Tax Liability Issues to Consider for High-Net-Worth Couples in Divorce
- Advisors to high-net-worth individuals with substantial assets located in the U.S. and abroad should consider the potential tax implications involved in a divorce, in particular, the tax treatment of alimony payments and transfer of property.
- When property transfers and payments are between former spouses of different nationalities or residing in separate countries, additional factors and considerations may be taken into account.
- This Holland & Knight alert examines certain tax planning opportunities that should be considered to minimize the tax liabilities for wealthy individuals resulting from a divorce.
Divorce is not a topic most clients or tax advisors enjoy discussing. Nevertheless, it is important in today's day and age to advise clients, especially high-net-worth individuals with substantial assets located in the U.S. and abroad, of the potential tax implications involved, in particular, the tax treatment of alimony payments and transfers of property as a result of the divorce. Depending which party you are representing in a divorce proceeding, certain tax planning opportunities should be considered in order to minimize the tax liability resulting from a divorce.
Alimony or Separate Maintenance Payments
Prior to the enactment of the Tax Cuts and Jobs Act (TCJA), alimony or separate maintenance payments were included in the income of the recipient ex-spouse, while being deductible by the payor ex-spouse. Because the recipient ex-spouse was generally in a lower tax bracket than the payor ex-spouse, this effectively resulted in an overall preservation of wealth. Moreover, when the payor ex-spouse was a U.S. federal income tax resident and the other ex-spouse was a nonresident alien for U.S. federal income tax purposes, the alimony or separate maintenance payments made by the U.S. payor ex-spouse to the non-U.S. payee ex-spouse were subject to a 30 percent withholding tax, unless an applicable tax treaty reduced or eliminated the withholding tax obligation.
As part of the TCJA, Congress repealed the sections of the Internal Revenue Code (I.R.C.) that provided for the deductibility of alimony or separate maintenance payments for the payor ex-spouse and removed the inclusion in income of alimony or separate maintenance payments for the payee ex-spouse. Pursuant to the TCJA, alimony or separate maintenance payments made pursuant to divorce agreements entered into after Jan. 1, 2019, are neither deductible by the payor ex-spouse nor includable in the income of the payee ex-spouse. Thus, payments by a U.S. payor ex-spouse to a non-U.S. payee ex-spouse are no longer subject to U.S. federal withholding tax because the alimony or separate maintenance payments are no longer treated as U.S. source income in the hands of the non-U.S. payee ex-spouse.
Property Transfers Resulting from Divorce
Aside from alimony and separate maintenance payments, property transfers resulting from divorce can have significant tax implications for both parties if not structured properly (especially for situations in which one ex-spouse is a U.S. person and the other ex-spouse is a nonresident alien). Generally, no gain or loss is recognized on transfers of property if: 1) it occurs within one year after the date of the end of the marriage or 2) is related to a cessation of marriage. A transfer is treated as "related to the cessation of the marriage" if the transfer occurs pursuant to a divorce or separation instrument and occurs not more than six years after termination of the marriage. Similar to transfers of property received by gift, the transferee ex-spouse will generally have a carryover basis in the property received. However, the foregoing general rule does not apply if the spouse/former spouse of the individual making the transfer is a nonresident alien.
In the event the transferee ex-spouse is a nonresident alien, the transfer of property by the transferor ex-spouse will be subject to gain recognition. The nonresident alien recipient ex-spouse also should receive the transferred property with a stepped-up basis. Counsel for the U.S. transferor ex-spouse should consider negotiating with counsel for the nonresident alien ex-spouse to transfer property that has not significantly appreciated so as to minimize the amount of gain recognition subject to tax for the U.S. transferor ex-spouse. Counsel for a nonresident alien transferee ex-spouse should understand how the receipt of property will be taxed, if at all, in the nonresident alien transferee ex-spouse's home country and how he or she will be taxed in the U.S. and the home country on income earned or gains recognized from the operation or future disposition of the property received (including under any applicable U.S. tax treaty).
