Matrimonial Planning Through Economic Turmoil

The markets are in turmoil. Tax, business, economic and, investment matters are increasingly uncertain. These developments affect every aspect of matrimonial planning and may continue to do so for years. Practitioners need to reevaluate all aspects of their planning. This article provides an overview of some of the points practitioners should consider.

Valuations

With the economy in a tailspin, valuation issues will come to the fore. Spouses owning business interests will argue that historical data are not fully relevant to current value in light of uncertainty, changes to the economy and so forth. In the extreme, it will be impossible to value a business using traditional historical data if the business is teetering on extinction (e.g., a mortgage brokerage business that the ex-spouse ran successfully for many years has now been reduced from a score of employees to just the ex-spouse working out of her basement). With the stock market declines and negative economic news coming in rapid spurts, the selection of a date to file ' and thereby establish a valuation date ' could have more importance than it has had in many decades.

Discounts

Discounts are a critical factor in valuations. A discount is simply illustrated as follows: Thirty percent of a $100 business is worth less than $30 because the minority interest is hard to market and has no control. Recent market turmoil may legitimately increase the discounts on certain asset valuations. To understand the impact, consider an approach of building up a capitalization rate for valuing real estate assets in today's environment: Corporate bond rate + Premium for lower liquidity of target asset as compared to bonds generally + Premium for greater management difficulty of real estate + Premium for unique difficulties of assets in question (location, difficulty to liquidate) + Premium for additional management burdens of residential real estate, vacancy and credit risks of tenants in the actual properties involved + Premium to reflect unique factors in 2008 = Total.

Capitalization Rate

Credit risks may be far greater than they have been in many years. Unique factors certainly exist in the current market. Higher discounts might be justified. Asset values may be depressed as a result of the greater discounts.

Prenuptial Agreements

Review client prenuptial agreements. The valuation of assets that formed the basis of a client's prenuptial agreement may have changed so dramatically as to undermine the entire basis for the agreement. One spouse may have had real estate assets that were pre-marital assets, and the other spouse may have had investment assets. Depending on the types of real estate and securities, the values that may have been equal upon signature may not be vastly different. Either spouse's assets may have their values largely intact while the others may have declined to nearly worthless. When negotiating future prenuptial agreements, perhaps the division of assets should be made contingent on the value or status of pre-marital property at a future date. The fact that one spouse had a $1 million immune interest in a family real estate business matters little if the marriage dissolves in the future when that business has no value. Perhaps in light of the tremendous uncertainty, specific parameters should be negotiated to address such contingencies.

529 Plans and Children's Trusts

It is common to establish 529 plans or trusts for children, especially when a couple is divorcing. Removing assets into a separate entity or plan can minimize the likelihood of the ex-couple feuding over decision-making (especially if an independent trustee is designated). However, tumultuous economic conditions raise a host of issues. Will the ex-couple realistically be able to continue their commitments to fund these college savings or other plans for the children in light of current economic developments? If one parent just lost half of his or her savings, are the contributions previously agreed to reasonable? What about the investment results for the plan or trust? If the assets weathered the recent market downturn poorly, were they invested appropriately considering the terms and objectives of the trust or plan, the circumstances, etc? If not, the trustee may be in violation of his or her duties under the Prudent Investor Act. This could provide a basis of removing the trustee.

Example: Your client and her ex-husband funded a 529 during the marriage for their child's college. The ex-husband was the account owner and demanded that he remain in such capacity. As account owner he made investment decisions. The results of the last six months have been nothing less than catastrophic for the fund. Should the ex-husband cede control to another in light of his devastating investment performance?

Debts

When times are good, clients tend to obsess over the division of assets. The recent economic crisis may change the dynamic to a greater focus on debts and liabilities. Recent developments could have an especially devastating impact on clients who fought bitterly to win control over a particular asset, only to realize a Pyrrhic victory. For example, your client fought and sacrificed to win the family home. Her perception that this asset would continue to appreciate was behind the fervor. Now, the mortgage is worth more than the reduced value of the house. What is the best way to handle the situation? An even more difficult situation exists where your client's ex-spouse has possession of the house or other asset, which is worth less then the mortgage or other debt associated with it, and your client remains co-liable with little control.

Lifestyle

How do you evaluate a married couple's lifestyle for purposes of determining expenses? The magnitude of the recent economic developments may have forever changed the standard of living the couple could continue in the future if they were not divorcing. Mandating that a payor spouse enable the payee spouse to maintain the lifestyle the couple enjoyed prior to the divorce and the recent economic tumult, may be impossible. However, who can forecast the likely permanence of these developments?

