Table of Contents
Divorce and Estate Planning
Divorce can be very difficult both emotionally and financially. One element that divorcing parties often overlook (during and after) is the impact divorce can have on their existing estate plan. Generally, most couples’ estate plans benefit the surviving spouse. After a divorce is contemplated, this may no longer be an objective. However, if an estate plan (including a will, revocable trust, and beneficiary designations) is not updated, unintended results can lead to extended and expensive litigation and financial devastation for a decedent’s intended beneficiaries.
Thinking About Divorce
When clients consider divorce, their attention is often focused on the division of property without fully understanding their financial needs. An individual considering divorce should have a conversation with their financial professional about their financial future. Each party should separately identify and quantify their immediate and long-term financial needs (including retirement as well as life, health, and disability insurance needs). The client should quantify their available resources and identify any financial gaps. Next, they can explore, analyze, and negotiate settlement options, understanding the financial and tax impact for each option.
Marital Property
The first step in negotiating a settlement is to determine what is marital property. The determination of marital property and how that property will be divided will depend on the particular state and whether the state is a community property state or common law (equitable distribution) state.
Community Property State
Property acquired in a community property state can be characterized as either community property or separate property. Property acquired during marriage, money earned by both spouses during marriage, and all property purchased with those earnings is considered community property and is equally owned by both spouses.
Additionally, debts incurred during the marriage are also the debts of both spouses. Separate property includes property acquired prior to marriage, property acquired by gift or inheritance, and property purchased with separate funds. If separate property is not kept distinct and is commingled with community property, it may also be deemed to be community property.
In general, the courts divide property that is community property equally, and separate property remains separate. The parties can argue for it, and the judge can consider a different division based on the facts of the case, or the parties can agree to a different outcome.
Common Law (Equitable Distribution States)
States that are not community property states are common law states (also called equitable distribution states). In a common law state, property a spouse paid for, or whose name appears on the ownership document, registration, or title is deemed to own the property. Property acquired during marriage by either spouse is generally considered marital property. At divorce, all property acquired during marriage (no matter who owns it) is subject to equitable division. The courts look at fairness determined by several factors, including:
- Length of the marriage
- Age and health of the parties
- Current income and future earning potential
- Child care issues
- Investment in respective spouse’s education, profession, and/or business
- And other factors it may deem relevant
The court has discretion as to the final result.
Property Transfers and Taxation
Transfers and payments between spouses or former spouses are generally characterized as either property settlements, spousal support, or child support. The category should be clearly indicated in the divorce agreement.
No Recognition of Income on Transfer Between Spouses
A transferring spouse will not recognize gain or loss if property is transferred to the other spouse. The transfer is treated as a gift for income tax purposes. The transferee spouse will take the transferring spouse’s basis in the property.
There is no income recognition even after the divorce as long as the transfer is incident to divorce. A transfer is incident to a divorce if made within one year of the end of the marriage or (if later) related to the ending of the marriage. A transfer is related to the ending of a marriage if it is pursuant to a divorce instrument and the transfer takes place within six years of the divorce. This income exception will not apply if the recipient spouse is a nonresident alien.
Gift Tax
Transfers made between spouses while still married that qualify for the marital deduction are exempt from gift taxation. Transfers of property between spouses in settlement of marital or property rights or to provide for the support of minor children are not taxable as gifts. For former spouses, the transfer will escape gift taxation if the transfer is pursuant to an instrument included in the divorce decree, if it is incident to a divorce under Internal Revenue Code (IRC) § 2516 (pursuant to a written agreement that is entered into during a three-year period that begins two years before the divorce and ends one year after the date of the divorce), or if the transfer is a proportionate division of jointly owned or community property.
Estate Planning And Divorce
Spousal Support and Child Support
Spousal support and child support can be awarded as part of a divorce. A payment qualifies as spousal support (alimony) if it is designated as such under a divorce agreement. Since January 1, 2019, spousal support payments are neither taxable nor deductible. Alimony payments that meet specific requirements and are pursuant to a divorce agreement finalized before January 1, 2019 continue to qualify as a deductible expense for the payor and an income tax item for the recipient. Child support payments are not income taxable nor deductible.
DocumentsWith respect to estate planning documents, each spouse may have estate plans that include a will and/or a revocable trust, a durable power of attorney, and a health care power of attorney. Each spouse has likely named the other as beneficiary, executor/trustee, and decision-maker for financial matters and health care.
Some states may revoke certain aspects of an estate plan as soon as divorce proceedings have begun. Other states may revoke certain will provisions and beneficiary and fiduciary designations when the marriage is dissolved. The client should meet with their personal estate planning attorney to review their estate plans as soon as they consider divorce. Under the guidance of their attorney, they can make the changes needed to meet their new objectives.
