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A QDOT is a specific type of marital deduction trust that is designed to ensure that non-citizen spouses will eventually pay any taxes that may be due upon distribution of the principal from the trust, even if the surviving spouse resides outside of the United States. Without a QDOT, an estate would be immediately taxable. More specifically, the marital deduction typically allows the assets of an estate to be passed to a spouse without tax consequences.

The marital deduction for property passing to a non-citizen spouse is generally not allowed without the existence of a Qualified Domestic Trust (QDOT).

Special Requirements

To ensure the taxes are eventually paid, there are certain required provisions:

  • The trustee of the trust, or one of the co-trustees, must be a U.S. citizen or a domestic corporation of the U.S.
  • The trust must contain a restriction that no principal will be distributed from the trust unless the U.S. citizen or domestic corporation trustee has the right to withhold any tax due from the distribution.
  • The trust must comply with Treasury Regulations to ensure the collection of any tax.
  • The trust must satisfy the applicable rules for marital trusts for U.S. citizen surviving spouses.
  • A QDOT election must be made on the decedent’s estate tax return.

If a trust fails to qualify as a QDOT, under certain circumstances a QDOT can be created by the use of a reformation (correction or change of an existing trust document). Some foreign countries prohibit trusts or prohibit a trust from having a U.S. trustee. In recognition of these situations, the Secretary of the Treasury has the authority to prescribe regulations allowing exceptions to the above requirements for qualifying as a QDOT. However, such regulations may only allow a marital deduction for nontrust arrangements or for trusts without a U.S. trustee under circumstances where the U.S. would retain jurisdiction and where there is adequate security to impose a tax on transfers by the surviving spouse of the property transferred by the deceased spouse.

Estates of $2 Million or Less

For estates of $2 million or less, the trust must either require that real property located outside of the U.S. accounts for no more than 35% of the fair market value of the trust property or meet the requirements for an estate that exceeds $2 million in assets.

Estates Exceeding $2 Million

For estates that exceed $2 million in assets, the QDOT must provide one of the following:

  • Require that at least one trustee is a U.S. bank
  • Post a surety bond in favor of the Internal Revenue Service (IRS) in an amount equal to 65% of the fair market value of the trust assets
  • Provide a letter of credit from a domestic bank or U.S. branch of a foreign bank, or issued by a foreign bank and confirmed by a domestic bank, in an amount equal to 65% of the fair market value of the trust assets

QDOT Property May be Subject to Estate Tax if:

  • Any principal distributions (except distributions made on account of hardship) to the surviving spouse will be subject to estate tax
  • The surviving spouse’s death prior to December 31, 2009 will cause the remaining property in the QDOT to be subject to estate tax as if it were included in the estate of the first spouse to die
  • If the QDOT ceases to meet the requirements under the regulations, an estate tax is imposed as if the surviving spouse had died on the date when the trust failed to qualify as a QDOT

Work with a Chicagoland Attorney and Mediator

Getting a Divorce is a difficult time of life, choosing the right attorney should not be! For over 4 decades Alan Pearlman, Ltd. has been serving Chicagoland and the surrounding Suburbs in obtaining solutions to these difficult matters. Contact my office at 847-205-4383 for your free 1/2 hour consultation and see how we can be of service to you.

Prior to filing for divorce, various federal tax considerations should be reviewed due to their potentially profound implications. Among the major issues commonly covered in a divorce decree or agreement are: alimony, sometimes referred to as “spousal” or “separate maintenance” support; division of property; and child support. Each has its own tax treatment and implications.

Division of Property

Most divorces involve a division of the property owned by the couple. Such a division of property is not usually a taxable event, i.e., neither owes taxes nor gets a deduction from income because he or she receives certain property as a result of the divorce.

There are, however, tax implications following divorce that affect future taxes. More specifically, selling personal and real property in the future may require spouses who received such property (pursuant to a divorce) to pay taxes in connection to that property.

Personal and real property have a “basis” for federal tax purposes. The basis is usually the purchase price of the property. When the property is sold later, the amount by which the sales price exceeds the basis is called “capital gain.” Capital gain is usually taxable at special rates. Thus, when property distributed pursuant to a divorce decree is subsequently sold by the receiving spouse, the receiving spouse may be required to pay taxes on the proceeds of the sale.

For example, in a divorce, the wife may receive the family home while the husband might receive stock or other investments equal in value to the house. If the house has a lower basis than the stock, when both are sold, the husband could end up with significantly more money, because he owes less capital gains tax.

