The War of the Roses is a movie classic above the trials and tribulations of marriage and divorce that sends shivers equally down the spine of about those married and unmarried. Several quotes from the movie include the following regarding marriage and divorce:

Quote #1 – There is no winning. Only degrees of losing.

Quote #2 – A civilized divorce is a contradiction.

Quote #3 – There are two dilemmas that rattle the skull – (1) How do you hold on to someone who won’t stay and (2) How do you get rid of someone who won’t go?

Under the theory that all is fair and love and war, tax planning can play a major role in the financial settlement. The “yin and yang” of tax planning for divorce seems to be a portion of the alimony and property settlement is taxable and what portion of the settlement and alimony is non-taxable. Clearly, the wealthier spouse bearing the burden of alimony payments and a property settlement would like everything to be deductible while the non-wealthier spouse as the recipient would love everything to be non-taxable. 

This article reviews the use of creative tax planning using charitable strategies with the intent of having Uncle Sam underwrite part of the property settlement. While I have frequently been accused of seeing the World through rose-primmed glasses by my mother (of blessed memory) and my wife, it seems to me that divorce property settlements might be more easily negotiated if tax-advantaged transfers were part of the divorce planning equation.

Divorce Tax Planning 101

The distribution of property is frequently the most important aspect of a separation agreement. Property transfers included in a divorce decree are subject to income and gift taxes unless they meet the requirements of IRC Sec 1041 and IRC Sec 2516.

Under the general rule of IRC Sec 1041, a transfer of property to an ex-spouse incident to divorce does not cause the recognition of or loss for income tax purposes. A transfer of property is incident to divorce if the transfer is made within one year of the date in which the marriage ceases. The transfer must be made pursuant to a divorce or separation agreement and must occur within six years after the date in which the divorce becomes final. The rules include any modification or amendment to the divorce decree.

Alimony payments are deductible to the payor and taxable as ordinary income to the payee. IRC Sec 71(b)(1) defines alimony as the transfer of cash made under a divorce or settlement agreement to a former spouse. In order to be considered alimony, the divorce agreement must designate the payment as alimony. The payments must cease with the death of the recipient or sooner. The former spouse cannot live in the same household when the transfer is made.

The divorce decree may not prevent a deduction by the payor or the recognition of income by the recipient. Payments made to third parties on behalf of the spouse may qualify as payments in cash. Child support payments are not considered alimony. Child support payments are generally non-deductible for the payor and are not included in the gross income of the recipient. IRC Sec 71(f) prevents the front loading of alimony payments.

A transfer of marital property rights under a property settlement agreement that was incorporated into a divorce decree is not subject to gift tax. In the settlement of marital property rights, IRC Sec 2516 provides that transfers of property or interests in property are treated as made for full and adequate consideration if the transfers are made pursuant to a written agreement and the divorce occurs within a three-year period beginning one year before the spouses enter into the agreement. The gift does not need to occur within three years of the divorce but rather within three years of the agreement.

With a Little Help from my Friends – Uncle Sam?

The cost of the property settlement can be reduced if the transfer has some income and transfer (estate and gift) tax benefits. As mentioned above, alimony payments must be made in cash. Child support payments are non-deductible payments. The charitable techniques outlined below can provide substantial tax relief for spouses in a tax settlement. The article describes how three different charitable tax planning techniques can be used to reduce the cost of a divorce settlement for taxpayers.

1. Pooled Income Fund

A pooled income fund is a trust that is established and maintained by a public charity. I.e. 501(c)(3) organization. The pooled income fund receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned "units of participation" in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.

Each year, the fund's entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, after which the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A pooled income fund could, therefore, also be described as a charitable remainder mutual fund.

Contributions to pooled income funds qualify for charitable income, gift, and estate tax deduction purposes. The donor's deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.

A cash contribution to a PIF is subject to an income tax deduction threshold of fifty percent of adjusted gross income (AGI). Appreciated assets are subject to the thirty percent of AGI threshold. Excess deductions may be carried forward for an additional five tax years. The taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.

