Applying the Structured Settlement Concept to Divorces Better Financial Results for Everyone s Clients

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1 Applying the Structured Settlement Concept to Divorces Better Financial Results for Everyone s Clients by James Godbout, Director - Stout Risius Ross & John J. McCulloch, JD, FLMI, Vice President, EPS Settlements Structured settlements have been used to resolve tort and workers' compensation claims for decades by providing tax efficient solutions that stretch the available settlement dollars further, bringing the parties to a satisfactory settlement allowing both sides to win. Recently, this concept has been applied to marital settlements in order to provide the parties with security, greater flexibility, and more importantly, a settlement that both sides can live with. Many marital settlements end up with the property or assets divided on a cash basis, or worse, dividing up properties that provide no cash flow to the Recipient Spouses. In fact, selling the property and recognizing additional tax may leave the Recipient worse off than before. This article describes a structured marital settlement, mainly for division of assets. This concept can also be applied to child support and maintenance obligations. We have used this idea to stretch the available dollars further and bring parties to resolution in challenging situations that have appeared hopeless, or when the parties were simply too far apart between offer and demand. It also creates financial certainty for the Recipient Spouse, who often is unprepared for the dramatic change in their finances and often find themselves in dire financial situations soon after the marital settlement. Parties often find that the traditional positional bargaining of a lump sum of cash being demanded or offered is limiting and turn to structured settlements many times during mediation or ADR, as a needs-based collaborative way to resolve a conflict and settle the case. Typically in a property settlement, the parties often divide up business or other assets. This has multiple disadvantages to a Recipient Spouse in that the property does not in and of itself create the cash flow needed to live on. Second, the property must be sold to create income, and while the property itself is transferred to the Recipient Spouse tax-exempt under Section 1041 of the Internal Revenue Code, upon the sale, the basis remains the same creating capital gains tax, and, if depreciation is recaptured, ordinary income tax is also triggered. A structured marital settlement for the property is both tax-efficient and simple. Property is transferred incident to a divorce if the transfer occurs within one year of the date on which the marriage ceases or if the transfer is related to the cessation of the marriage. A transfer is presumed to be related to the cessation of the marriage when the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than six years after the date on which the marriage ceases. In a structured marital settlement, the parties settle for a stream of payments in lieu of a piece of property and takes place pursuant to a divorce instrument as required by the Code. The payments themselves need not be limited to six years in duration. The not more than six years after the date on which the marriage ceases requirement, found in Treas. Reg T(b) Q&A-7 ( Q&A-7 ), is a presumption and not an absolute rule. The parties can overcome the presumption with evidence that a later payment is indeed incident to the divorce.

2 In two private letter rulings, the IRS concluded that Section 1041 applied, and the presumption of Q&A-7 was rebutted, where, as part of a negotiated property settlement agreement, the Payor Spouse, for valid business reasons, agreed to make installment payments to the Recipient Spouse which extended beyond the six-year cutoff. In PLR , installment payments for a division of marital assets went beyond 60 months, but the IRS held all of the payments excludable under Section More importantly, in PLR , divorcing spouses agreed to a property division which included the Payor Spouse s payment of an annuity to the Recipient Spouse in extinguishment of the Payee Spouse s marital rights. The parties agreed to such arrangement to effect their property settlement because a transfer of closely-held corporate stock (the Payor Spouse s major asset) would not generate sufficient cash flow for the Recipient Spouse. As the Payor Spouse (or his estate) would be obligated to make annuity payments for the remainder of the Recipient Spouse s life, the IRS recognized that such payments could extend beyond the six-year cutoff. The IRS held that the presumption in Q&A-7 had been rebutted and Section 1041 applied to all future annuity payments to explain why the Payor Spouse s payment to the Recipient Spouse would be spread over the Recipient Spouse s life. The key to exclusion of the full periodic payments (and non-recognition of any gain) is to ensure that the Marital Settlement Agreement stipulates the settlement is for periodic payments, not a lump sum that will grow at a stated rate, nor should there be any stated interest amount. Normally, periodic payments must state adequate interest, or interest will be applied under the OID (Original Issue Discount) rules. Fortunately, the Code makes specific exceptions for stated interest on deferred payments when it comes to Section Sections 1273 through 1275, dealing with OID, will normally re-characterize a portion of each of certain deferred payments as interest where a debt instrument does not contain adequate stated interest, but the original issue discount rules do not apply to Section 1041 transfers. Treasury Regulation (b)(3)(iii) states, Section 1274 does not apply to any debt instrument issued in consideration for a transfer of property subject to section Section 483 of the Code also imputes interest on certain deferred payments, but similarly does not apply to Section 1041 transfers. Treasury Regulation (c)(3) states, Section 483 does not apply to any transfer of property subject to Section A structured marital settlement is straightforward and requires only a few steps. Typically, the attorney or financial expert contacts a settlement planner, who often works as an intermediary between the parties, and can help transform a fixed amount of cash into a more workable periodic payment solution. This often entails sitting down with the Recipient Spouse and determining what his/her needs are for the future and crafting a periodic payment proposal that suits those needs, as well as educating the Recipient Spouse about the long- and short-term tax and financial consequences of the various settlement proposals. Ultimately, this helps him/her feel more secure about the process and more comfortable about reaching an agreement. A settlement planner does not charge the parties for their work and often works hand-in-hand with the financial expert and the attorneys. After a suitable periodic payment agreement has been determined, the Payor Spouse stipulates to settle the property interest in the form of installment, or periodic payments to the Recipient Spouse. The Marital Settlement Agreement obligates the Payor Spouse to make specified periodic payments for a stated number of years. After the execution of the Marital Settlement Agreement, the Payor Spouse assigns his obligation to an assignment company. The Payor Spouse transfers a lump sum, representing the discounted value of the payment stream due under the Marital Settlement Agreement. In return, the assignment company agrees to assume the Payor Spouse's payment obligations. The assignment company is a subsidiary or an affiliated company of a highly rated life insurer which issues the annuity contract to the assignment company, which makes all periodic payments required