With respect to moving and transferring assets, each spouse has a fiduciary relationship to the other. Therefore, both of them have the responsibility to act in good faith. Transfers of assets and modifications prior to filing the divorce petition may be deemed a violation of fiduciary duty and a voidable transfer.
It is important to note that the filing of the divorce petition in some states will automatically trigger an asset restraining order (ARO), which only allows reasonable use of property. In states where the ARO is not automatically triggered, either spouse can request the order. This restraining order will prevent either spouse from:
- Selling, transferring, or borrowing against property.
- Borrowing or selling insurance.
- Modifying beneficiary arrangements.
- Changing bank accounts.
Life Insurance
Life Insurance plays an important role when parties terminate their marriage. One spouse may remain responsible for the future financial security of the recipient spouse and any children through alimony and/or child support payments. Life insurance can play a role in that future financial security. The ownership and beneficiary designations of existing life insurance and the need for additional coverage should be reviewed:
- Who should own and be the beneficiary of existing policies?
- Will only new insurance be required?
- Who will pay the premiums due on the policy?
- What is the tax impact?
A few options for the ownership of a life insurance policy after divorce include:
- The recipient spouse can be owner, beneficiary, and premium payor of the policy (the funds to pay the premiums can be negotiated as part of the overall settlement). The receiving spouse will have greater control over the policy. In this option, the parties may also want to add to the agreement that the policy will be offered to the insured when the obligation is satisfied.
- Alternatively, if the obligated spouse wants the policy after the alimony or child support obligation is satisfied, the obligated spouse could own the policy and designate the recipient spouse as the irrevocable beneficiary until the obligation is satisfied pursuant to the divorce decree.
- Another option is for the obligated spouse to collaterally assign the policy to the extent of the outstanding obligation to the recipient spouse. Parties should work with their attorneys and the insurer to make sure they comply with specific procedures to meet their objectives.
Spouse as Beneficiary
In many states, the final judgment of divorce does not terminate the life insurance beneficiary designation. If the insured dies after the divorce, the beneficiary designation will control, and the former spouse will receive the death proceeds. Some states, however, have statutes that automatically terminate the beneficiary status of a former spouse after the marriage has been dissolved. Each policyowner should make sure they update their beneficiary designations as soon as allowable to reflect their new objectives and the property settlement in their divorce agreement.
If the former spouse will remain as beneficiary of the insured’s life insurance policy and the divorce is in a state that provides for automatic revocation of a beneficiary designation, the policyowner must restate the former spouse as beneficiary in writing with the insurance company after the divorce.
Beneficiary Options for Minors
An insurance company will not pay death proceeds to a minor beneficiary. If a client wants to name their children as beneficiaries and they are minors, consider using a custodial arrangement under the Uniform Transfers to Minors Act (UTMA) or a living or testamentary trust.
Under a custodial arrangement, the policyowner can designate the adult they want as custodian under the UTMA. The disadvantage of this is that the child controls the account when they reach the age of majority (generally age 18 or 21). Alternatively, the policyowner spouse can create a living trust or testamentary trust in their will.1 The trustee will control the distribution of the proceeds under the trust document.
Additionally, if the policyowner is concerned about estate taxes, an irrevocable trust as owner and beneficiary of the policy will keep the proceeds out of the estate. The children will be beneficiaries of the trust, and a corporate trustee or individual trustee who is not the former spouse can be designated as trustee.
- 1 In a living trust, the trust is effective immediately. Typically, the grantor will be the trustee of the trust for their benefit and the benefit of their family. Upon the grantor’s death or disability, a successor trustee will be appointed for the benefit of the family. This trust can be named as the beneficiary of a client’s will, retirement fund, life insurance, etc. Alternatively, a client can create a trust in their will.
The transfer of an existing policy (or other property) that is incident to a divorce is treated as a gift for income tax purposes. Transfers of a policy made while still married that qualify for the marital deduction are exempt from gift taxation. For former spouses, the transfer will escape gift taxation if the transfer is pursuant to an instrument included in the divorce decree, if it is incident to a divorce under Internal Revenue Code 2516 (pursuant to a written agreement that is entered into during a three-year period that begins two years before the divorce and ends one year after the date of the divorce), or if the transfer is a proportionate division of jointly owned or community property.
Estate TaxesIf the insured owns the policy, they will also have incidents of ownership in the policy. Therefore, the proceeds will be in the insured spouse’s estate for federal estate tax purposes. The decedent spouse might receive an offsetting estate tax deduction for a claim against, or a debt of, the estate if certain requirements are met. If the insured spouse has a net worth greater than the federal estate tax exemption, they should consider a transfer to an irrevocable trust. The ex-spouse would be the beneficiary of the trust (with contingent or remainder beneficiaries — generally the children — identified). The trust would contain the terms of the payout to the recipient spouse. The proceeds would be out of the insured spouse’s estate.
