Frank and Betty were married for twenty years, two of which they spent divorcing.
Frank owned part of a profitable trucking company. As news spread that Frank and his business partners planned to sell the company, Betty eagerly pushed her attorney to retrieve a share of the cash. After protracted litigation and settlement negotiations, Frank, Betty and their attorneys arrived at a nineteen page settlement agreement. In exchange for Betty's release of her marital rights in the business, Frank would pay her $25,000 within 30 days of receipt of the buyer's first purchase price payment, then $202,000 in semiannual payments of at least $10,000 until the balance was paid in full. Frank thought the deal was solid. He negotiated the semiannual payments to coincide with the dates he anticipated receiving purchase price payments from the buyer. He even negotiated his payments to be conditional on the buyer's, so that if the buyer failed to pay, he would not have to pay Betty. To Frank, Betty was a fool for accepting this deal - if Frank did not get his money, Betty would not get hers.
The problem? Frank did get his money, but not the $10,000 he hoped. Turns out, the buyer's purchase agreement with Frank's business included a loophole through which the purchase price would fall as the market price fell. The market tanked. Frank went back to his judge and complained that Betty should receive less because they either intended her payments to rise and fall as his from the buyer did (Betty guffawed) or, alternatively, a reduced price was only fair. judge thought the reduced price was fair, with sympathy for penniless Frank.
But Betty brought that written settlement agreement to the appellate court and pointed out exactly what they agreed - not a price reduction loophole to be found. The appellate court reversed the judge's decision and rebuked Frank: "[Frank] wants the trial court to make a property settlement for him that he did not make for himself . . . . The only mistake of the parties was with respect to the final purchase price of the stock. . . . It must be assumed that the parties considered the risks of the property settlement agreement that they made . . . ." See Marshall v Marshall, 135 Mich App 702; 355 NW2d 661 (1984).
Frank would have no out from under that settlement agreement He owed Betty all $227,000, with interest, even though his business deal soured and he got a trifling of it.
In most states, once parties have negotiated and entered into a settlement agreement that the divorce court then incorporates into a decree, the court cannot modify the agreement absent fraud, duress or mutual mistake. So, what can you do to avoid Frank's mistake and others like it? Here are some suggestions.
Mistake #1: You Forgot The IRS
You know the saying, "There are two certain things in life: death and taxes." Yet, when it comes to negotiating a divorce settlement (which sometimes feels like death), too many spouses fail to consider the tax consequences of their settlement. They focus on what appears to be a big win (keeping the house, getting the boat) without focusing on the tax costs. It may be obvious to you that a checking account with a $50,000 deposit and immediate accessibility is not the same as a $50,000 deferred compensation retirement account, but there are subtler tax issues to consider as you settle, too:
Transfers of property between spouses or former spouses incident to their divorce are generally tax free. See IRC 1041. This means the transferor spouse does not have to report a discharge of indebtedness, nor the transferee spouse income, for the transfer when filing the tax return for the year of the transfer. This does not mean, however, that there are no tax consequences. Under IRC 1041, the transferee spouse takes the transferor spouse's basis and holding period in the property. The transferor spouse must provide the transferee spouse with sufficient documentation to determine the basis and the holding period. Treas Reg 1.1041-1T, Q7. When the transferee spouse disposes of the property, the transferee spouse pays taxes on the entire disposition. This is, in a sense, a delayed tax. For example, if during the marriage each spouse would have taken 50% of their stock's $50,000 appreciation, after divorce the burden is 100% the transferee spouse's. Therefore, be mindful of the basis and the holding period transferred to you whenever you accept property in your settlement.
The most important thing for you to do is plan ahead. Consider all tax consequences early in your settlement discussions.
simple chart listing all of your property, with a column for fair market value, a column for outstanding debt, a column for pre-tax value and a column for estimated tax costs will help you and your attorney.
So too will a tax adviser. Have you tax adviser review the final draft of your settlement before you sign it, and ask for a thorough assessment from a tax perspective. It is better to pay for these services now than to find out, ten years from now, that you have to report $50,000 of gain.
The court will not listen to you complain that you did not anticipate the tax consequences. As the Michigan Court of Appeals said of an ex-husband making that argument, "His claim regarding unexpected income taxes is, of course, without merit. He either knew, or should have known, of the income tax consequences of his actions. . . . [W]e decline to permit plaintiff to use his income taxes as a basis for a [modification]." Couzens v Couzens, 140 Mich App 423; 364 NW2d 340 (1985).
MORE TO COME...