Forensic Accounting Perspectives : New York Business Valuation, Divorce, Business Disputes, Shareholder Disputes, Litigation Support & Accounting Forensics in Connecticut, New York & New Jersey

December is an exciting month for sports fans, particularly New York sports fans. The area’s football teams are both bidding for playoff berths; basketball and hockey fans are settling in with mixed feelings about their team’s early performance; and major league baseball’s “hot stove” league is a buzz with the potential of free agent signings.

This year’s biggest baseball free agent star is pitcher Cliff Lee. And to no surprise the New York Yankees are among the few teams bidding for his affection. The Angels, Rangers, and Yankees have all reportedly “pitched” Cliff Lee and have offered him a king’s ransom to play for their team. 

Each of the three teams courting Mr. Lee has something different to offer. California has beautiful weather; Texas has no state income tax; and New York has an opportunity to earn millions of dollars above a baseball contract in endorsements and sponsorships. There is little doubt that in addition to his agent, family, and friends Mr. Lee is getting plenty of advice from a variety of marketing, legal, and tax professionals.

Even though I have not been asked, I thought I would give my two cents to Mr. Lee’s quandary. Cliff, stay away from New York. It could be your financial ruin.

Assume Cliff Lee signs with the Yankees for seven years at $25 million per year and contracts for an additional $5 million per year for marketing. It doesn’t take a forensic accountant to compute that during the next seven years he will earn $210 million.   But suppose Lee, A-Rod, and Jeter go out one night to celebrate a big win over their arch rivals, the Boston Red Sox. We all know that Alex Rodriguez and Derek Jeter are magnets for beautiful women. And just suppose Cliff Lee decides shortly thereafter that he would be happier living as a bachelor in New York City. Unlike any other state in the union, New York State provides equitable distribution for the enhanced earnings capacity acquired during marriage; a concept that the future ex-Mrs. Lee will shortly learn.

The enhanced earnings capacity (commonly referred to as EEC) is computed as the present value of the enhancement in earnings over an expected work life. In Lee’s case, this expectancy would extend over the next seven years of his new contract and may proceed for many years thereafter, if he should be fortunate enough to become a coach, commentator, or television analyst after his playing days are over.

The approach to calculating the enhanced earnings capacity in New York State was established in 1985 as a result of a New York Appellate Court’s decision in O’Brien v. O’Brien. This concept was later reaffirmed in 1995 in the New York Court’s decision in McSparron v. McSparron; as well as many other cases that followed. The methodology employed to this calculationspecific to Cliff Lee can be broken down into five steps:

1. Determine Cliff Lee’s earnings capacity at the commencement of the hypothetical divorce action, resulting from signing with the NY Yankees. This is referred to as Top-Line Earnings.
2. Determine Cliff Lee’s earnings capacity if he had not become a baseball phenom and continued the career path chosen at the time of marriage. This is referred to as Base-Line Earnings.
3. Compute the after-tax earnings of the Top-Line and Base-Line amounts by applying federal, state and local income tax rates, as well as the social security and medicare tax.
4. The difference between the net after-tax earnings of each earnings base is the net enhanced earnings capacity attributable to his record setting contract.
5. Compute the present value of the net enhanced earnings capacity over his NY Yankee contract.

For illustrative purposes, let’s assume that Cliff Lee had a bachelor’s degree at the time of marriage. Let’s further assume that a white male with a bachelor’s degree, living in New York City at Mr. Lee’s current age would earn $125,000 per year. This is the amount considered as a proxy for Base-Line earnings.

The following table illustrates the after-tax earnings of both the Top-line and Base-Line amounts; as well as the annual net enhanced earnings capacity.

A present value discount rate is designed to reflect the value of money in a relatively risk free investment. Economists, financial analysts and accountants generally agree that the real rate of interest is between 2% and 4%. The courts have historically accepted 3% as the present value factor applied in this computation; but in recent cases have considered rates between 5% and 10%. The present value discount rate is very important. As the present value discount factor increases, the total enhanced earnings computation decreases.