On the other hand, under tax law applicable at the beginning of 2004, the first $250,000 (for individuals) or $500,000 (for couples) of the taxable gain on the sale of a qualifying personal residence is exempt from tax. In light of these tax issues, selling the house before the divorce, then dividing the proceeds, might make more sense.

Child Support

The parent who is granted custody of the child or children from the marriage, usually receives a set amount of money per month as “child support.” Child support payments are not includable in the taxable income of the receiving spouse and are not tax deductible by the spouse making the payments.

If the written agreement or divorce decree orders both child support and alimony and the spouse making the payments pays less than the required total amount, for tax purposes, the child support obligation is deemed paid in full first. Only money exceeding the amount of the child support obligation is treated as alimony.

Alimony or “Spousal Support”

In general, for federal income tax purposes, alimony and “separate maintenance payments” are “deductible” from the income of the spouse paying and includable in income for the recipient. Keep in mind that ALL THIS changes on January 1, 2019 according to the new tax laws signed into law this past December when Alimony i.e. Maintenance will no longer be deductible by the payor nor includable in the income of the recipient for Federal Tax Purposes. A word to the wise is simply if you are contemplating and/or are presently in the process of Divorce and you are going to be paying Alimony/Maintenance then if at all possible try to complete your matters prior to 1/1/2019. In that way you will be able to claim the deduction in all future years and you will not lose this benifit to you. “Deductible” for federal income tax purposes means it is subtracted from a taxpayer’s gross income before taxes are calculated, resulting in lower taxes. Taxpayers with a threshold amount of deductions must file a particular form with the IRS when paying income taxes and list such deductions.

Between the time a couple separates and a divorce decree is granted, one spouse may pay money for the support of the other spouse. These payments are deductible as long as they are made pursuant to a decree, court order or a “written separation agreement.” In order for alimony payments to be deductible, federal tax laws and regulations require the following:

  • The payments are made in cash, check or money order (no promissory notes, transfers or use of property, transfer of services, etc.) to the spouse, or to a third party in lieu of alimony at the written request of the recipient spouse, stating the payments are intended as alimony, and the request is received before the tax return is filed
  • The divorce decree, order or the written agreement of the parties does not identify the payments as something other than alimony
  • The spouses do not file a joint return with each other
  • The spouses are not members of the same household when the payments are made, if they are legally separated under a decree of divorce or separate maintenance – separation within the family home is not sufficient
  • There is no liability to make the alimony payments after the death of the recipient spouse – if part of the payment amount continues after death, that portion is not deemed alimony, and if all of the payment continues, none of it is alimony
  • The alimony payments are not treated as child support

Three major issues commonly resolved in a divorce decree or agreement are: alimony, or spousal support; division of property; and child support. Each has its own tax treatment and implications. In general, for federal income tax purposes, alimony is “deductible” from the income of the spouse paying it and considered taxable income to the spouse receiving it.

If the payor spouse has a significantly higher income, there is an incentive to maximize the amount of payments that are considered alimony to the ex-spouse, as opposed to nondeductible payments such as property distributions and child support payments. The recipient (ex-spouse) may be in a much lower income tax bracket and agree to the plan.

It is important to note, however, that the IRS objects to attempts to mischaracterize child support or property divisions as alimony, because of the tax effects.

Child Support Disguised as Alimony

Child support payments are not deductible from the income of the payor spouse for federal income tax purposes. Payments that are specifically designated as child support in the divorce decree or written agreement between the spouses cannot be treated as alimony for income tax purposes.

Moreover, if the spouse making alimony and child support payments pays less than the required total for both, the child support obligation is deemed paid in full first for tax purposes. Only money exceeding the amount of the child support obligation may be treated as alimony.

When Alimony May Be Deemed Child Support

Payments characterized as alimony may be treated as child support if, and to the extent that, the payments are reduced on the happening of a contingency related to the child, such as if the child:

  • Becomes employed
  • Dies
  • Leaves the home
  • Leaves school
  • Marries
  • Reaches a specified age or income level

Contingencies Associated with a Child-Related Event

In addition, alimony payments may not be reduced based upon an event “associated with a contingency” related to the child. This is the same concept in a sense, but refers to more indirect methods. If the divorce decree or agreement does not reference a child, but merely sets a date when the amount of alimony is reduced, it may still indicate the alimony is child support if, upon investigation, either of the following is discovered:

  • That the alimony is reduced within six months, before or after, the birthday on which the child becomes an adult under local law (typically 18 or 21 years old)
  • If there are two or more children of the marriage and at least two reduction dates for the “alimony,” and the reductions all occur within one year (before or after) the date on which one of the children reaches a certain age between 18 and 24 years old

If the alimony provisions satisfy either of the above “tests,” there is a rebuttable presumption that the payments are really child support to the extent of the reduction. Thus, if the alimony amount is reduced one or more times on dates related to a child’s birthday, the amounts by which the alimony is reduced are considered “child support” and are not deductible by the payor spouse for federal income tax purposes.