GRATs, Note Sale and Private Annuity Transactions

Grantor Retained Annuity Trusts (GRATs) are estate planning transactions that can take myriad forms, such as a sale of assets for a note to a defective grantor trust. In the context of a matrimonial action, if your client (or your client's ex-spouse to be) is a beneficiary of one of these transactions, you should evaluate the likely economics of a transaction structured when the market and economy were humming before expending significant time ' and client fees ' endeavoring to determine the impact on or relevance such separate assets may have to the establishment of alimony or child support. Many of these transactions will simply implode with the assets all being repaid in the form of note or annuity payments to the grantor ' not the client (or spouse). It may simply not be worth the legal battle to make any claim on interests that may never reach the intended remainder beneficiary.

Example: Mother set up a GRAT for the benefit of her daughter, your client's soon-to-be-ex-wife. Mother contributed assets valued at $2 million to the GRAT four years ago. The GRAT is intended to end in one year at which time her daughter, the ex-wife-to-be, will receive whatever assets remain in the GRAT at that time, outright and free of trust. Your client is divorcing. While the property is clearly immune gift assets of the ex-wife, should the income they will generate for her, beginning in one year when the GRAT ends, be immune? The recent stock market meltdown may have evaporated all of the growth the trust would have shifted to the daughter, obviating the need to expend resources pursuing the issue.

Business Contractions

With economic problems growing, your client might be inclined to contract his or her business or professional practice. Unfortunately, there are myriad issues and problems with this seemingly simple task that could make your expert's evaluation of the status of the business difficult and more dangerous.

People faced with cash needs, who have experienced dramatic portfolio declines, reductions in business revenues, etc. will undoubtedly draw funds out of closely held and family-controlled business entities with greater aggressiveness. The need for careful forensic analysis will increase.

The payment of loans from these same entities, to avoid payroll taxes and current income tax withholding, in order to fund current expenses will similarly increase.

When business was humming, marginal partners may have been profitable. If your client or the ex-spouse is a partner in a professional practice, is that position really assured? Since there may be no right under state law to remove a partner, the provisions of the partnership agreement are essential to consider. Therefore, start by reviewing all governing documents (employment agreement, shareholders' agreement, etc.). What do the agreements provide for? Is there a mechanism to force a buyout or termination? Has the situation eroded to a point where application of a “for cause” provision can be justified?

There is a “flip side” to the coin of your client or the ex-spouse potentially being terminated from a business or practice. If your client owns a business that has terminated employees because of the economic contraction, are there potential claims that should be considered in valuing that business interest for the matrimonial case? Remaining partners owe a fiduciary duty to the terminated partner. The violation of this duty is often cited as a cause of action. What are the demographics of the particular partner your client is seeking to terminate? Evaluate the risk that a terminated partner may claim age discrimination, or discrimination based on some other protected category. Terminated partners might also sue on the basis that the remaining partners violated their contractual obligations due the terminated partner. It might be necessary to consult with an employment attorney to evaluate the impact these claims may have on the business.

The fact that the terminated employee or partner accepted a severance payment and in return provided a release of claims to the business is not a guarantee against a lawsuit. If the employee was not afforded reasonable time to review the release, or if the release was dense legalese that was incomprehensible to the employee, it may not be effective. Some claims cannot be waived in a release signed by an employee, such as claims under the Fair Labor Standards Act (FLSA). An opinion of an employment attorney may be necessary.

Property and Casualty Insurance

People too often cut the wrong corners when they feel pinched, frequently including insurance. Advise your clients to have an insurance consultant review property, casualty, liability and other insurance coverage. If the clients dropped key insurance coverage (or perhaps the ex-spouse simply stopped paying without informing your client), a casualty could jeopardize the entire marital estate. Economic downturns require more vigilance with regard to insurance coverage.

Life Insurance

Insist on having your client's insurance program reviewed. How stable is the policy? If the client had a variable life policy, the underlying mutual funds may have been so decimated by the recent stock market collapse that the policy itself is in jeopardy. Is the insurance company safe? Without the underlying insurance analysis, the provisions you negotiate in the property settlement agreement mandating insurance coverage on the ex-spouse to protect your client may be worthless. Further, the agreement should mandate periodic reviews of the carriers and adequacy of policy performance and a reporting mechanism for your client to verify this. Even if the insurance company is stable today, if your client's coverage is provided by a carrier that becomes tomorrow's headline, the provision lacking follow-up monitoring could come back to haunt the draftsperson.

