The Prenuptial Agreement - Tax Consequences
It is essential that the parties entering into an agreement be advised of tax ramifications of property transfers made pursuant to the agreement, and that the agreement be examined from time to time to be sure that the results are reflected in the current tax law.
While merely executing a prenuptial agreement usually does not result in any immediate tax consequences, taxes will become an issue later upon divorce or death for all transfers made prior to the marriage, during the marriage, and upon the cessation of the marriage.
Prior To and During Marriage
Since the issue in a prenuptial agreement is to transfer property rights in exchange for release of marital rights or against a will, the tax consequences will depend on when the transfer takes place. Generally, property transfers made before the marriage may have adverse income and gift tax results, while they will not incur gift tax or income tax if made during the marriage. Therefore, the prenuptial agreement should stipulate that any transfer of property occur after the wedding.
Prior to the enactment of Sec. 1041, the Supreme Court ruled that the transferor recognized gain for income tax purposes equal to the difference between the fair market value of the property transferred and its adjusted basis when such property is transferred in exchange for the release of property rights. No income tax was recognized by the party who released the marital rights, as both the IRS and the courts have held that for income tax purposes, the value of marital rights is equal to the value of the property received. However, for estate and gift tax purposes, marital rights are not considered full and adequate consideration, and consequently, the transfer of property is treated as a gift (Sec. 2043(b); Reg. Sec. 25.2512-8).
Sec. 1041 was entered to override the court's decision to tax the gain on property transferred between spouses and former spouses when the transfer is made incident to divorce. Transfers within six years after divorce that are pursuant to the terms of a divorce decree are deemed to be incident to divorce. A transfer between prospective spouses, however, is still treated as a sale and the transferor will recognize gain if the value of the property exceeds his or her adjusted basis.
For example, a man and woman are contemplating marriage. She has substantial assets she wishes to protect in the event of divorce or death; therefore, she and her fiance execute a prenuptial agreement that allows her to transfer $250,000 to him in exchange for his release of all marital claims against any of her property in the event of divorce or death. One month before the wedding, she transfers stock worth $250,000 to him. Since she had purchased the stock several years ago for $50,000, the transfer of the stock causes her to have a taxable gain for income tax purposes of $200,000. In addition, she has made a gift (subject to the gift tax rules) of $250,000 and his basis in the stock is $250,000.
If the transfer of the stock had occurred after the wedding, then she would have not recognized gain on the transfer, as Sec. 1041(a) provides that property transfers between spouses do not result in recognition of gain or loss. Neither would she have been subject to gift tax because Sec. 2523(a) provides for an unlimited marital deduction for gifts between spouses. Therefore, the prenuptial agreement should provide for property transfers to occur after the wedding.
If terms of the prenuptial agreement provide for a series of payments by one spouse in return for the other spouse's release against the transferor's assets in the event of divorce or death, then no income or gift tax consequences result as long as the couple is married during the entire stream of payments. If the couple divorces before the last payment, remaining payments may constitute gifts made outside marriage.
After Cessation of the Marriage
If the marriage ends in divorce, the prenuptial agreement often spells out the property rights and obligations of both parties. Property transfers between former spouses pursuant to a prenuptial agreement are classified as property settlements, alimony, or child support. Alimony is taxable to the recipient and deductible by the payor, but property settlements and child support are neither taxable to the recipient nor deductible by the payor.
Alimony is objectively defined because the payor spouse benefits from payments being classified as alimony, while the payee spouse benefits from payments being classified as either child support or a property settlement, for federal income tax purposes. All payments meeting the seven objective criteria are classified as alimony payments, regardless of the parties' intent, even if the payments do not satisfy the payor's support obligation under state law. Similarly, payments that do not meet the objective criteria for alimony for tax purposes are not deductible to the payor, even if such payments qualify as alimony under state law or the parties intend for them to qualify as alimony.
To be deductible for tax purposes, alimony payments must meet the seven objective criteria provided in IRC Sec. 71. Payments that do not meet these criteria are recharacterized as either child support or a property settlement. Consequently, if the parties wish to have certain payments qualify as alimony, it is essential that the terms of the prenuptial agreement be structured so all criteria are satisfied. Each of the objective criteria is provided below.