In the event the transferor is classified as a nonresident alien and the transferee/recipient is classified as a U.S. person for U.S. federal income tax purposes, the transfer of property will result in the U.S. transferee ex-spouse receiving the property with a carryover basis and possibly an underlying built-in gain. Counsel for the U.S. transferee ex-spouse should consider negotiating with counsel for the nonresident alien transferor ex-spouse to have the nonresident alien transferor ex-spouse engage in pre-transfer activity to step up the basis in the property being transferred in order to minimize the built-in gain in the property received by the U.S. transferee ex-spouse. More specifically, the nonresident alien transferor ex-spouse could contribute appreciated foreign real estate into a foreign eligible entity, and the U.S. transferee ex-spouse could check the box to treat the foreign eligible entity as a disregarded entity effective as of a date prior to U.S. transferee ex-spouse's receipt of the shares of that foreign eligible entity (with the consent of the nonresident alien transferor ex-spouse). Local tax laws applicable in the jurisdiction of the transferring ex-spouse do still need to be considered, as transfers to an entity prior to a transfer to an ex-spouse could be taxable in the transferor's home country.
The type of asset transferred also can result in additional tax to a nonresident alien transferor ex-spouse. Specifically, the transfer of a U.S. real property interest (USRPI) by a nonresident alien ex-spouse is subject to Foreign Investment in Real Property Tax Act (FIRPTA) withholding tax if the transferee ex-spouse is also a nonresident alien. In such case, the nonresident alien transferor ex-spouse will need to recognize gain on the disposition of a USRPI and the nonresident alien transferee ex-spouse will be requested to withhold 15 percent of the "amount realized." Often this withholding tax exposure is not identified and the burden will then fall on the nonresident alien transferee ex-spouse. However, in the event the transferee ex-spouse is a U.S. person, no withholding tax should be triggered as the transfer is effectively treated as a gift with a transferred basis.
U.S. Gift Tax Treatment of Property Transfers Resulting from Divorce
In addition to the U.S. federal income tax consequences that should be considered when transferring property as a result of divorce, the gift tax treatment of property transferred pursuant to a divorce settlement or agreement also must be considered. Generally, where a husband and wife enter into a written agreement relative to their marital and property rights (and divorce occurs within the three-year period beginning on the date one year before such agreement is entered into) any transfers of property or interests in property made pursuant to such agreement to either spouse in settlement of his or her marital or property rights or to provide a reasonable allowance for the support of children of the marriage during minority shall be deemed to be transfers made for full and adequate consideration in money or money's worth.
Essentially, so long as the requirements discussed above are met, a transfer of property pursuant to a divorce settlement or agreement will not be considered a taxable gift in the United States. In the event the requirements discussed above are not met, such transfer may be subject to U.S. federal gift tax and the transferor ex-spouse will have to utilize their lifetime unified credit exemption amount (if such ex-spouse is a U.S. citizen or U.S. domiciliary) or potentially pay U.S. federal gift tax (regardless of the tax residency of the transferor ex-spouse and the transferee ex-spouse) depending upon the type of property transferred (i.e., U.S. real estate or tangible personal property located in the United States).
Treatment of Grantor Trusts Post-Divorce (Repeal of I.R.C. §682)
In 2017, as part of the TCJA, Congress repealed I.R.C. § 682 and established that said Code section no longer applied to divorce agreements executed after Dec. 31, 2018. Accordingly, from 2019 forward, a grantor trust created for the benefit of an ex-spouse prior to the couple's divorce shall continue to be classified as a grantor trust for U.S. federal tax purposes. This causes the grantor/transferor ex-spouse to continue to be liable for the income tax on that trust's income going forward. Therefore, in drafting new trusts, decanting or deemed death of the beneficiary spouse on divorce clauses should be considered in order to protect from this harsh result. Once the ex-spouse is no longer considered a beneficiary (and provided the grantor is also not a beneficiary), the trust will generally become a non-grantor trust for U.S. federal income tax purposes and its own separate taxpayer.
If you have any questions about the topic or Holland & Knight's services, please contact the authors.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.