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Should High Net Worth Couples Plan for Divorce Taxes?

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Should High Net Worth Couples Plan for Divorce Taxes?

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For high net worth couples, the division and distribution of marital property are often the most crucial aspect affecting the execution of a divorce or separation agreement. The High net worth couple has not only significant amounts of property and assets that must be accounted for but also may face additional complications through prenuptial agreements, divorce taxes, and other aspects of the divorce settlement. Prenuptial agreements, or “prenups”, are common among wealthy couples. While the existence of a prenuptial agreement is something a lawyer or accountant should always verify, tax considerations would exist regardless of whether the distribution of property is guided by a prenuptial agreement.

Assessing Whether a Prenuptial Agreement Exists and Is Likely to be Upheld in a High Net Worth Divorce

A prenuptial or premarital agreement allows spouses to plan for the distribution of property should the marriage end in divorce. A party’s rights to engage in a prenuptial agreement is codified in California Family Code Sections 1610-1617. In California, a pre-marital agreement is accomplished by opting out of state community property laws and contractually characterizing the property that exist at the inception of the marriage or that will be acquired during the marriage as separate or joint and defining the rights between the spouses in such property. Since a prenuptial agreement will set forth how property is to be distributed, an inquiry into the existence of any premarital agreement is a prerequisite that must occur prior to any tax planning can begin.

Are Transfers of Property During a Divorce Taxed?

Tax practitioners need to be sufficiently knowledgeable and competent in order to clearly explain to a divorcing client the specific tax ramifications they will face in order to avoid any potential post-divorce malpractice exposure-causing tax surprises. Mistakes in rending professional advice on property divisions, support obligations or tax or financial fraud inherent in a particular divorce scenario can produce unintended consequences to the client that the tax practitioner will most likely be unable to reverse or mitigate. Thus, it is essential to understand that divorce can have major tax implications and result in significant expenses unless there are a careful assessment and planning.

Generally, under Sec. 1041(a), a property transfer to a former spouse deemed to be incident to divorce will not result in the recognition of taxable gain or loss or transfer (gift) taxes. A transfer is incident to a divorce when one of the following is true:

  1. the transfer occurs within one year after the date on which the marriage ceases
  2. it is directly related to the cessation of marriage, which requires that the transfer:
    • is made pursuant to a divorce or separation instrument, and
    • occurs not more than six years after the date on which the marriage ended.

Furthermore, under Harris, 340 U.S. 106 (1950), the U.S. Supreme Court held a transfer made pursuant to a court decree, is not a promise or agreement between the spouses resulting in a “gift” under gift tax law and is therefore not subject to gift or transfer tax. Likewise, if a transfer is not made under a property settlement agreement incorporated into a divorce decree (such that is qualifies for IRC Sec 1041), it may be exempted from gift tax under IRC Sec. 2516.

Built-in Gain in Transferred Property Can Result in Tax Liability

While Section 1041 does not typically result in tax at the time of transfer, one must account for the fact that subsequent transfers can in some cases result in the party having to account for the built-in gain present in the property. That is, when the property is eventually sold or otherwise liquated, the party will need to account and pay state and federal tax on the item. If tax for the built-in gain in property is likely to be due, careful tax planning can minimize its impact. For instance, it may make sense to shift property of this type to the spouse with a lower marginal tax rate. In any case, the party should be aware that this tax will eventually come due to avoid the surprise of a divorce settlement that is worth significantly less than what you believed at the time of settlement.