Rebutting the Presumption

The above are not the only times the IRS may seek to recharacterize alimony as child support. The IRS may scrutinize any major reductions of alimony after a period of years.

Reductions which are made at a specified date on or near the birthday(s) of a child or children, as described above, however, create a “presumption” that the payments were really child support. The taxpayer may “rebut” this presumption. One way to do this might be to show that there is another rationale for the reduction date, such as it coincides with one half the duration of the marriage and/or is a common time for reduction or elimination of alimony under local law and practice.

In a rare 8-0 decision, the Supreme Court recently overturned a ruling by the highest court of Arizona regarding the division of military retirement pay under a divorce decree. Howell v. Howell, decided May 15, held that any waived portion of military retirement pay cannot be treated as divisible community property in the case of divorce (197 L. Ed. 2d 781).

The ruling reaffirmed the Court’s decision in Mansell v. Mansell, clarifying that waived pay is exempt from division, regardless of whether the waiver was made before or after the issuance of the divorce decree (490 U.S. 581).

When John and Sandra Howell divorced, Sandra was awarded 50 percent of any military retirement pay John would receive. John subsequently retired and Sandra received her share for about 13 years.

Thirteen years after the issuance of the decree, John was found to be partially disabled and eligible to receive disability pay, a non-taxable benefit. In order to receive this disability pay, John was required to waive a corresponding amount of his retirement pay, which he did. This waiver decreased Sandra’s monthly payment pursuant to the division established in the decree by $125.

 She petitioned the Arizona family court to enforce the original decree, requiring John to indemnify Sandra in the amount of his disability pay—$125. The court ruled that Sandra had a “vested” interest in an amount equal to 50 percent of John’s retired pay at the time of the decree and granted Sandra’s petition. The Arizona Supreme Court affirmed, ordering John to “reimburse” Sandra for the decrease in her share of the military retirement pay (238 Ariz. 407).

John appealed and the Supreme Court reversed the decision of the Arizona Supreme Court. In 1982 Congress passed the Uniformed Services Former Spouses’ Protection Act. 10 U.S.C. §1408. This law made military retirement pay divisible by state courts as community property in the case of divorce. The law specifically excluded amounts deducted from retired pay.

The Supreme Court subsequently held in Mansell that state courts could not divide “military retirement pay that has been waived to receive veterans’ disability benefits” (490 U.S. 581 at 595).

Arizona’s Supreme Court attempted to distinguish Mansell on the basis that the waiver in Mansell was made pre-decree, whereas John Howell waived a portion of his retired pay many years post-decree. The Supreme Court was not persuaded that Mansell was distinguishable.

The court held that a waiver of retirement pay, regardless of when it was made, exempted that amount from division in a divorce decree. The Court also held that Sandra did not have a vested interest because “state courts cannot ‘vest’ that which (under governing federal law) they lack the authority to give. (Howell, 197 L. Ed. 2d. 781 at 788).

The Arizona Supreme Court’s phrasing of the decision as requiring “indemnification” likewise did not change the protection of the waived retirement pay, because “such reimbursement and indemnification orders displace the federal rule and stand as an obstacle to the accomplishment and execution of the purposes and objectives of Congress” in enacting the Uniformed Services Former Spouses’ Protection Act (Id. at 789).

The Supreme Court’s decision in Howell addresses a complex question about military disability pay and indemnification. As the Court says, “the question is complicated, but the answer is not.”

Our cases and the statute make clear that the answer to the indemnification question is ‘no’” (Id. at 785).

A court may take into account the possibility of a future change to the retirement pay when deciding award amounts at the time of a divorce decree, but waived retirement pay is off limits for division.

 

 

Prior to filing for divorce, various federal tax considerations should be reviewed due to their potentially profound implications. Among the major issues commonly covered in a divorce decree or agreement are: alimony, sometimes referred to as “spousal” or “separate maintenance” support; division of property; and child support. Each has its own tax treatment and implications.

Division of Property

Most divorces involve a division of the property owned by the couple. Such a division of property is not usually a taxable event, i.e., neither owes taxes nor gets a deduction from income because he or she receives certain property as a result of the divorce.

