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Addressing Estate and Gift Tax Issues in a Prenup or Divorce

Published: June 11, 2015 in the NJ Law Journal

By: Catherine Romania and Tara Sinha

It is well settled that trial courts have discretionary authority to compel parties in divorce proceedings to file joint income tax returns. However, the marital relationship can have implications with respect to other types of tax returns, such as estate and gift tax returns. While many state courts, including New Jersey courts, have addressed the filing of income tax returns in divorce situations, similar authority does not exist with respect to the filing of gift tax returns.

In Bursztyn v. Bursztyn, 379 N.J. Super. 385 (App. Div. 2005), the court held that the trial courts have discretionary authority to compel parties in divorce proceedings to file joint income tax returns. Whether to do so in a given case will depend on the facts. Moreover, trial courts should avoid ordering the parties to execute joint income tax returns because of: (i) the potential liability to which either party could be exposed; and (ii) the ability to compensate a party for the adverse tax consequences resulting from the insistence of one party on filing separately.

In Bursztyn, the trial court's decision to compel the wife to execute a joint income tax return was upheld based on the following: (i) there was a significant tax savings, and filing separately would have unnecessarily depleted funds for the support of the family; (ii) there was no evidence the husband had filed fraudulent returns in the past or intended to do so in the year in question; (iii) the husband was the source of all income reported; (iv) the wife expressed no "principled" reason why she should file a separate return; and (v) the majority of marital assets were required to pay marital debts, thus the court had no means of altering equitable distribution to compensate the husband for the adverse tax consequence in filing separately. The court also upheld the trial court's ruling that conditioned the wife's receipt of alimony upon her executing the joint returns, requiring the alimony be held in escrow until the returns were filed.

Each person has a federal tax exemption for lifetime gifts and estate transfers equal to $5,430,000 (which amount is adjusted annually for inflation). In addition, each person is entitled to give a gift each year of a present interest equal to $14,000 (which amount is also periodically adjusted for inflation) per done, without incurring a gift tax or utilizing a portion of the exemption and without the need to file a gift tax return. When a married taxpayer makes a gift to a third party, his or her spouse can consent to split the gift, that is, treat the gift as having been made half by each spouse. In essence, this means that while an individual can transfer $14,000 to a third party without utilizing his/her exemption, a married couple can transfer $28,000 to such third party without utilizing either spouse's exemption. However, a gift tax return is required to be filed if the parties are consenting to split gifts.

In order to split gifts, the parties must be U.S. citizens and married at the time of the gift, and, if thereafter divorced, have not remarried during the calendar year in which the gift is made. More importantly, the spouse of the donor must consent to split the gift, and all gifts made by the parties during the calendar year must then be split. There are also a number of factual situations where gift splitting is not permitted.

Unlike for income tax purposes, there is no joint gift tax return. Instead, usually each party files his or her own gift tax return, and the other spouse will check a box on the donor's return indicating consent to split gifts. The nondonor spouse must also sign the donor's gift tax return under penalties of perjury ("Under penalties of perjury, I declare that I have examined this return, including any accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete"). By consenting to gift splitting, the nondonor spouse agrees to joint and several liability for any tax imposed (as well as interest and/or penalties) if the taxing authority adjusts the value of the gift and/or determines that gift tax is owed. The consent is irrevocable after the due date of the return.

To the extent split gifts merely utilize one's annual gift exclusion of $14,000 per donee, there is likely no economic consequence to the nondonor consenting spouse. However, to the extent the split gifts utilize one's exemption, the nondonor spouse may be relinquishing a significant economic right (since the exemption is limited), while providing the donor spouse with an economic benefit. Using the analysis set forth in Bursztyn, where the gifts do not exceed the annual gift exclusion amount, a spouse may be ordered to consent to split gifts. By contrast, it appears a "principled" reason may exist supporting a spouse's refusal to consent to gifts made by the other spouse to third parties if it uses up a portion of his/her exemption. However, as noted, there appears to be no reported case where the courts have addressed the issue of gift splitting in divorce situations.

