The United States Supreme Court long ago held that “fashioning a divorce agreement in accordance with tax consequences is an appropriate and legitimate practice. After all, the parties may for tax purposes act as their best interests dictate.” Commissioner v. Lester, 366 U.S. 299, 306, 81 S. Ct. 1343, 1348, 6 L. Ed.2d 308 (1961). Indeed, the failure to properly consider tax consequences may well complicate the parties’ situation. See Strealdorf v. Commissioner, 726 F.2d 1521 (11th Cir., 1984). These principles apply equally to a prenuptial agreement as they do to a settlement or separation agreement.
The single most important practical consideration in drafting a prenuptial agreement is disclosure. Full and complete disclosure is required, which generally entails each party divulging all information regarding assets, liabilities, property, income, and general financial condition. It is foolhardy to attempt to cut corners on disclosure or to allow your clients to be less than truthful and candid. If the agreement is subsequently deemed unenforceable because of nondisclosure, any nominal advantage or benefit, which may have been perceived as the result of complete or partial secrecy, will have been lost.
Similarly, as we have all learned with the passage of the Tax Cuts and Jobs Act (TCJA) in 2018 and, among other things, the repeal of the tax deduction for alimony payments as of January 1, 2019 (see former I.R.C. § 71, January 1, 2019), we cannot predict how the tax laws may change over time. Accordingly, the practitioner may want to consider language that any necessary calculations be done to preserve the intent of the agreement, regardless of any changes in the tax laws, so the prenuptial agreement is a “living document” that continues to be meaningful and fair, even in the face of ever-changing treatment of such important considerations as the federal taxability of spousal maintenance.
“Substantive fairness” is often the focus of a challenge to a prenuptial agreement. It is a rather vague term, which implies that courts will consider the consequences of enforcing a prenuptial agreement and whether the enforcement of its specific terms would be “fair” to both spouses. Generally speaking, the agreement should be reasonable and not unconscionable to survive a court’s scrutiny. A cogent judicial definition of the term “unconscionability” appears in a decision of the Colorado Court of Appeals in In re Marriage of Seely, 689 P.2d 1154 (1984), which stands for the proposition that a court must review the provisions of an agreement
for fraud, overreaching, concealment of assets, or sharp dealing not consistent with the obligations of marital partners to deal fairly with each other, and then look to the economic circumstances of the parties which result from the agreement, including a determination as to whether under the totality of the circumstances the property disposition is fair, just, and reasonable.
A complete approach to the desired “fair, just, and reasonable” result requires that the practitioner drafting a prenuptial agreement consider not only the broad, substantive provisions of the agreement, but also the inherent tax implications.
Taxability of Spousal Support
Using our prior example of the repeal of the long-established tax treatment of spousal maintenance (or alimony), if the parties agreed in advance to a certain amount, or percentage, for spousal maintenance based upon the prior law that provided that payments be tax deductible to the payor and taxable to the payee—as was provided by IRC § 71 for time immemorial prior to its repeal—it would be fair to provide that the amount of maintenance to be paid be calculated “net of any tax consequence” to either the payor or the payee (one or the other, or even a blended rate, because they will presumably be in different tax brackets at the time of payment). However, many states, including New York, adopted statutory formulae for the calculation of spousal support (see, e.g., New York DRL §§ 236B (1), et seq., 256-B-(5-a)(c)) prior to the repeal of IRC § 71, but the legislature made no adjustment to the calculation after the deduction was eliminated. Obviously, this previously unexpected change in the tax law makes it much more difficult for the payor spouse to afford the payments and, at the same time, results in a windfall for the payee spouse. While the appellate courts have not yet come to a consensus, several courts have ruled that it is fair and proper to consider tax consequences in fashioning a spousal maintenance (alimony) award, to deal with this obvious inequity. See, e.g., Wisseman v. Wisseman, 63 Misc.3d 819 (Sup. Ct. Duchess Co., 2019) in accordance with the mandate that the court consider “the tax consequences to each party,” among other things, in its determination of whether or not to deviate from the “presumptive” maintenance amount pursuant to the formula. New York DRL § 256-B(5-a)(e)(1). Thus, there is no reason why, when asked to prepare a prenuptial agreement, the practitioner cannot include language that would require consideration of the tax consequences of nondeductibility in the calculation of spousal maintenance (alimony) after a “triggering event” (such as the commencement of a divorce action) brings the relevant terms of the prenuptial agreement into play. Note, however, that child support has never been tax deductible to the paying spouse nor taxable to the receiving spouse.
Distribution of Retirement Plans
Another common subject of prenuptial agreements is the disposition of the parties’ respective interests in retirement assets—IRAs, 401(k)s, defined benefit plans, and the like. Often, a prenuptial agreement will provide that each party waives any right he or she may have in the other’s retirement benefits. In that situation, it is important to provide for appropriate Employee Retirement Income Security Act of 1974 (ERISA) waivers to be signed, usually after the parties’ marry, so that each spouse’s waiver of his or her interest in the other’s retirement plan will be recognized and effective under federal law.
