Trusts, Buy-Sells, Prenups: A Rubik’s Cube Of Traps And Worries
Martin Shenkman Contributor Forbes.com
Your estate planning, including business buy-sell arrangements, trusts, prenups, are all intertwined, and all affected by the 2017 Tax Act, often in surprising and odd ways. It is not enough to maximize your 199A business deduction unless you also consider and address how that might affect your estate plan and prenuptial agreement. So often it is the indirect and unexpected ripple effects of tax changes and new planning techniques that create the opportunities or headaches. Just like with the Rubik’s cube, you turn one block, and undesirable changes occur on the other side. What are some of the unexpected traps and planning options that might be important to you?
The 2017 Tax Act flipped the historic tax treatment of alimony (payor deducts, payee reports as income). If you divorce after 2018 alimony you pay won’t be deductible. Can you salvage any tax benefit? If you’re on the edge of wrapping up a divorce, perhaps you can conclude a sufficient agreement before New Year’s to secure a valuable tax benefit.
If you can’t wrap up your divorce before the ball drops in Times Square there might be an option to indirectly garner an equivalent benefit to deductible alimony. Consider giving your ex-spouse a slice of your retirement plan using a qualified domestic relations order (QDRO). If you transfer a retirement plan to your ex-spouse, and the ex then takes distributions from the plan or the IRA, the ex, not you, reports the income to the IRS. That has the same effect as if you had gotten a deduction for paying alimony! But before you let the tax tail wag your QDRO-dog consider that you are giving up an asset that has tax deferral and asset protection benefits. Also, carefully consider what estate planning provisions you might have made for that qualified plan. You might have had it paid on death to a special trust designed to preserve income tax treatment. If that trust is no longer needed you might eliminate it the next time you restate the revocable trust that included it (or if it was a separate independent trust perhaps it should be terminated).
There has been much talk about the new Code Section 199A 20% deduction for certain business income, but that tax benefit might have surprising implications to your prenuptial agreement. 199A provides a new 20% deduction for qualified business income (QBI) for flow-through entities not tainted as specified service trades or businesses (SSTBs). The quirky wage requirements might have your CPA suggest restructuring some portion of the income that might have been distributed into wages to maximize that benefit. Well, that might enhance your 20% deduction but what about matrimonial considerations? If you restructure business operation to increase wages that otherwise might have been earnings that may change the characterization of the income under a premarital agreement. If your prenup says that income from separate property (e.g. a rental property you inherited) remains separate, but earnings during the marriage are deemed marital property, you might have transformed separate assets that would be immune from divorce into a property that might be subject to division if you divorce. Before restructuring operating to maximize new 199A benefits, consider all the possible ramifications (including that the 199A deduction might disappear in 2026). So, before you head down the path of restructuring investment and business operations to get a temporary 20% tax benefit, review the proposed changes with your matrimonial attorney to see if those risks might outweigh the potential benefits. For more background on prenuptial agreements and trusts click here. You might modify or amend your prenuptial agreement to avoid those issues. But be careful with that step too. Not all states treat a modification of a prenuptial during the marriage with the same respect as a prenup done well before the marriage.
All the above planning has a myriad of implications for estate planning. If you change the nature or structure of investment and business operations considering the new 199A deduction, and perhaps in a manner that does not negatively impact your prenup, consider: What is the impact on buy-sell agreements. These are the legal arrangements as to what happens with a business or entity interest in the event of death, disability, and other events. If you change the wage structure that may wreak havoc with the formulas the governing documents contain for a buyout. For example, you own ½ a closely held business S-corporation with an unrelated partner. You increase the salaries you are taking to enhance the 199A benefit. What if your shareholders’ agreement includes a buyout provision on death based on a formula applied to last year’s profits. If the salary increase to you and your partner benefits you in terms of 199A deductions, what impact might that have on the buyout formula? All these implications should be reviewed and buy out agreements amended as appropriate.
I am an estate planning attorney, author of 42 books, and more than 1,200 articles. I serve on the editorial boards of Trusts & Estates Magazine, CCH (Wolters Kluwer) Professional Advisory Board, CPA Magazine, and the CPA Journal. I’m active in many charitable and community organizations.
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