1. Payments must be made in cash.
2. Payments must be received by or on behalf of a spouse under a divorce or separation instrument. Further, if the parties have entered into a prenuptial agreement providing for the support of either spouse, and the divorce decree or written separation instrument refers to the prenuptial agreement for the determination of alimony, then the prenuptial agreement will be treated as pursuant to a divorce instrument.
3. The payor's obligation to make payments must end with the death of the payee spouse.
4. The instrument must not specifically designate that the payments are not alimony.
5. The filing of a joint tax return is prohibited.
6. In the case of legally separated spouses, the payor and payee spouses must not be members of the same household at the time of the payment.
7. Payments cannot be fixed as child support or treated as fixed as child support.
Keep each of the seven criteria in mind when reviewing the tax consequences of the terms provided in a prenuptial agreement. Some of the common problems encountered causing alimony payments to be classified as a property settlement for tax purposes are discussed below.
First, non-cash spousal support payments made pursuant to the terms of a prenuptial agreement, even those that satisfy the payor's obligation for alimony under state law, are not deductible. The prenuptial agreement should specify that all alimony is to be paid in cash.
Second, the terms of the prenuptial agreement should be structured so the payor spouse has no obligation to make any payments after the payee spouse's death. If such payments are permitted to occur, then none of the payments, even those made before the death of the payee spouse, qualify as alimony.
For example, the husband is required to pay his wife $20,000 per year for 15 years or until her death, whichever is earlier. The agreement also provides that if she dies before the end of 15 years, he will pay her estate the difference between the $300,000 that she would have received over the 15 years, less the amount that she actually received. The fact that he is required to make a lump sum payment to hwe estate upon her death suggests all payments are a substitute for a $300,000 lump sum payment. Consequently, none of the annual $20,000 payments qualify as alimony.
When the prenuptial agreement does not address this issue, state law determines whether the payee spouse has any continuing obligation to make payments. In most states, support payments automatically cease upon the payee's death; however, it is possible for payments that were not classified as alimony, for state purposes, to have qualified as alimony for federal income tax purposes. Such payments would not cease upon the payee's death and all payments, even those made before the payee's death, would be recharacterized as property settlements. To ensure that payments are characterized as alimony for federal income tax purposes, the prenuptial agreement should contain a formal statement that the obligation to make payments terminates at the recipient spouse's death.
Third, if the parties wish to treat cash payments as something other than alimony, the prenuptial agreement must state which payments the parties do not want treated as alimony. For federal income tax purposes, all payments that qualify as alimony will be treated as such unless the payments are specifically designated as child support or a property settlement. It is a good idea for the prenuptial agreement to contain a provision that allows the spouses to change the designation of those payments from non-alimony to alimony in future years. This gives the parties some flexibility in case the circumstances of the parties change in future years.
Finally, the terms of the prenuptial agreement should be structured to avoid any language that could be construed as representing child support. If it is possible to determine, by reference to the prenuptial agreement, what portion of a payment was intended as child support, then that portion of the payment will be treated as child support and only the remainder will be considered alimony. Payments are treated as child support to the extent that they are subject to reduction on the happening of a contingency specified in the instrument relating to the child; or at a time that can be clearly associated with a contingency related to the child.
Contingencies relating to a child include, but are not limited to, the child attaining a specific age or income level; the child marrying, dying, or gaining employment, and the child leaving school or the spouse's household Reg. Sec. 1.71-1T(c), Q&A-17. A payment reduction associated with a contingency with respect to a child is a much more ambiguous standard and depends on an analysis of the facts and circumstances of the situation. See Reg. Sec. 1.71-1T(c), Q&A-18, for specific instances that are deemed to be associated with a contingency with respect to a child.
Example: Scott agrees to pay Debbie $2,000 per month until she dies. Debbie has custody of their child, Eric. The agreement states that upon Eric attaining the age of 16, the monthly payment will be reduced to $1,200. Of each $2,000 payment, $1,200 is alimony and the remaining $800 is treated as child support.
Alimony Recapture. Payments that would otherwise qualify as alimony that decreases rapidly in the first three years following separation or divorce, may be recharacterized as a property settlement. After the terms of the prenuptial agreement have been analyzed to determine which payments qualify as alimony for tax purposes, it is necessary to check whether the alimony recapture provisions apply. Recapture does not apply to payments reduced due to death of either spouse; the remarriage of the payee spouse where payments cease under the terms of the divorce decree; temporary support payments; or fluctuating payments from a pre- existing formula (e.g., percentage of gross income from a business), when the formula is fixed under the terms of the divorce or separation instrument and is effective for at least three years.