Based upon these computations, the enhanced earnings capacity attributed to Cliff Lee’s potential seven year contract with the NY Yankees is $102 Million (Rounded). The following table illustrates this computation.

Since New York is an equitable distribution State, a portion of this amount would belong to his soon to be ex-wife. In some instances the courts have awarded as much as a 50% share and in others as little as 10%.

As you can imagine, there are a variety of things Cliff Lee has to consider when deciding which mound to call home next year. Will he flourish in the California sun; the familiarity of Texas home cooking; or the cement jungle of New York City. Only time will tell. But what we do know is this – getting divorced in New York State after signing a record setting free agent contract could be more painful than losing in the World Series to the San Francisco Giants.

For more information about the computation and application of the enhanced earnings capacity calculation, including our Enhanced Earnings Capacity Questionnaire, please visit our website.

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There may be no glory in being a family law attorney these days, especially when it comes to dealing with the often challenging economic consequences in a divorce action.

Clients may initially contact you with one issue related to their potential divorce, but often these concerns can quickly manifest as emotions and pressures begin to develop.

Perhaps the questions attorneys resist the most or feel least comfortable in answering pertain to divorce-related tax matters. Many individuals, including those contemplating divorce, will be reaching out to you for answers to a variety of tax-related divorce questions. So, this may be the best time to revisit some of the questions you may be faced with.

Here are ten divorce-related tax issues that all matrimonial and family law attorneys should know.

1.       Taxability of Assets Distributed Incident to Divorce

In many instances one of the most disputed issues in a divorce is the distribution of the marital assets. This is commonly referred to as “equitable distribution” or “ED”. Under the Internal Revenue Code (IRC) Section 1041 (a), no gain or loss is recognized on the transfer (acquisition or distribution) incident to divorce provided such transfer occurs within one year after the divorce or related to the ending of the marriage. 

The ending of the marriage is defined pursuant to a divorce or separation agreement and occurs within six years after the date on which the marriage ended. 

Practice Tip: Often, one of the most significant marital assets is the marital residence and/or a business. The values of these assets should be appraised by an independent credentialed valuation expert in the early stages of the divorce proceeding.

2.       Tax Deductibility of Professional Fees

Legal and other professional fees related to getting a divorce are generally not tax deductible. These non-deductible costs include expenses related in arriving at financial settlements and retaining income-producing property. However, some legal and accounting expenses can be deducted as a miscellaneous itemized deduction, subject to the 2% limitation (and also as a preference for alternative minimum tax purposes). Here is a short list of some of these exceptions:

• Fees related to tax advice related to a divorce,
• Fees to determine or collect alimony,
• Fees to determine estate tax consequences of property settlements, and
•  Appraisal and actuary fees to determine tax liabilities or to assist in obtaining alimony

Practice Tip: When your client retains an accounting/tax professional ask them to prepare their invoices with specific descriptions so that the tax deductible portion of their charges can be easily determined.

3.       Alimony v. Child Support

In simple terms, alimony is taxable to the recipient and deductible by the payer. To qualify as alimony under IRC Section 71(b) the payments must meet the following requirements:

• Payments are required under a written divorce or separation agreement,
• The payment cannot be designated as “not alimony”,
• Spouses may not be members of the same household,
•  Payments may not be treated as child support,
•  Payments must cease upon death of recipient, and
•  The parties cannot file a joint tax return

Child Support is never taxable, and there are a few other common payments that do not qualify as alimony, such as:

• Non-cash transfers,
• Payments for use of property, and
• Payments to keep up the payer’s property

In addition, an often neglected issue pertains to the short-fall of child support obligations. When an individual is obligated to pay (both) alimony and child support, payments are first applied to satisfy child support obligations and then to alimony. In other words, child support obligations must be fully satisfied before any amount of alimony is considered deductible.

