For some people the luster of a new marriage wears off quickly when they find that the person they married is not who they thought they were. In some cases, significant disagreements over spending, investment, and other financial issues can drive a couple apart and motivate a tax motivated divorce or annulment. In other situations, the tax-motivated divorce may be part of a scheme to shield assets from a legal judgment or other obligations.
While parties may wish to seek a legal outcome of this type, tax-motivated divorces and annulments may be disregarded for tax purposes by the taxing authorities. Therefore, a careful assessment of the settlement is absolutely essential.
The Uniform Fraudulent Transfer Act (UFTA) is intended to prevent a citizen from divesting themselves of assets while claims are pending, or in anticipation of future claims. Under UFTA 4(a)(1), a transfer is fraudulent (whether the creditor’s claim arose before or after the transfer was made) if the debtor made the transfer with actual intent to hinder, delay, or defraud any creditor.
Consider the case of U.S. v. Baker, 116 AFTR 2d 2015-5674. In February of 2007, the Bakers were asked to complete a Form 433-A, as the IRS was attempting to collect an assessment in excess of $5,000,000 related to the husband’s use of a Son of Boss tax shelter on his 2002 federal tax return. The husband and wife simultaneously began to retitle assets. The husband’s interest in the family residence was transferred into two trusts listing the couple’s two minor children as beneficiaries.
A federal district court held that transfers of the husband’s property to the wife, as part of a divorce settlement were made to delay or defraud creditors (including the IRS). In the settlement, H received a disproportionally small allocation of H and W’s assets while W received a disproportionately small amount of H and W’s debts. The Court noted that only the wife was represented by divorce counsel and that the husband and wife continued to live together subsequent to the divorce in the same house that was allegedly transferred to the wife as part of a divorce settlement. Family and friends of the couple testified that the husband held themselves out and carried on as married couple after the divorce by sleeping in the same master bedroom in the same bed, engaging in sexual relations and mutually taking on extensive renovations of the family home. The court held that divorce was obtained to facilitate fraudulent asset transfers.
In a similar matter it was held that the execution of a separation agreement by a judge in a divorce as fair and equitable between spouses does not “represent a determination that the agreement perpetrates no fraud upon the creditors of one spouse, particularly where the claims of creditors are not made known to the court.” In re Chevrie, 2001 WL 120132, at 10 (Bankr. N.D. Ill. Feb. 13, 2001). In another similar matter the court clarified that, a fraudulent transfer may be held to have occurred when a divorce is merely a sham although procedurally complete, “but the transferor nonetheless favors transferring assets to the ex-spouse rather than seeing them go to a creditor body.” In re Hill, 342 B.R. 183, 196 (Bankr. D.N.J. 2006)
Individuals contemplating or engaged in a divorce need to have a professional review of their estate plans and get out in front of the income and transfer tax issues that will certainly arise as a result of the divorce. Individuals faced with divorce must also consider the effects of the divorce on their will, life insurance, property rights, gift tax aspects of any property transfers incident to the divorce, and the effect of prenuptial agreements and what would happen if the individual dies before the divorce finalized. Furthermore, most states’ have statutes that automatically invalidate will provisions that benefit the former ex-spouse following a divorce.
It may be wise to invalidate or edit a will during the pendency of a divorce or unintended consequences could ensue if an individual happened to die before the divorce was final and assets went to the soon to be ex-spouse that were not so intended. For the same reason, beneficiary designations on life insurance should be changed. The way in which property is titled should be reviewed for the same reason as property could pass to the ex-spouse in an unintended fashion. Working with an experienced tax professional can help you assess and address these challenges in a divorce.