The taxpayer does not recognize gain or loss on the transfer of property to the PIF. If a pooled income fund has existed for less than three taxable years, the charity is able to use an interest rate in calculating the charitable deduction by first calculating the average annual Applicable Federal Mid Term Rate. The rate for the 2016 tax year is 1.2 percent.

In practice, this feature makes pooled income funds ideal for use by persons who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow. It is important to note the double tax leverage that can be accomplished by avoiding recognition of capital gain and creating an immediate charitable income tax deduction.

Comparison of Charitable Remainder Trust vs. Pooled Income Fund

Strategy Example

1. The Facts

Joe Smith, age 50, is the managing member of Acme Funds, an investment manager.  Joe is finalizing a divorce settlement with his wife Maria. The agreement requires alimony payments for a ten year period and child support payments for the couple’s three children. Joe is also supposed to transfer a portion of his personal investment account ($1 million) and investment real estate ($1 million) as part of the settlement. Joe would like to minimize the financial cost of the transfer by structuring the settlement with tax benefits.

2. Solution

Good Samaritan Charities is a 501(c)(3) organization that sponsors donations to pooled income funds. The charity creates a new pooled income fund. Joe contributes $1 million of tenants in common interests in the investment real estate to a new PIF. He contributes an additional $1 million of personal investment assets to the PIF.  Joe’s brother Sam contributes $250 to the PIF. Joe’s donor advised fund is the remainderman of the PIF. The tax deduction is 70.8 percent of the PIF contribution or $1.416 million. The deduction threshold in this case is 30 percent of AGI. The excess deduction can be used over the subsequent five tax years.  Joe’s ex-wife will receive all of the income for the rest of her life. The PIF’s definition of income may be structured to include short term capital gains and a portion of long term capital gains. The income payout may be structured so that the income also continues for the lifetime of their only child who is 10 years old. The tax deduction would only be reduced to 45 percent of the total transfers.

2. Family Investment LLC

The family investment company is the cousin of the family limited partnership. The business purposes of the family LLC is the creation of a single entity to consolidate a families investment assets. The senior generation of a family can retain control over the management of the LLC while transferring membership units to family members or a family trust without relinquishing management and control of the family investment LLC and its assets.  Multi-member LLCs are taxed as partnerships for federal tax purposes. The strategy focuses on the idea of donating LLC membership units in a family investment LLC to a donor advised fund or a public charity. The Internal Revenue Code allows for a variety of deductions for charitable contributions.

The family investment LLC is a simple but elegant philanthropic solution that adequately addresses other traditional problems related to charitable gifts – (1) Loss of control over gifted assets (2) Loss of control over the distribution of gifted assets (3) Loss of investment control (4) Loss of access to use of the gifted assets for financial planning purposes.

In the context of divorce planning, the family investment company provides a series of benefits in context of divorce planning. The spouse making the transfer the property transfer, can leverage the property settlement by making a charitable gift to his spouse’s donor advised fund (DAF). Simultaneously, the spouse can transfer the management and control of the family LLC to the former spouse. In making the transfer of management and control. The former spouse can enjoy full management and control over the LLC and its assets. The spouse can retain a reasonable management fee as well as borrow from the LLC on an arms-length basis. The family investment company would also provide “charging order” protection from personal creditors. The grant-making authority of the taxpayer’s family can extend beyond their lifetime and they can change charities frequently. The taxpayer may also contribute to foreign charities through the Donor Advised Fund.

Strategy Example

1. The Facts

Joe Smith, age 50, is the managing member of Acme Funds, an investment manager.  Joe is finalizing a divorce settlement with his wife Maria. The agreement requires alimony payments for a ten year period and child support payments for the couple’s three children. Joe is also supposed to transfer a portion of his personal investment account ($1 million) and investment real estate ($1 million) as part of the settlement. Joe would like to minimize the financial cost of the transfer by structuring the settlement with tax benefits.

2. Solution

Good Samaritan Charities is a 501(c)(3) organization that administers donor advised funds. Joe’s ex-wife creates a new donor advised fund that is administered by Good Samaritan Charities.  Joe contributes $1 million of tenants in common interest in the investment real estate to the family investment LLC.  He contributes an additional $1 million of marketable securities to a new family investment LLC.  The company is structured so that 90 percent of the membership units are non-voting preferred units providing for a three percent cumulative return (Class B). Ten percent of the units are structured as voting common equity units that are entitled to the excess investment return above the Class B preferred return of three percent.