Practice Tip: When structuring alimony agreements one should be conscious of the possible applicable alimony recapture rules. If there is a decrease or termination of alimony during the first three calendar years, recapture rules apply if the alimony in the second or third calendar year is $15,000 less than in the prior year. The recapture provision may be initiated by one or more of the following:

• Failure to make timely payments,
• Change in divorce or separation agreement,
• Reduction in spouse support needs, and
• Reduction in payers ability to provide support

4.       Sale of Personal Residence

If you live in your “Principal Residence” for any two of the last five years you are eligible for a capital gain exclusion upon the sale of the home. This exclusion is $250,000 for a single taxpayer and $500,000 for a married couple. Because of the significant difference in tax treatment, the tax consequences related to the sale of the marital home should be considered early on in the divorce settlement negotiations.

Practice Tip: If the sale of the marital residence is contemplated, consider the transaction prior to the termination of the marriage in order to take advantage the higher exclusion amount in order to secure more proceeds from the sale.

5.       Filing Status

An individual’s marital status is determined as of the last day of the calendar year – December 31^st. Married individuals can file jointly or married filing separate. When the parties file jointly each is jointly liable for the tax obligation, regardless of what a divorce instrument may say. 

The married filing separate status is the highest tax rate. When spouses file separate returns they both must utilize the standard or itemized deductions. The first one to file establishes the requirements for the other to follow. When married individuals file their tax returns separately we often find other critical issues being considered. 

If an individual is divorced as of December 31^st, even if married and living together with their ex-spouse sometime during the year, they must file as a single taxpayer or head of household for that year.

For those that are still married at the end of the year but were legally separated on December 31^st or have not lived with their spouse for the last six months of the year – they may be able to file as head of household. This filing status is attractive because the tax rates are significantly less than for those filing as married filing separate. 

To file head of household a number of requirements must be met:

• The individual must have paid more than half of the cost of keeping a home for a child or other qualifying person,
•  This individual is entitled to claim the qualifying person as a tax exemption, and
•   The qualifying person must have lived in the individual’s home for more than half the year

Practice Tip: Income Tax projections utilizing different scenarios are an often neglected but valuable planning tool. This exercise should be performed for years before and after the termination of the marriage.

6.       Children/Dependents Personal Exemptions

Generally, the custodial parent is entitled to the dependency exemption as long as the parents (individually or together) provide at least one-half of the dependents support. However, there are two exceptions to this general rule:

•  When the custodial parent relinquishes the rights to the exemption, or
•   When a multiple support agreement is established

Practice Tip: Dependent exemptions often vary by agreement. When preparing these arrangements make sure you consider the age of the child/dependent and the taxable income of each parent.

7.       Deductibility of Mortgage Interest & Real Estate Taxes

When a couples’ principal residence is jointly owned and the mortgage interest and real estate taxes are paid from a joint account there is a presumption that these payments are attributed to each party on a 50/50 basis. 

However, when a home is jointly owned and these payments are paid directly by the non-occupant spouse, half of the mortgage interest and real estate taxes is deductible to the paying spouse as an itemized deduction and the remainder qualifies as alimony. The occupying spouse must report these amounts as income (alimony) but is able to deduct the interest and taxes as an itemized deduction.

If the home is owned only by the occupying spouse but the non-occupying spouse is still obligated on the mortgage, the non-occupying spouse can only deduct the mortgage interest if a minor child of the marriage resides in the home. The non-occupying spouse cannot deduct any of the real estate taxes, since he or she has no ownership in the property.

Alternatively, if the non-occupying spouse solely owns the house and pays the mortgage interest and real estate taxes then those amounts can be deducted in their entirety as an itemized deduction. The occupying spouse would not have to report these amounts as alimony.

Practice Tip: Don’t assume that the marital residence is jointly owned by each the husband and wife. Inquire as to who owns the property and who is obligated on the primary and secondary mortgages.

8.       IRA’s and Retirement Plans

A Qualified Domestic Relations Order (QDRO) is a useful tool to designate a portion of a qualified retirement plan to the other spouse. This vehicle allows the distribution of the marital asset without damaging the integrity of the plan or the creation of a taxable event. Benefits are taxed when distributions are made, not when the QDRO is established. QDRO’s do not apply to Individual Retirement Accounts (IRA’s); however, IRA’s transferred pursuant to a divorce or separation agreement is not a taxable event.

Practice Tip: The use of a QDRO is an accessible tool to facilitate the equitable distribution of assets when there are limited liquid assets.