If the recapture rules apply, then before signing the prenuptial agreement the parties need to revise the terms of the agreement so payments are not subject to alimony recapture. Payments recharacterized under the alimony recapture rules become income to the payor spouse and a deduction to the recipient spouse.
Alimony recapture, if applicable, occurs in the third post-separation year and is the sum of the excess payments made in both the first and second post-separation years. The second-year excess payment is determined first and is calculated as the amount by which the second year's payment exceeds the third-year payment plus $15,000. The first- year excess payment is then calculated as being the amount by which the first-year payment exceeds the average of the adjusted payments from the second year and the payments from the third year, plus $15,000.
The recapture rules apply only to excess payments made in the first three post-separation years. Consequently, payments made after the third year may be reduced without recapture. Payments increasing from year to year do not trigger recapture.
Property Settlements. When the parties intend to use a prenuptial agreement to designate each spouse's property rights and obligations in the event of divorce and want to ensure that all transfers made after divorce avoid both income and gift tax, the prenuptial agreement should include a provision that makes all payments conditional on their being included as part of the divorce decree. Sec. 1041 provides that no gain or loss is recognized for income tax purposes on the transfer of property incident to divorce and that such transfers are treated as gifts. In situations where there is nonresident alien spouse, extreme caution is necessary as the benefits of Sec. 1041 are sharply curtailed Sec. 1041(d).
The code also states that transfers occurring within one year after the cessation of marriage are deemed to be incident to divorce, and the regulations provide that transfers made within six years after a divorce are deemed to be incident to divorce, only if the transfers are made pursuant to the terms of the divorce or separation instrument Reg. Sec. 1.71-1T(b), Q&A-7.
Child Support. If the parties intend for certain payments to qualify as child support, rather than alimony, then the amount of the payment constituting child support should be specifically stated in the terms of the agreement. In situations where payments are reduced in violation of the terms of the agreement (i.e., the payor spouse is delinquent), payments are first treated as child support payments before any alimony income is reported by the recipient.14
Example: Under terms of the separation agreement, Jack is required to pay Lisa $1,000 per month, $600 of which is designated in the agreement as support for their minor child. If Jack only pays Lisa $9,000 during 1992, then $7,200 will be considered child support and the remaining $1,800 will qualify as alimony.
In situations where the prenuptial agreement requires a specific payment for both alimony and child support without separately stating the amount of each, the entire payment will be treated as alimony.
Example: Hal agrees to pay Wanda $600 per month until she dies. Wanda has custody of their child, Chris. The agreement states that as long as Hal continues to make monthly payments to Wanda, he is relieved of all support obligations for Chris. Even if Wanda can show that the entire amount was used to support Chris, the entire $600 qualifies as alimony since it cannot be determined from the agreement how much of each payment is for child support.
In the Event of Death
When a prenuptial agreement takes effect due to the death of a spouse, the property is included in the decedent's gross estate and the recipient spouse takes a basis in the property equal to its fair market value Sec. 2043(b). As previously discussed, most states give the surviving spouse the right to elect against what was provided in the will and instead takes a set percentage of the deceased spouse's assets. This problem is eliminated when the parties address the issue in an enforceable prenuptial agreement.
Example: Richard and Molly are contemplating marriage. Richard, who was previously married, has accumulated a considerable amount of wealth that he wishes to leave to his children. Richard and Molly enter into a prenuptial agreement wherein Molly agrees to waive any claims against Richard's assets upon his death. In return, Richard agrees to transfer, at the time of his death, a percentage of his assets into trust with the income to go to Molly for the remainder of her life and the property to go to his children upon her death. The remainder of Richard's estate goes directly to his children. In the event of Richard's death, Molly would be unable to elect against the will provisions and the executor of Richard's estate could elect to treat the trust as a QTIP trust, since the property in the trust is qualified terminable interest property and Molly is entitled to the income from the property for life. Thus, the estate would receive a marital deduction for the value of the trust assets Sec. 2056(b)(7).
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