Although some state courts have held that a waiver of rights contained in a prenuptial agreement is effective (see, e.g., Strong v. Dubin, 75 A.D.3d 66, 901 N.Y.S.2d 214 (1st Dept., 2010); In re Hopkins, 214 Ill. App. 3d 427, 574 N.E.2d 230, appeal denied, 141 Ill. 2d 542, 580 N.E.2d 115 (1991), and some courts have drawn a distinction between a waiver of “survivorship rights” and a waiver of “marital property rights” (see, e.g., Savage-Keough v. Keough, 373 N.J. Super. 198, 861 A.2d 131 (N.J. Super. Ct. App. Div., 2004)), no Federal Circuit Court has yet ruled that a waiver in a prenuptial agreement can be an effective waiver of rights in a qualified plan. See National Automobile Dealers Retirement Trust v. Arbeitman, 89 F.3d 496, (8th Cir., 1996); and Hurwitz v. Sher, 982 F.2d 778 (2d Cir., 1992). However, it is interesting to note that, while both Circuit Courts held, in substance, that a “fiancée” is not a “spouse” and that, therefore, a waiver in a prenuptial agreement does not satisfy the requirements of the Internal Revenue Code, the Second Circuit observed in a footnote in Hurwitz, supra, that it was reserving judgment as to whether the prenuptial agreement in question would have been an effective waiver “if its only deficiency was that it had been signed prior to the marriage.” Nevertheless, it is suggested that the better practice continues to be to bring the clients back to the attorneys’ offices to have those waivers signed after the parties are married. Indeed, Treas. Reg. § 1.401(a)-20 appears to state clearly that the IRS position is that a waiver contained in an agreement entered into before marriage does not satisfy the applicable consent requirements of IRC §§ 401(a)(11) and 417.
Accordingly, upon the signing of the prenuptial agreement, make an appointment for your client and his or her spouse to come to your office on a date certain shortly after the marriage to sign those waivers, as it will be much easier to get them signed at that point, right after the honeymoon while (hopefully) the parties still happy with one another, rather than leaving it undone until after the marriage goes awry. Once the waivers are signed, they should immediately be forwarded to the plan administrator(s) so that they will be properly reflected in the plan’s records.
In the event that some or all of a parties’ interests in the other’s retirement assets is not going to be waived pursuant to the terms of a prenuptial agreement, it also is important to note that any distribution of previously untaxed retirement assets between spouses will trigger a taxable event in the absence of an appropriate Qualified Domestic Relations Order (QDRO), which has been pre-approved by the plan and signed by the court. IRC § 414(b) provides very specific rules for qualifying the transfer of retirement assets from one spouse to the other for tax-free treatment. Among other things, a QDRO cannot alter the amount or form of benefits available under the rules of the plan administrator, and the assets must be rolled into another retirement plan (usually a rollover IRA) owned by the recipient spouse, or set up for the specific purpose of receiving the rollover retirement assets.
Thus, it is important to include a provision in a prenuptial agreement for the parties’ to cooperate in the preparation and submission of appropriate waivers and/or a QDRO (including an allocation of the ever-escalating cost of preparation by the attorneys, usually with the assistance of an actuarial firm), because oftentimes one spouse or the other may have some degree of control over their plan administrator, particularly in closely held businesses. A written agreement, requiring cooperation in the process, will avoid later complications and delays when the QDRO is being prepared and submitted to the plan for the required “pre-approval” in the context of a divorce.
Taxation of Distributive Awards
Generally speaking, the distribution of assets between spouses incident to a divorce is nontaxable, pursuant to IRC § 1041. However, in drafting the distribution provisions of a prenuptial agreement, which may affect the distribution of assets in the future, it is important to keep in mind that many assets may have hidden tax implications, which may not be apparent for years to come. For example, the unrealized gain in a nonretirement investment account, or in real property that has increased in value, will likely have tax ramifications in the year in which those assets are ultimately liquidated, for one reason or another. Accordingly, consider a provision that requires tax-effecting of any asset whose value fluctuates over time to get a true measure of its real worth. Yes, it may seem obvious, but you would be surprised at how often this seemingly straightforward issue becomes a bone of contention in a litigation. Dealing with it in the prenuptial agreement will leave one less issue to be dealt with later.
For example, clearly, an asset such as an investment account that has a built-in capital gain may not be worth the same as a nominally similar cash asset that has no such built-in gain. If possible, determine the party’s “tax basis” in any particular asset (that is, generally, his or her original cost), so that you will have a better idea of potential exposure to income taxes on any built-in gain. This will enable you to make appropriate adjustments in evaluating particular assets that are addressed in the prenuptial agreement, ensuring the “fairness” of any proposed distribution.
