D-I-V-O-R-C-E Doesn't Have to Spell High T-A-X-E-S
Thanks to stock-option compensation and bulging 401(k) plans, the bull market has made getting rich on paper a new reality for millions.
But here's a reality that's not so new: The divorce rate is holding steady at 50%, as it has for years.
These new financial windfalls are creating a slew of new concerns for couples going through a divorce. Emotional traumas aside, there are steps you can take to minimize the tax bite when the time comes to divvy up your assets.
To start, you need to determine which assets were acquired during the marriage and which are from your single days, says Carol Ann Wilson, president and founder of the Institute of Certified Divorce Planners in Denver. Marital assets must be shared. Any assets acquired before your marriage are yours to keep.To make equitable distributions to both sides, these assets then must be valued. If you and your spouse started a dot-com company or have a slew of stock options, these valuations can be challenging, to say the least. But this process is a necessity before any distributions can be made to each spouse. Distributions can come in many forms, but alimony is the most common. How you decide to handle distributions is dependent upon your situation. If you make substantially more money than your spouse and have the cash available, you may opt to pay your spouse's fair share in alimony. Then you won't have to worry about liquidating your assets and owing big taxes at the time of sale. Even better, you'll get a tax deduction for any alimony you pay. But if both spouses earn similar amounts, odds are good you may have to divide up the assets. If that's the case, as we'll see, you should lobby for the assets with the highest cost basis, or original cost. That'll save you a ton in taxes.
Payout of PropertyThe transfer of stocks, bonds, houses or any other tangible property at the time of the divorce is not a taxable event and the assets' original basis and holding period also are transferred. So, if one spouse gets the house while the other gets the stock portfolio, there's no tax until the assets are sold. Be aware of the original cost in the property you receive because this is where the financially savvy spouse can play sneaky. "Couples tend to look at fair market value and that's it, but you want the higher basis property," says Paula Kennedy, a senior manager in Ernst & Young's personal financial counseling group in Minneapolis. Let's assume the current fair market value of your joint stock portfolio is $100,000 -- 1,000 shares currently valued at $100. According to the divorce settlement, you'll each get $50,000 in stock. But 500 shares have a $2 basis and the other 500 have $90 cost basis. Here's why you want that high-basis stock. If sold today, the spouse who gets the shares with the $2 basis will owe capital-gains tax on $98 ($100 - $2). Even at the long-term capital-gains rate of 20%, $9,800 (49,000 x 20%) goes to Uncle Sam and $40,200 goes in the spouse's pocket. But the spouse who gets the high-basis stock can sell it and owe a mere $1,000 in tax and will walk away with $49,000. "It's no surprise that the less-savvy spouse could get stiffed," notes Kennedy.
The Aliases of AlimonyThe upside to the alimony payment is that it's a tax deduction for the person paying. If the receiver is in a much lower tax bracket, than it's actually worth more to the payer to get the tax deduction, notes Dan Caine, president of Split-Up.com, a software company that helps people going through divorce. "The tax savings to the payer exceeds the tax bill to the receiver." But while there is an incentive to disguise other payments as alimony, the Internal Revenue Service keeps a watchful eye on this maneuvering. For instance, instead of paying out $50,000 in stock at the time of the divorce as a property settlement, one spouse may opt to pay, say, $20,000 over the next three years to the other spouse as alimony. Now the payer gets a $20,000 alimony deduction, while the receiving spouse has to include that amount in income and will owe tax on it. Sometimes paying out alimony as property settlement is actually a very good approach, says Larry Kasper, a CPA in Columbus, Ohio, and author of Tax Aspects of Divorce. Particularly if have there's a business involved. "It's better to do that than liquidate the business." But, no surprise, there is an IRS rule to prevent the "front loading" of alimony. The alimony recapture rules prevent the payer from handing over large sums in the first three years and then decreasing or terminating payments after that. Check out Section 71 of the tax code for more details. So if you're going to give your spouse $20,000 a year as part of a property settlement, disguised as an alimony payment, make sure you can sustain that payment. Check out the IRS's Publication 504 -- Divorced or Separated Individuals for a worksheet to help you determine if you are front loading your payments. Since child support is not deductible or taxable, child support payers sometimes try to get that money through as alimony, too. But if that so-called "alimony" terminates on a child's milestone, like little Johnny's 18th birthday, the IRS will call those payments child support and require the payer to pay tax on all of it, says Kasper.
Stock Options and Retirement PlansBeefed-up stock options and retirement plans add an additional challenge to the marital asset valuation process. "These assets are so new that they have not been tested in court," says Wilson. So the valuation guidelines are very subjective. On the options front, the transfer of incentive stock options is clear. You can't transfer incentive stock options to anyone. So if there are no other marital assets, the options may have to be exercised (i.e., turned into stock) so the stock can be transferred. The issues surrounding nonqualified stock options were a bit murkier but, fortunately, the IRS addressed these concerns in February. In general, you can transfer nonqualified stock options to anyone. But if you transfer them to a spouse as part of a divorce settlement, you first will owe tax on their current value, says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young. The options are valued using the Black-Scholes option pricing model, which uses the stock price, strike price, expiration date, and other variables to determine the worth of the option. The receiving spouse then gets the options with a basis stepped up to the amount the employee spouse paid tax on. Pensions and retirement accounts, such as 401(k)s, are valued as if employee were to leave today, says Kasper, then divided. "In most instances, the [unemployed] spouse is entitled to half," says Wilson. But be aware that liquidating a retirement plan before 59 1/2 can mean big taxes and penalties. So make sure that is considered at the bargaining table. Granted, no divorce is easy, but fully understanding the value of your assets can give you some leverage during the settlement process. Take Liz Taylor. I'm sure she was well aware of her worth each of the eight times she visited her divorce lawyer. We can all probably learn a lesson from Hollywood in this instance.
Send your questions and comments to firstname.lastname@example.org, and please include your full name. Tax Forum appears Tuesdays, Thursdays and Saturdays.
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