The management fee provides for a one percent management fee plus ten percent of excess profits above one percent. The Class B membership units have a liquidation preference of $1.00 per unit with a preferred cumulative return of three percent to the Class B member, the DAF. The excess return accrues for the benefit of the Class A member, Joe’s ex-wife.

The $2 million contribution to the DAF is reduced for lack of marketability and control. The deduction is $1.6 million which may be taken by Joe up to 30 percent of AGI. The excess deductions may be carried forward an additional five years. The management fee is $20,000 per year with an expected performance fee of $15,000. As managing member, Maria will retain full management and control over the LLC and its investment operations

3. Charitable Split Annuity

The split annuity concept is a life insurance concept that provides an investor with a guaranteed stream of income along with principal preservation. The investor concurrently purchases two non-qualified annuity contracts: a fixed period annuity for a term of years for income and a single premium fixed deferred annuity for growth. The concept is that the deferred annuity replaces the portion of investor funds allocated to the immediate annuity.

My charitable version of this concept involves the concurrent application of investment funds to a charitable lead annuity trust (CLAT) and a pooled income fund. The PIF provides for a substantial upfront tax deduction and lifetime income for the taxpayer. The PIF’s remainder interest passes to the taxpayer’s donor advised fund or a charity when the income phase terminates at death. The CLAT provides a charity or the taxpayer’s donor advised fund with an income interest for a term of years or the taxpayer’s lifetime.

1. The Facts

Joe Smith, age 50, is the managing member of Acme Funds, an investment manager.  Joe is finalizing a divorce settlement with his wife Maria. The agreement requires alimony payments for a ten year period and child support payments for the couple’s three children. Joe is also supposed to transfer a portion of his personal investment account ($1 million) and investment real estate ($1 million) as part of the settlement. Joe would like to minimize the financial cost of the transfer by structuring the settlement with tax benefits.

2. Solution

Joe funds a new charitable lead annuity trust (CLAT) with real estate tenants in common interest worth $1 million.  The CLAT is a grantor trust that provides for a fifteen year income term. At the end of fifteen years, the real estate interests will pass directly to Maria. The tax deduction is equal to $1 million. The income payments to the Maria’s donor advised fund increase by twenty percent for the income term. The initial payout percentage is $16,870. Assuming an investment return of seven percent, the remainder interest is projected to be worth $1.1 million at the end of year 15.  

Joe contributes the investment portfolio to a new PIF. The tax deduction is $707,000. The deduction is limited to 30 percent of AGI with a carry forward of the unused deduction for an additional five tax years. Maria will receive the PIF’s income for her lifetime. At her death, the remainder interest will pass to her donor advised fund.

The combined deductions are worth approximately $1.7 million. The strategy provides for lifetime income through a combination of income and assets. The projected income during the income term is $50,000 per year. The CLAT remainder interest is projected to be worth $1.1 million at the end of the fifteen year period. The combined income beginning in Year 16 should exceed $100,000 per year. The assets could further be structured within a family investment LLC in order to provide greater management control over the underlying assets.

Summary

Most of you that have been reading my articles for a long time, know that I am a huge Tower of Power (TOP) fan. The classic TOP hit “So Very Hard To Go” provides an overview of the emotional state of the spouse that pays alimony and their obligated to make a large transfer of wealth as part of a property settlement.

                                                                So Very Hard to Go

I knew the time would come, 
I'd have to pay for my mistakes,
I can't blame you for what you're doin' to me girl, 
Even tho' my heart aches.

Your dreams have all come true

Just the way you planned them

So I'll just step aside, I'm gonna step aside

And lend a helping hand then.

Even if your money has to go, creative tax structuring courtesy of everybody’s favorite in-law, Uncle Sam, might ease the pain of a large property settlement. The tax strategies provide significant front-loaded tax deductions for the payor while providing a lifetime income stream for the payee as well retained management and control.