In the absence of established precedent, it is recommended that the issue of gift splitting be addressed in a premarital agreement. Many times, premarital agreements will address income tax issues, including whether the parties will file married or jointly, how any income tax liability will be paid by the parties, and the effect of a divorce filing on the couple's income tax filings and refunds. However, in preparing premarital agreements, practitioners should also consider incorporating provisions regarding the use of the parties' gift and estate tax exemption amounts and under what circumstances the parties will consent to split gifts. These provisions may be particularly relevant when one party to the marriage has significantly more wealth than the other.

As an illustration, assume the parties do not have a premarital agreement or that their premarital agreement only addresses income tax issues and does not address gift and estate tax issues. Further assume that prior to the marriage, neither party made any significant gifts and thus each have remaining their entire exemption. As the marriage begins to crumble, the husband makes significant noncash gifts, for example $8 million of his own closely held real estate entities, to his other family members. If the wife refuses to consent to gift splitting, the husband will utilize his entire exemption and incur a gift tax on the excess (currently at the rate of 40 percent) totaling over $1 million. However, if the wife consents to gift splitting, each party will utilize only $4 million of his/her exemption and no immediate gift tax will be incurred. Upon the wife's refusal to consent to splitting the gift, the husband files for divorce and requests that the court order his wife to execute gift tax returns consenting to split the gift.

In the absence of relevant case law, the family court must evaluate the competing arguments of the parties. The husband likely relies upon the fact that there is no immediate tax consequence to the wife in executing the consent, whereas should she refuse to exercise the consent, the husband will be assessed substantial gift tax. If the parties' respective wealth is disproportionate, the husband may also argue that the wife will never need to utilize her full exemption, thus the use of her exemption poses no economic hardship to her.

The wife may object based upon the following arguments: (i) execution of the consent is under penalties of perjury and creates joint and several liability for any gift tax imposed; (ii) the consent is irrevocable once given; (iii) the wife receives no benefit from executing the consent, yet the husband receives a significant benefit; (iv) by signing the consent, the wife incurs economic detriment in that she loses $4 million of her exemption without compensation and any potential future transfers she makes by gift or upon death may incur gift or estate tax, whereas by not splitting the husband's gift, her full exemption remains intact; (v) even if the wife's assets are presently not significant enough to require use of most of her exemption, she may in the future acquire assets and/or may be able to transfer her unused exemption to a potential future spouse utilizing portability, thus economically benefitting her future heirs; and (vi) as clearly husband had sufficient assets to make the significant gifts, the tax imposed upon the husband will likely not result in undue detriment to him or the marital unit requiring a need to minimize the tax.

Ultimately, in the aforesaid illustration, perhaps the family court will order the wife to be compensated by the wealthy husband for use of her exemption, or the parties through the efforts of their attorneys or mediation can agree upon a figure to compensate the wife. That, however, does not address the other concerns of the nondonor spouse, such as affirming the value of the gift and agreeing to joint and several liability.

It should quickly become evident that a properly prepared premarital agreement that addresses gift splitting and use of the parties' gift and estate tax exemption can potentially eliminate costly litigation, delays that may detrimentally impact the parties based upon tax filing deadlines, and uncertainty regarding the court's discretionary ruling in the absence of precedent. Generally, a premarital agreement should provide that the parties freely agree to consent to gifts, provided the gifts do not exceed the combined annual exclusion amount (i.e., "Each party agrees that so long as they are married, he or she will consent to and sign any and all tax returns which may be made by reason of such consent, in order to take full advantage of the gift-splitting provisions of Section 2513 of the Internal Revenue Code, or any other relevant Section, provided however such gifts do not exceed the annual gift tax exclusion."). In the event of taxable gifts, the agreement may delineate compensation that must be paid to the consenting nondonor spouse conditioned upon the amount of such spouse's exemption that is used by the gift, and any other uncertainties such as the risk the Internal Revenue Service may contest the reported value of the gift or the ability of the donor to ensure payment of any tax or penalties that may be assessed.

Although a premarital agreement can obviate the necessity of court intervention, since a court will not rewrite a premarital agreement in order to provide a better bargain for the parties than that contained in the parties' agreement, it is imperative that attorneys consider gift and estate tax issues in preparing these agreements and sufficiently address the variety of issues the situation may present. •

Romania is a member of Witman Stadtmauer in Florham Park. Sinha is an associate of the firm.

Reprinted with permission from the June 8, 2015 edition of New Jersey Law Journal. © 2015 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited

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