Even in rosy financial environments, it is advisable to review the financial status of the insurance company every couple of years and obtain an in-force illustration. Neither your client, nor the provisions you draft in a property settlement agreement, should assume that the insurance company on which your client is relying is safe.

Asset Allocation

You know the drill. Determine an optimal allocation and periodically rebalance the allocation when necessary. It is also pretty common knowledge that most divorces decimate any intelligent asset allocation. It is difficult enough to factor in the tax aspects of a settlement, let alone the investment considerations. Advise your client through the pendency of the divorce and following any final property settlement to monitor investment allocations carefully with a financial planner. The dramatic stock market declines in recent times, which occurred over very short time periods and continue, emphasize the dangerous dynamics involved. Clients cannot afford to defer investment allocations until the dust settles. What will be the consequences of a client holding marital investment assets that have declined by 50% between the date of the divorce and the date of settlement? At the very least, you should advise clients holding any marital assets to have their financial planner develop an investment policy statement (IPS) that documents an appropriate asset allocation under the circumstances (current market conditions, pending divorce, new post-divorce financial realities). With this type of document in hand, if the appropriateness of the investment plan is questioned, your client will have adhered to the same standards to which fiduciaries adhere.

Family Loans

Many family members will be helping other family members out with increasing frequency during these tough economic times. Consider the economics and value of such assets. Will they ever be repaid? Were they made with legitimate intent or as a means of encumbering otherwise accessible marital assets to protect them from the divorce? If the transactions were really loans, no gift tax return should have been filed, the loan should be evidenced by a written signed loan document with a stated interest rate and maturity date ' again, more work for your forensic accountant.

Conclusion

Negotiating most divorce settlements is challenging. Balancing the complex financial, emotional and other considerations is often a near miraculous feat for which practitioners rarely get the credit due them. The current economic turmoil, stock market and real estate market collapses, and tremendous uncertainty, will make the divorce process more difficult and complex. This article has outlined many of the ways that these developments impact the divorce and matrimonial process. The bottom line is that there are a multitude of new landmines to watch for; the services of forensic experts will become more important, and there are a host of new issues about which to caution your clients.

Martin M. Shenkman, CPA, MBA, PFS, JD, a member of this newsletter's Board of Editors, is an estate and tax practitioner and expert witness in Paramus, NJ. He provides a free planning newsletter that is available at www.laweasy.com.

The markets are in turmoil. Tax, business, economic and, investment matters are increasingly uncertain. These developments affect every aspect of matrimonial planning and may continue to do so for years. Practitioners need to reevaluate all aspects of their planning. This article provides an overview of some of the points practitioners should consider.

Valuations

With the economy in a tailspin, valuation issues will come to the fore. Spouses owning business interests will argue that historical data are not fully relevant to current value in light of uncertainty, changes to the economy and so forth. In the extreme, it will be impossible to value a business using traditional historical data if the business is teetering on extinction (e.g., a mortgage brokerage business that the ex-spouse ran successfully for many years has now been reduced from a score of employees to just the ex-spouse working out of her basement). With the stock market declines and negative economic news coming in rapid spurts, the selection of a date to file ' and thereby establish a valuation date ' could have more importance than it has had in many decades.

Discounts

Discounts are a critical factor in valuations. A discount is simply illustrated as follows: Thirty percent of a $100 business is worth less than $30 because the minority interest is hard to market and has no control. Recent market turmoil may legitimately increase the discounts on certain asset valuations. To understand the impact, consider an approach of building up a capitalization rate for valuing real estate assets in today's environment: Corporate bond rate + Premium for lower liquidity of target asset as compared to bonds generally + Premium for greater management difficulty of real estate + Premium for unique difficulties of assets in question (location, difficulty to liquidate) + Premium for additional management burdens of residential real estate, vacancy and credit risks of tenants in the actual properties involved + Premium to reflect unique factors in 2008 = Total.

Capitalization Rate

Credit risks may be far greater than they have been in many years. Unique factors certainly exist in the current market. Higher discounts might be justified. Asset values may be depressed as a result of the greater discounts.

Prenuptial Agreements

Review client prenuptial agreements. The valuation of assets that formed the basis of a client's prenuptial agreement may have changed so dramatically as to undermine the entire basis for the agreement. One spouse may have had real estate assets that were pre-marital assets, and the other spouse may have had investment assets. Depending on the types of real estate and securities, the values that may have been equal upon signature may not be vastly different. Either spouse's assets may have their values largely intact while the others may have declined to nearly worthless. When negotiating future prenuptial agreements, perhaps the division of assets should be made contingent on the value or status of pre-marital property at a future date. The fact that one spouse had a $1 million immune interest in a family real estate business matters little if the marriage dissolves in the future when that business has no value. Perhaps in light of the tremendous uncertainty, specific parameters should be negotiated to address such contingencies.