Trusts
There are a variety of trusts that are important estate planning tools. Both inter vivos irrevocable trusts as well as revocable trusts are created during an individual’s life.
- An irrevocable trust cannot be altered, amended, or revoked and is created during their lifetime to meet their tax and non-tax objectives. A trustee manages the trust funds for the beneficiaries. The trustee has the power to make discretionary and/or mandatory distributions of income and principal as provided in the trust document. The trust assets are excludable from the individual’s/grantor’s estate.
- A revocable trust (living trust) is also created during an individual’s life but has no tax advantages because the individual retains control and has the power to revoke. A revocable trust is generally created to avoid probate, maintain privacy, and to provide continued management in the event of incapacity. A revocable trust can become irrevocable at death or can terminate.
Alternatively, testamentary trusts are created in an individual’s will and do not come into existence until the death of the testator.
Third-Party Trusts
Many parents create irrevocable trusts for their children and even grandchildren for tax and non-tax reasons. One of the primary objectives of irrevocable trusts is to protect assets from the beneficiary’s immaturity, from their creditors, and also from the possibility of bad marriages.
For many years, the interests in these third-party created trusts have not been considered property in the event of a child’s divorce. However, state statutes as well as judicial decisions are allowing, to varying degrees, an interest in these types of trusts to be taken into consideration in a divorce. The answer can be surprising, is often complicated, and is dependent on state and case law and the specific facts of the case.
Consideration of a third-party trust in a divorce settlement is an evolving area of law. It is important to note the possible exposure, particularly in equitable distribution states. A judge may take into consideration the interest the beneficiary spouse has in the trust as a factor in determining how to split the marital property or to offset the beneficiary spouse's share of the marital property. Rarely, but depending on the facts of the case and the terms of the trust, the court may actually assign a portion of the beneficiary spouse's interest to the other spouse. The court may consider factors such as: the level of control the beneficiary spouse has in the trust, whether the trust distributions are discretionary or mandatory, and whether or not the interest is vested or not vested. The rare and unexpected outcome of assigning a portion of the beneficiary spouse's interest in the trust to the spouse appears to be based largely on a perfect storm of the trust terms, extreme case facts, and a judicial attempt to achieve equity based on these facts.
Irrevocable Trusts Created by the Spouses
As part of a couple’s estate plan one or both spouses may have created an irrevocable trust for the benefit of the other spouse and their children. If the couple ultimately divorce, how would the spouse as beneficiary and/or trustee be addressed? The drafting attorney may have included language in the trust to address a divorce (i.e., to the spouse I am legally married to; upon divorce, former spouse is treated as having predeceased the grantor). If the trust language does not address the issue, during the divorce settlement negotiation, the non beneficiary spouse can irrevocably agree to disclaim or waive their interest in the trust, or the grantor spouse may be allowed to decant certain provisions pursuant to a judicial decanting order. There are additional steps that might be taken after a discussion with their divorce and estate planning attorney as soon as divorce is considered.
Revocable Trust
If the trust is a revocable trust, the grantor is still considered the owner of the assets. If it was created and funded with separate property and no marital property was commingled with property in that trust, it may remain separate property.
If the revocable trust is established after marriage and/or funded with property acquired during the marriage, the property may be subject to division and distribution upon divorce unless there was a pre- or post-nuptial agreement to the contrary.
If the trust is a joint-funded revocable trust, it would probably terminate with assets distributed under the terms of the divorce decree.
Qualified Retirement Plans and IRAs
Qualified retirement plans and IRAs attributable to contributions during the marriage and the appreciation on those contributions are marital property. Individuals must be extremely careful in transferring interests in these types of plans and accounts. If not done properly, the transfer would be treated as a distribution, which is taxable to the qualified retirement plan participant or IRA owner.
Dividing a Qualified Retirement Plan
A divorce decree or property settlement agreement is not sufficient to divide a qualified retirement plan. The parties need a Qualified Domestic Relations Order (QDRO) that is submitted to the participant’s plan. This order has federal requirements as well as individual plan requirements.
First: The parties reach an agreement on the division of the qualified retirement plan. A QDRO is drafted based on this agreement. The order is then submitted to the judge who signs and certifies. It is then submitted to the plan administrator for review and approval.
Dividing an IRA
An IRA is not an ERISA plan. A QDRO is not needed; however, any transfers (i.e., a transfer of some or all of the IRA) must be incident to a divorce. This means that the transfer must take place under a divorce decree or other written document that is part of the judgment of divorce. If the transfer is not incident to the divorce, the IRA owner may face unfavorable tax consequences. It might be prudent during this process to consult with the financial institution to determine what procedures and documents are needed. Generally, the divorce decree or document incident to the divorce should specifically address the division of the IRA and identify: the specific percentage or dollar amount, the specific account number(s), and the financial institution.
