential tax benefit. Some can be deducted from future income, and others affect the basis of the transferred property. A review of the couples’ tax return is important so that you can include these carryforwards as part of the settlement negotiations. A CDFA professional can help you find and negotiate unused capital losses, net operating losses, passive activity losses, charitable contribution carryforwards, and unused investment interest expenses.
Most lawyers are aware that the Consolidated Omnibus Budget Reconciliation Act (COBRA) contains provisions giving certain former spouses the right to temporary continuation of health coverage at 102% of the actual employer’s premium. Although this is expensive, it can allow 36 months of coverage that is not subject to pre-existing condition coverage. Many lawyers, however, are unaware of the requirement that the alternate payee informs the employer of the divorce within a certain time after the divorce. The CDFA professional can make sure that the client is informed of this important deadline and help them keep their health insurance coverage.
Andrew Hoffman, FCA, CFP®, CDFA™ is chairman of the Institute for Divorce Financial Analysts’ Editorial Committee and a member of the IDFA Advisory Board. He is a financial trainer on the National Interdisciplinary Collaborative Divorce Training Team. To learn more about how a CDFA™ professional can help you and your client address the financial issues of divorce, go to www.InstituteDFA.com/Lawyer.
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