3 by the Marital Settlement Agreement. In this way, the Recipient Spouse will not be financially dependent on the Payor Spouse, but rather, on a highly rated, well capitalized life insurer. The assignment process is required in order to preserve the tax treatment afforded to the Recipient Spouse by avoiding any timing of income problems that would be created if he/she should own the annuity directly. The tax doctrines include constructive receipt, economic benefit and cash equivalency. Constructive receipt prohibits taxpayers from deliberately turning their backs on income and selecting the year in which they want to receive (and report) it. Under Regs (a), income is constructively received if it is credited to the taxpayer s account, set apart or otherwise made available to the taxpayer. Closely related to this is the economic-benefit doctrine, which is triggered when money or property has been transferred to an arrangement (such as a trust) for the taxpayer s sole economic benefit, even if the money is not necessarily available at any time. There is no constructive receipt if the taxpayer s control is subject to substantial limits or restrictions. Here, the Recipient Spouse cannot accelerate or withdraw the payments in advance of what was agreed to, nor does she own or exercise any ownership rights over the annuity contract, defeating constructive receipt and economic benefit. The cash-equivalency doctrine focuses primarily on deferred payment obligations that the taxpayer can readily discount. Here, the Recipient Spouse cannot convert the annuity into cash, and has no rights to it. Both the assignment document and the annuity contract forbid the Recipient Spouse from transferring, assigning, selling or encumbering rights to future payments, precluding the application of the cash-equivalency doctrine. Neither does the use of an assignment company create any tax issues. In Martin v. U.S., 159 F.3d 932 (5th Cir. I998), the court indicated that a payment by a third party entity could fall within Section 1041 if the payment was made at the behest of the Payor Spouse and related to the Payee Spouse s marital rights. In a structured marital settlement, the Payor Spouse is specifically and deliberately engaging the Assignment Company (and life insurer) to make payments to the Recipient Spouse on the Payor Spouse s behalf to extinguish the Recipient Spouse s marital property rights, making the obligation clearly incident to the parties divorce. DIVISION OF MARITAL ASSETS The structured marital settlement can prove to be a huge benefit to both sides. Recently, we were called in to help with a marital estate that was subsequently valued at $10 million, comprised mostly of the husband's family business which he refused to put up for sale, nor did he want to give his wife control over half the company. The wife was entitled to 50%, but taking half of the business would not give her the cash flow she needed, and she would pay tax on any ordinary income or profit from the business. Borrowing $4 million against the business, the husband funded a 20-year stream of structured payments that resulted in $6 million of tax exempt funds to the wife. Both parties gained substantially: the wife received more money tax-exempt, has no financial reliance on her husband, and has no investment risk inherent in a small business. Similarly, the husband received a $1 million discount for fully funding the obligation and does not have to deal with his wife having a say in the operation of the business. FUNDING MAINTENANCE In another situation, the Payor Spouse (in this case, husband ) was the sole owner of a business. Not only where we called upon to value the business, but also to determine the true economic income of the owner. As most family law practioners know, the value of a closely held business is only one part of

4 the financial aspect of the case. Frequently in small to middle market businesses, the owner(s) may purposely be understating business income by running personal expenses through the company. In addition, many times the non-property or Recipient Spouse (in this case, wife ) does not have a good handle on the overall household expenses or a good idea as to what may be needed in the future. In this case, we were also called upon to perform a lifestyle analysis of the parties. The reported adjusted gross income for the parties was approximately $500,000, the majority of which came from the operations of the business. Interestingly, when the parties produced their respective financial disclosure statements, the annual expenditures far exceeded the reported income. Historical after-tax annual expenditures averaged approximately $750,000. Furthermore, the lifestyle analysis for only the Recipient Spouse indicated that she needed annual after tax cash flow of $300,000 to meet her expenses. Upon a forensic accounting exercise, we determined that the Payor s true economic income was approximately $1,000,000. While this was a long-term marriage, both the Payor Spouse and Recipient Spouse were in their early 50s and a long-term maintenance package was expected. It was apparent with the level of underreported income that the Recipient Spouse was at a substantial risk of not receiving any court determined maintenance payment. No matter what might be awarded to the Recipient Spouse, the Payor Spouse would most likely continue to underreport income and the Recipient Spouse was simply along for the ride unless she wanted to get involved in on-going forensic accounting exercises and court appearances. A structured settlement was the perfect solution. The Recipient Spouse received a 20-year stream of structured payments which provide her with annual tax-exempt funds of $300,000. The Payor Spouse funded the structured settlement for approximately $4.3 million instead of paying permanent maintenance (on an after-tax basis) of $300,000 per year. CHILD SUPPORT Additionally, structured settlements can be applied solely to child support. While there is no tax benefit (child support is neither deductible by the Payor Spouse nor includable in the income of the Recipient Spouse), having the payments fully funded by an A rated life insurer created enhanced security, peace of mind and freedom from worrying about the Payor's financial solvency for the Recipient Spouse. Despite the difficult economic times, the pace of divorces continues unabated and there is more concern about safety and security. Added to that the decrease in value of most homes and real property which makes settlement even more difficult, the structured marital settlement offers a unique vehicle that creates a tax advantaged settlement that stretches the settlement dollars further while providing maximum security and safety for the parties. If you want more information on structured marital settlements, contact James Godbout of Stout Risius Ross at (312) , or John McCulloch of EPS at (630) ,

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