The agreement or other written instrument that is incident to the divorce is sent to the IRA custodian with a request for a direct transfer of the specified amount to the recipient spouse’s IRA.
Alternatively, the recipient spouse can establish a new IRA, and the current owner can direct a portion to be transferred directly to it. As long as this transfer is made from the obligated spouse’s existing IRA directly to the receiving spouse’s IRA under the terms of the divorce decree, the transfer is not taxable. If the receiving spouse is entitled to the obligated owner-spouse’s entire IRA, they can simply change the name on the IRA to the receiving spouse pursuant to the divorce decree.
Nonqualified Deferred Compensation Arrangements
Nonqualified deferred compensation (NQDC) as marital property has triggered much discussion with respect to property division, particularly because of its nature as an unfunded and unsecured plan. There are two broad categories of NQDC arrangements. The first category, salary reduction, is funded wholly or partly through an employee’s own deferrals. Under IRC § 409A, an employee must be fully vested in the employee’s own contributions. However, the second category is a SERP plan, which is unfunded (but can be informally funded with employer contributions). State law determines if the non-owner spouse has an interest in the participant spouse’s plan. In a community property state, a spouse may automatically have an interest in a nonqualified deferred compensation plan that was created during marriage.
If the divorce settlement provides for a split of the NQDC, the specific plan may not allow for a current division of the account to the former spouse. In that case, the agreement reached would govern the distribution “if, as, and when” distributions are made to the participant spouse. A primary issue in the case of NQDC is valuing the interest held by the participant spouse (including taking into consideration the unfunded nature and general creditor status of the participant). The settlement may allow the participant to retain their entire NQDC account and reflect the value of the spouse’s interest in that account in another asset.
Business Interest
A business is often the largest financial asset of a family. The transfer of a portion of that interest to the non-owner spouse may be devastating not only to the owner spouse but also to the co-owners. Business owners generally do not want to end up in business with their former spouse or in business with a co-owner’s former spouse. Ownership by a former spouse pursuant to a divorce can ultimately result in the sale and dissolution of a business.
What happens to a business as a result of a divorce?
In both community property states and non-community property states, a former spouse could end up with an ownership interest in the business. A former spouse could be given an interest in the business if:
- The business was started during marriage.
- The business was inherited and the non-owner spouse was involved in the business (i.e., worked in the business, provided ideas or other support).
- The owner spouse poured most of the profits back into the business and received less than adequate compensation.
Options to protect the business: There are several ways to address the impact a divorce might have on a business interest. First, the operating, partnership, or shareholder agreements can restrict a former spouse from owning an interest in the business. These agreements can require all owners to have a prenuptial agreement that prevents the former spouse from having an ownership interest in the business.
The former spouse may have an interest in the value but no ownership interest in the business. A buy-sell agreement can be drafted to include divorce as a triggering event. A well-drafted agreement with a divorce trigger would require the former spouse of the owner to sell any interest received in a divorce settlement back to the company or the other co-owners pursuant to the terms of the agreement.
Social Security
The incidents of divorce are increasing for those over 50. One of the primary concerns at that age is retirement and the age to collect Social Security.
A divorced spouse whose marriage lasted at least 10 years will be able to receive Social Security benefits based on their ex-spouse’s earnings record, if that benefit is higher than the benefit based on their own earnings record. The benefit is 50% of the benefit the ex-spouse is entitled to receive at their full retirement age (FRA).
An individual can apply for a divorced spousal retirement benefit if they are unmarried, age 62 or older, and the ex-spouse is eligible for Social Security retirement or disability benefits.
If the ex-spouse has not filed, then the applying former spouse can qualify if they have been divorced for at least two years. If the applying spouse has not reached FRA at the time of application, they will be subject to a permanent reduction of the full benefit amount. The applying former spouse will not benefit from any delayed retirement credit the ex-spouse might receive. If the applying spouse remarries, they will lose the divorced spousal retirement benefit.
Conclusion
If a client is contemplating a divorce, they should:
- Seek professional legal advice.
- Review and inventory their assets, ownership and beneficiary designations, estate planning documents, digital assets, and passwords, in light of new objectives.
- Clients should review and update the guardian designation for their children.
- With the guidance of the appropriate financial professional and/or tax and legal advisor, update documents, beneficiary and fiduciary designations as and when allowed including:
- Powers of attorney
- Will
- Revocable trust
- Qualified Plan Beneficiaries
- Nonqualified Plan
- Life Insurance beneficiaries
- Digital assets and passwords
- Payable on death (POD) accounts
- Additionally, a client should have a complete review of their financial and retirement plan in light of their new circumstances and address any new life insurance and disability income insurance needs.
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