There are, however, tax implications following divorce that affect future taxes. More specifically, selling personal and real property in the future may require spouses who received such property (pursuant to a divorce) to pay taxes in connection to that property.

Continue Reading Divorce and Federal Income Taxes

 Although “loss of consortium” damages are traditionally associated with spousal relationships, modern cases have extended the right to recover them to parent-child relationships. Referred to as “filial consortium damages,” these awards are intended to compensate the parent for the loss of affection, love and companionship that results from a child’s injury or death.

Wrongful Death Actions Distinguished

In cases where parents sue for the wrongful death of their child, most jurisdictions permit parents to recover filial consortium damages from the wrongdoer. Parents can generally recover these damages under the state’s wrongful death statute.

The situation is much different, however, in cases where the child survives. Under these circumstances, although the child may have suffered severe permanent injuries, state law varies significantly with respect to the availability of filial consortium damages. As a general proposition, most states do not recognize parents’ claims for lost consortium when the child survives.

Majority of States: No Filial Consortium Damages for Non-Fatal Injuries

A majority of jurisdictions do not permit parents of non-fatally injured children to recover filial consortium damages. The following examples reflect the status of the law in several states:

  • In 2003, the Texas Supreme Court declined to extend a claim for loss of consortium to the parents of a child with a non-fatal injury. As such, Texas does not permit parents to recover loss of consortium damages resulting from a child’s serious injuries.
  • In 1988, Michigan’s highest state court held that a parent has no cause of action for loss of consortium damages when a child is negligently injured. However, the parent is still entitled to sue for loss of services as well as medical expenses.
  • In 1986, the Wyoming Supreme Court similarly rejected a parent’s right to consortium damages resulting from serious injuries to a child.

Some States Allow Parents to Recover for Non-Fatal Injuries

A substantial minority of jurisdictions authorize parental recovery of consortium damages for injured minor children. In some states, parents may recover under a statute which expressly sanctions such damages. In other states, however, parents must rely on case law and judicial interpretation to recover filial consortium damages.

Though not an exhaustive list, the following states permit a parent to recover loss of filial consortium for non-fatal injuries:

  • A Massachusetts statute sets forth the following rule: “The parents of a minor child or an adult child who is dependent on his parents for support shall have a cause of action for loss of consortium of the child who has been seriously injured against any person who is legally responsible for causing such an injury.”
  • In 1994, the Florida Supreme Court expressly ruled that a parent has a common law right to recover for loss of an injured child’s consortium, stating “The loss of a child’s companionship and society is one of the primary losses that the parent of a severely injured child must endure.”
  • In 1986, the Arizona Supreme Court granted parents the right to recover consortium damages from a third party who permanently injures their adult child. The court expressly refused to limit loss of consortium damages in severe injury cases to cases involving minors: “Loss of consortium is a compensable harm, and we see no basis for limiting this action solely to cases of wrongful death [and] no reason for limiting the class of plaintiffs to parents of minor children when the parents of adult children may suffer equal or greater harm.

An increasingly large portion of the assets of married couples consist of rights to payments and stock from pension plans.  In many states such assets are subject to division during a divorce.  Divorce and division of property are generally controlled by state law, but pension plans are controlled by federal law in many respects.

 
Pension Plans and ERISA
A major advantage of saving for retirement through a pension plan is that contributions from employees and employers for plans such as a 401(k) plan are not taxed as income until distributed by the plan, usually after retirement, at lower tax rates. However, under provisions of the Federal Internal Revenue Code, the assignment of pension benefits, including transfers to a spouse during divorce, may result in the loss of such tax benefits.
 
In 1984, Congress passed the Employee Retirement Income Security Act (ERISA), which governs most private pension plans (government and some other plans are not covered, nor are IRAs).  To remedy the anti-assignment problem, the Retirement Equity Act of 1984 (REA) amended ERISA to establish an exception to the anti-assignment bar to division of ERISA plan benefits during divorce. 
 
Federal Tax Treatment of QDRO Plan Distributions
To avoid adverse tax consequences, the plan participant/spouse must obtain a "Qualified Domestic Relations Order" (QDRO).  A QDRO is usually entered by the court, although under certain circumstances other entities may approve a QDRO.  The QDRO must also be approved by the administrator of each plan affected. 
 
The QDRO must contain certain information specified in ERISA, as amended by REA, including the names and addresses of the plan participant and the recipient(s) of the court award (the "alternate payee").  There are also certain provisions that are prohibited in a QDRO, including the authorization of plan benefits and payouts that are not allowed by the plan.
 