9.       Stock Option & Deferred Compensation Plans

The transfer of an interest in a non-statutory stock option or a non-qualified deferred compensation plan incident to a divorce is not a taxable event. However, income is reported when the former spouse exercises the stock options or when the deferred compensation is paid (or made available).

Practice Tip: Stock option & deferred compensation plans can be identified within employment contracts and/or annual wage reporting statements. Obtain the periodic statements (monthly, quarterly, annual, etc.) for your file.

10.   Innocent Spouse Relief

There are currently three sections of Internal Revenue Code that provide relief from tax liability to spouses:

• Innocent Spouse (IRC Section 6015 (b)),
• Separation of Liability (IRC Section 6015 (c)), and
• Equitable Relief (IRC Section 6015 (f))
• When applicable, the courts have considered the following factors to determine their applicability:
• Knowledge,
• Economic hardship,
• Benefit,
• Compliance with tax laws,
• Tax liability attributed to non-requesting spouse,
• Marital status, and
• Spousal abuse

Practice Tip: If you plan to invoke the innocent spouse rule prepare your argument by addressing as many of the above factors discussed above. IRS Form 8857, Request for Innocent Spouse Relief, is filed separately, not with the couples’ individual income tax returns.

We hope this brief summary is of value to you and your practice. Your questions or comments regarding this information are always welcome.  

For additional timely information to assist your family law and matrimonial law practice please feel free to visit our website www.msgcpa@msgcpa.com, or call our offices.

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Over on New Jersey Family Legal Blog, I saw a post that editor Eric Solotoff, a family law attorney at Fox Rothschild wrote that struck my interest.

Upon reading the post, Madoff Mess Hits Divorce Court, I knew I had to sit down with Eric for a podcast, to discuss what all this means in respect to forensic accounting.

For context, Justice Saralee Evans in Manhattan recently decided on a case regarding a divorcing spouse who attempted to revise his agreement with his wife.

First, some background for our readers who may not be that familiar with the case:

After thirty years of marriage, a husband and his ex-wife spent nearly two years debating the value of their home in Scarsdale, The husband's law partnership, and their Manhattan apartment. The two agreed on at least one thing: an account they opened during their marriage with Bernard Madoff Investment Securities LLC was worth $5.4 million.

As part of a 2006 equitable distribution agreement, the husband claimed he paid his wife some $2.7 million, which represented what he thought was his ex-wife's fair share of their investments with Madoff. But after Madoff's arrest in December 2008, the husband attempted to redo the agreement, claiming it was based on a "material, mutual mistake" and resulted in a windfall for his ex-wife.

After the husband learned that he and his wife had "been tricked by a sophisticated fraudster," he sought to reform the divorce agreement. The husband claimed the agreement did not accomplish the parties' goal of ensuring that each would keep approximately half of the marital assets.

The husband alleged that because the Madoff account turned out to be valueless, the spirit of the agreement was broken. But according to Justice Evans, there was no evidence that defendant was unjustly enriched.

Justice Evans last December held that while the husband's decision to hold on to the Madoff account may have been "improvident," that did not give the Court an equitable basis to set the agreement aside. In dismissing the suit, Justice Evans wrote, "There is no evidence that defendant was unjustly enriched. In 2006, at the time of their agreement, each of the parties received the benefit of his or her bargain."

Justice Evans rejected the husband's argument that the mutual releases of both parties signed as part of their divorce agreement were based on a mutual mistake. The husband had liquidated part of his Madoff investment to fund his wife's equitable entitlement. So in 2006, and several years after, that the husband maintained this investment, the account could have been redeemed for cash, presumably in excess of its 2004 value. The wife's attorneys said Justice Evans' ruling underscored the importance of ensuring that both sides in a divorce agreement waive future claims against each other.

The lesson of this case is that clients and their divorce attorneys should be very careful in fashioning settlement agreements. Even when significant mistakes are made at the time the agreements are entered into, it's very difficult to set them aside--even in such extreme circumstances as being a victim of a historic scam.

To learn more about this decision please listen to our podcast with Eric.

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