Structured settlements have been used for decades to resolve tort and workers’ compensation claims by providing tax efficient solutions that stretch available settlement dollars further 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.
The following article describes the application of structured marital settlements in the division of marital assets, as well as their use in meeting child support and maintenance obligations. Parties to divorce actions often find the traditional bargaining position of the demand for a lump sum cash payment to be limiting, and thus turn to structured settlements as a needs-based means to resolve their case. This idea is used to stretch available dollars further and to bring about resolution when the parties to the divorce were simply too far apart between offer and demand. Structured settlements can also be employed in divorces to create financial certainty for the Recipient Spouse, who often is unprepared for a dramatic change in finances that can accompany divorce.
Background
Many marital settlements include property that is divided on a cash basis, or worse, the division of property that provides no cash flow to the Recipient Spouse. This may necessitate the sale of the property in order to generate income, leaving the Recipient Spouse worse off than before after consideration of tax ramifications. This is because while the property is transferred to the Recipient Spouse incident to the divorce tax-exempt under Section 1041 of the Internal Revenue Code (the “Code”), upon the sale of the property, capital gains, and/or ordinary income tax may be recognized.1
Alternatively, a structured settlement involving marital 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 affected 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, with the stream of payments being governed 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. § 1.1041-1T(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.”
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 9123051, installment payments for a division of marital assets went beyond 60 months, but the IRS held all of the payments excludable under Section 1041. More importantly, in PLR 9644053, 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 affect 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 because valid business reasons exist 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 1041. 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 § 1.1273-1(b)(3)(iii) states, “Section 1274 does not apply to any debt instrument issued in consideration for a transfer of property subject to section 1041.” Section 483 of the Code also imputes interest on certain deferred payments, but similarly does not apply to Section 1041 transfers. Treasury Regulation § 1.483-1(c)(3) states, “Section 483 does not apply to any transfer of property subject to Section 1041.”
In order to ensure this type of arrangement is 100% tax-free, both the preparer and the Life Insurance Company must understand the nuances and complexities of the transaction. Without the appropriate language and approval from the specific Life Insurance Company, the proceeds would likely be deemed fully taxable to the recipient and non-deductible by the purchaser. Absent this structure or knowledge, other Life Insurance Companies would issue a 1099 and would not support a tax-free solution.
Application
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 an 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 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. § 1.451-2(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.
Examples
Division of Marital Assets
We were recently engaged to assist in a divorce matter with a marital estate valued at $10 million and comprised primarily of Husband’s family business. In this instance, Husband refused to put the business up for sale and did not want to give Wife control over half the company. While Wife was entitled to a 50% interest in the business, this interest would not provide her with the cash flow she needed, and would subject her to taxes payable on any ordinary income or profit generated by the business. Borrowing $4 million against the business, Husband funded a 20-year stream of structured payments that resulted in $6 million of tax exempt funds to Wife. Both parties gained substantially: Wife received more money tax-exempt, has no financial reliance on her husband, and has no investment risk inherent in a small business. Similarly, Husband received a $1 million discount for fully funding the obligation and does not have to deal with wife having a say in the operations of the business.
Funding Maintenance
In another recent engagement, Husband was the sole owner of a business. We were engaged to value the business, determine the true economic income of the owner, and prepare a lifestyle analysis for the parties. Frequently, owners of small to middle market businesses understate business income by running personal expenses through the company. Further distorting the financial picture of the parties is the fact that the non-owning spouse does not have a good understanding of the overall historical (or future) household expenses.
The parties reported adjusted gross income of approximately $500,000, the majority of which came from the operations of the business. However, when the parties produced their respective financial disclosure statements, annual expenditures far exceeded their reported income. In fact, historical after-tax annual expenditures averaged approximately $750,000. Conversely, the lifestyle analysis for 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 husband’s true economic income was approximately $1 million.
While this was a long-term marriage, both Husband and Wife were in their early 50s and a long-term maintenance package was expected. It was apparent with the level of underreported income that the wife was at a substantial risk of not receiving any court determined maintenance payment from the husband. No matter what might be awarded to wife, husband would most likely continue to underreport income and wife was simply “along for the ride” unless she wanted to get involved in a series of future 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 provided 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
Structured settlements can also be applied 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 can create enhanced security for the Recipient Spouse who is no longer dependent on the Payor Spouse’s financial solvency.
Even in difficult economic times, the pace of divorces continues unabated, driving concerns about financial safety and security post decree. More recently, theses concerns have been magnified by decreasing real property values which have made settling divorce matters even more difficult. However, the structured marital settlement offers a unique vehicle which can lead to a tax advantaged settlement that stretches settlement dollars further while providing maximum security and safety for the parties involved.
1 This occurs because the basis in the property remains the same under a transfer pursuant to Section 1041 of the Code. Further, ordinary income tax may be assessed upon the sale of the property if depreciation is required to be recaptured.