A QDRO creates or recognizes an "alternate payee’s" right to receive all or a portion of the plan benefits, or it may actually assign that right to the "alternate payee."  An "alternate payee" may only be a spouse, former spouse, child, or other dependent of the plan participant.  A validly created and approved QDRO allows the recipient spouse to be treated, for federal income tax purposes, as a plan participant.  In addition, the QDRO may allow the alternate payee to take a lump sum withdrawal (if allowed by the plan) or commence payments at the earliest time allowed for retirement, regardless of when the participant actually retires.
 
Consequences of Plan Withdrawals Absent a QDRO
If a court orders the division of an interest in an ERISA pension plan during a divorce and the plan participant simply pays the amount from the pension plan without obtaining a QDRO, the participant may become liable for an early withdrawal penalty of 10% (depending on age and method of withdrawal), plus income and/or capital gains taxes on the amounts distributed to the former spouse.  Federal courts have repeatedly upheld this principle, despite claims of plan participants that they were forced to comply with the court’s order and had no other source for the payments, and therefore should not be penalized.
 

Absent a QDRO, the amount withdrawn from the plan thus becomes income and/or capital gains to the plan participant, not the former spouse.  If a valid QDRO is in place, however, the distributions from the plan are treated as income and/or capital gains to the alternate payee/spouse.  However, if distributions from the plan are used to satisfy child support or payments to some other dependent of the plan participant/spouse, the distributions are still treated as taxable to the plan participant/spouse for federal income tax purposes, notwithstanding the existence of the QDRO.

Divorce mediation, an alternative to traditional divorce proceedings, is a means to resolve the complex issues of a divorce. Mediation involves the services of a trained and neutral person who works with the parties to facilitate the settlement of disputed issues. Such person is known as the "mediator."

In traditional divorce proceedings, the judge ultimately determines child support, child custody, spousal support and property issues. Mediation, on the other hand, allows couples to control the outcome of their divorce. Additionally, the mediation process is non-adversarial in nature, which is especially important for couples with children, as like-minded parents can establish parenting plans with minimum disruption to the lives of their children.

Continue Reading Successful Divorce Mediation

Many marital settlement agreements require one party to maintain a life insurance policy on his or her life naming the former spouse as the primary beneficiary. While this provides some financial security for the former spouse, it may also result in an adverse unintended tax consequence for the insured spouse’s estate.

For example, if the ex-husband is required to maintain a $1 million life insurance policy on his life, naming his ex-wife as beneficiary, on the ex-husband’s death his ex-wife will receive the $1 million face amount of the policy directly from the life insurance company. If the ex-husband was the owner of the life insurance policy and paid the premiums on the policy, the IRS will include the $1 million face amount of the policy in the ex-husband’s estate for the purposes of calculating the amount of estate tax owed by the ex-husband’s estate. If the ex-husband died in 2007 with a taxable estate of $3 million plus the $1 million in life insurance, the inclusion of the life insurance proceeds would result in a $450,000 increase in the estate tax owed.

The foregoing result may be avoided through the use of a tax-sensitive marital settlement agreement and an irrevocable life insurance trust. The ex-husband may still be required to maintain a $1 million life insurance policy with his ex-wife as beneficiary, but the life insurance policy would be owned by the trustee of the irrevocable life insurance trust. The ex-husband may transfer money to the trust for the payment of the premiums. Since the payments are required pursuant to a court order, the payments are not considered taxable gifts. Since the irrevocable life insurance trust, not the ex-husband, is the owner of the policy, the $1 million life insurance policy will not be included in the ex-husband’s estate for the purpose of calculating the estate tax owed.

It has been estimated that more than one half of all first marriages end in divorce; the number of failed marriages is even higher for second marriages. One major issue in most divorces is the division of property. Commonly, a large portion of the marital assets consist of rights in or payments from one or more pension plans.

Pension Plans and ERISA
Divorce and division of property are generally controlled by state law. However, when state law contradicts or is inconsistent with federal law, the federal law "preempts" the state law; federal law controls the outcome. In 1984, Congress passed the Employee Retirement Income Security Act (ERISA), which governs most private pension plans (government and some other plans are not covered).

Federal law prohibits the assignment of pension benefits in ERISA plans. This appeared to include transfers to a spouse during divorce, regardless of a state court decision on division. To remedy this, the Retirement Equity Act of 1984 (REA) established an exception to the rule through use of a "QDRO."
Continue Reading Qualified Domestic Relations Orders and Divorce Settlements