An often-overlooked asset is the “Loss Carry-Forward.” Essentially, IRC § 1212(b) allows a taxpayer to “carry forward” for an unlimited time capital losses from prior years, which could not be used because of the various limitations on the deduction of losses. See, e.g., IRC § 1211(b). Obviously, those loss carry-forwards have a value in the nature of reduced taxes, which is dependent upon the incremental tax bracket of the particular taxpayer. At least some courts have determined that loss carry-forwards are, in fact, assets that may be valued and distributed. See, e.g., Finkelstein v. Finkelstein, 268 A.D.2d 273, 701 N.Y.S.2d 52 (1st Dept., 2000). Cf., Haley v. Haley, 936 So.2d 1136 (Fla. App. 5 Dist., Aug. 11, 2006).) Therefore, it is important to include any pre-existing loss carry-forwards in your list of premarital assets and to consider the disposition of any loss carry-forwards in any proposed distribution of accumulated marital assets that might be set forth in the prenuptial agreement. Note that the loss-carryforward rules are set to expire in 2025, so consultation with a tax expert as to questions regarding the ever-evolving tax law is critical.
Although most frequently there will not yet be any children of the marriage when the prenuptial agreement is drafted, the parties should consider sharing the dependency exemptions for any future children of the marriage. In the absence of an agreement to the contrary, the party with whom a child primarily resides is generally entitled to claim the dependency exemption on his or her income tax return in accordance with IRC § 152(e)(a), an issue which often leads to much negotiation if not actual litigation. However, parties are free to agree to split the exemptions between them any way they see fit, as long as their agreement is incorporated into an appropriate writing. Again, on the theory that it is likely to be easier to get the parties to agree to this in the context of a prenuptial agreement than it might be in a later divorce proceeding, it may be wise to include such a provision in the prenuptial agreement.
Of course, there are many factors to consider, not the least of which is that tax law has been in flux in recent years with regard to the deductibility of personal exemptions. Personal exemptions have been suspended from 2018 until 2025. However, in 2017, each personal exemption provided a reduction of taxable income in the amount of $4,050 per person. For 2017, the exemption was reduced for single filers who had an adjusted gross income (AGI) above $262,500. The exemption removed entirely if the AGI was over $384,000. For joint filers the exemption started to be reduced at an AGI of $313,800. It was removed entirely if AGI was above $436,300. Being that the personal exemptions will return in 2026 at the 2017 levels, it may be wise to provide for a sharing of the personal exemptions for children; in the case of high-income taxpayers, that provision should include language that allows the parties to realize the overall greatest tax benefit as a result of the distribution of those personal exemptions, so that the exemption is not lost on a party who will not benefit from it because of the phase out.
Benefits of the Joint Return
The most obvious benefit of filing a joint income tax return is the lower overall tax rate that normally is enjoyed by the parties. Often, in the context of a divorce, one spouse or the other refuses to sign a joint income tax return, thereby not only losing the benefit of the lower rates for joint income tax returns but, even worse, incurring the penalty rates for “married, filing separately.”(Of course, there may be circumstances under which it is actually financially beneficial to file “married, filing separately,” such as the presence of circumstances leading to the imposition of an alternative minimum tax, so consultation with a CPA familiar with the parties’ finances is always a good idea.) This situation can be avoided by including language in the prenuptial agreement that provides for the filing of joint income tax returns, if beneficial to the parties overall, up until the entry of a judgment of divorce.
Of course, an agreement to file joint income tax returns primarily benefits the higher-earning spouse (assuming the incomes of the two intended spouses are not equal). The converse of this is that the lower-earning spouse, or a spouse who wants to maintain his or her status as an “innocent spouse,” as defined in IRC § 6015, may prefer not to a sign joint return, particularly if he or she is not comfortable with the representations of the other with respect to income and deductions. A carefully drafted provision in a prenuptial agreement that provides for appropriate indemnification of the proposed “innocent spouse” and sharing of the tax benefit resulting from the joint filing may serve to reduce any angst arising out of the joint return, while at the same time allowing the overall marital estate to enjoy the benefit of the lower tax.
Although the nuts and bolts of asset identification and the drafting of prenuptial agreements have been widely addressed in prior articles and publications, it is important to be aware of the substantial tax implications that almost certainly will arise and that must be considered to ensure a desired, fair result. Such awareness will allow the attorney to identify important tax issues when they are presented and to include appropriate provisions to address those issues in the agreement.
This article is an update of “Thinking Through the Tax Ramifications of a Prenup” by Neil S. Cohen and Stephen W. Schlissel (Family Advocate, Winter 2011, Vol. 33, No. 2).