529 Plans and Children's Trusts

It is common to establish 529 plans or trusts for children, especially when a couple is divorcing. Removing assets into a separate entity or plan can minimize the likelihood of the ex-couple feuding over decision-making (especially if an independent trustee is designated). However, tumultuous economic conditions raise a host of issues. Will the ex-couple realistically be able to continue their commitments to fund these college savings or other plans for the children in light of current economic developments? If one parent just lost half of his or her savings, are the contributions previously agreed to reasonable? What about the investment results for the plan or trust? If the assets weathered the recent market downturn poorly, were they invested appropriately considering the terms and objectives of the trust or plan, the circumstances, etc? If not, the trustee may be in violation of his or her duties under the Prudent Investor Act. This could provide a basis of removing the trustee.

Example: Your client and her ex-husband funded a 529 during the marriage for their child's college. The ex-husband was the account owner and demanded that he remain in such capacity. As account owner he made investment decisions. The results of the last six months have been nothing less than catastrophic for the fund. Should the ex-husband cede control to another in light of his devastating investment performance?

Debts

When times are good, clients tend to obsess over the division of assets. The recent economic crisis may change the dynamic to a greater focus on debts and liabilities. Recent developments could have an especially devastating impact on clients who fought bitterly to win control over a particular asset, only to realize a Pyrrhic victory. For example, your client fought and sacrificed to win the family home. Her perception that this asset would continue to appreciate was behind the fervor. Now, the mortgage is worth more than the reduced value of the house. What is the best way to handle the situation? An even more difficult situation exists where your client's ex-spouse has possession of the house or other asset, which is worth less then the mortgage or other debt associated with it, and your client remains co-liable with little control.

Lifestyle

How do you evaluate a married couple's lifestyle for purposes of determining expenses? The magnitude of the recent economic developments may have forever changed the standard of living the couple could continue in the future if they were not divorcing. Mandating that a payor spouse enable the payee spouse to maintain the lifestyle the couple enjoyed prior to the divorce and the recent economic tumult, may be impossible. However, who can forecast the likely permanence of these developments?

GRATs, Note Sale and Private Annuity Transactions

Grantor Retained Annuity Trusts (GRATs) are estate planning transactions that can take myriad forms, such as a sale of assets for a note to a defective grantor trust. In the context of a matrimonial action, if your client (or your client's ex-spouse to be) is a beneficiary of one of these transactions, you should evaluate the likely economics of a transaction structured when the market and economy were humming before expending significant time ' and client fees ' endeavoring to determine the impact on or relevance such separate assets may have to the establishment of alimony or child support. Many of these transactions will simply implode with the assets all being repaid in the form of note or annuity payments to the grantor ' not the client (or spouse). It may simply not be worth the legal battle to make any claim on interests that may never reach the intended remainder beneficiary.

Example: Mother set up a GRAT for the benefit of her daughter, your client's soon-to-be-ex-wife. Mother contributed assets valued at $2 million to the GRAT four years ago. The GRAT is intended to end in one year at which time her daughter, the ex-wife-to-be, will receive whatever assets remain in the GRAT at that time, outright and free of trust. Your client is divorcing. While the property is clearly immune gift assets of the ex-wife, should the income they will generate for her, beginning in one year when the GRAT ends, be immune? The recent stock market meltdown may have evaporated all of the growth the trust would have shifted to the daughter, obviating the need to expend resources pursuing the issue.

Business Contractions

With economic problems growing, your client might be inclined to contract his or her business or professional practice. Unfortunately, there are myriad issues and problems with this seemingly simple task that could make your expert's evaluation of the status of the business difficult and more dangerous.

People faced with cash needs, who have experienced dramatic portfolio declines, reductions in business revenues, etc. will undoubtedly draw funds out of closely held and family-controlled business entities with greater aggressiveness. The need for careful forensic analysis will increase.

The payment of loans from these same entities, to avoid payroll taxes and current income tax withholding, in order to fund current expenses will similarly increase.

When business was humming, marginal partners may have been profitable. If your client or the ex-spouse is a partner in a professional practice, is that position really assured? Since there may be no right under state law to remove a partner, the provisions of the partnership agreement are essential to consider. Therefore, start by reviewing all governing documents (employment agreement, shareholders' agreement, etc.). What do the agreements provide for? Is there a mechanism to force a buyout or termination? Has the situation eroded to a point where application of a “for cause” provision can be justified?

There is a “flip side” to the coin of your client or the ex-spouse potentially being terminated from a business or practice. If your client owns a business that has terminated employees because of the economic contraction, are there potential claims that should be considered in valuing that business interest for the matrimonial case? Remaining partners owe a fiduciary duty to the terminated partner. The violation of this duty is often cited as a cause of action. What are the demographics of the particular partner your client is seeking to terminate? Evaluate the risk that a terminated partner may claim age discrimination, or discrimination based on some other protected category. Terminated partners might also sue on the basis that the remaining partners violated their contractual obligations due the terminated partner. It might be necessary to consult with an employment attorney to evaluate the impact these claims may have on the business.

The fact that the terminated employee or partner accepted a severance payment and in return provided a release of claims to the business is not a guarantee against a lawsuit. If the employee was not afforded reasonable time to review the release, or if the release was dense legalese that was incomprehensible to the employee, it may not be effective. Some claims cannot be waived in a release signed by an employee, such as claims under the Fair Labor Standards Act (FLSA). An opinion of an employment attorney may be necessary.

Property and Casualty Insurance

People too often cut the wrong corners when they feel pinched, frequently including insurance. Advise your clients to have an insurance consultant review property, casualty, liability and other insurance coverage. If the clients dropped key insurance coverage (or perhaps the ex-spouse simply stopped paying without informing your client), a casualty could jeopardize the entire marital estate. Economic downturns require more vigilance with regard to insurance coverage.

Life Insurance

Insist on having your client's insurance program reviewed. How stable is the policy? If the client had a variable life policy, the underlying mutual funds may have been so decimated by the recent stock market collapse that the policy itself is in jeopardy. Is the insurance company safe? Without the underlying insurance analysis, the provisions you negotiate in the property settlement agreement mandating insurance coverage on the ex-spouse to protect your client may be worthless. Further, the agreement should mandate periodic reviews of the carriers and adequacy of policy performance and a reporting mechanism for your client to verify this. Even if the insurance company is stable today, if your client's coverage is provided by a carrier that becomes tomorrow's headline, the provision lacking follow-up monitoring could come back to haunt the draftsperson.

Even in rosy financial environments, it is advisable to review the financial status of the insurance company every couple of years and obtain an in-force illustration. Neither your client, nor the provisions you draft in a property settlement agreement, should assume that the insurance company on which your client is relying is safe.

Asset Allocation

You know the drill. Determine an optimal allocation and periodically rebalance the allocation when necessary. It is also pretty common knowledge that most divorces decimate any intelligent asset allocation. It is difficult enough to factor in the tax aspects of a settlement, let alone the investment considerations. Advise your client through the pendency of the divorce and following any final property settlement to monitor investment allocations carefully with a financial planner. The dramatic stock market declines in recent times, which occurred over very short time periods and continue, emphasize the dangerous dynamics involved. Clients cannot afford to defer investment allocations until the dust settles. What will be the consequences of a client holding marital investment assets that have declined by 50% between the date of the divorce and the date of settlement? At the very least, you should advise clients holding any marital assets to have their financial planner develop an investment policy statement (IPS) that documents an appropriate asset allocation under the circumstances (current market conditions, pending divorce, new post-divorce financial realities). With this type of document in hand, if the appropriateness of the investment plan is questioned, your client will have adhered to the same standards to which fiduciaries adhere.

Family Loans

Many family members will be helping other family members out with increasing frequency during these tough economic times. Consider the economics and value of such assets. Will they ever be repaid? Were they made with legitimate intent or as a means of encumbering otherwise accessible marital assets to protect them from the divorce? If the transactions were really loans, no gift tax return should have been filed, the loan should be evidenced by a written signed loan document with a stated interest rate and maturity date ' again, more work for your forensic accountant.

Conclusion

Negotiating most divorce settlements is challenging. Balancing the complex financial, emotional and other considerations is often a near miraculous feat for which practitioners rarely get the credit due them. The current economic turmoil, stock market and real estate market collapses, and tremendous uncertainty, will make the divorce process more difficult and complex. This article has outlined many of the ways that these developments impact the divorce and matrimonial process. The bottom line is that there are a multitude of new landmines to watch for; the services of forensic experts will become more important, and there are a host of new issues about which to caution your clients.

Martin M. Shenkman, CPA, MBA, PFS, JD, a member of this newsletter's Board of Editors, is an estate and tax practitioner and expert witness in Paramus, NJ. He provides a free planning newsletter that is available at www.laweasy.com.