Kelly v. Kelly, NO. 2012-CA-001081-MR (Ky. App. 2014)
When There is No QDRO, Income Tax Liabilities and Reporting Obligations Must Be Negotiated, Allocated and Structured Between the Parties

Rendered: August 29, 2014
Not To Be Published
Opinion Reversing

To: Domestic Relations Attorneys on BOTH Sides of the River
Re: I’m Sorry, and You’re Welcome

Let me start by saying, if you hate QDROs, I wager that this post will help you see QDROs through a more affectionate lens….

To that end, qualified ERISA-based plans should be your preference when assigning retirement benefits to a former spouse. In fact, a red flag should go up whenever you encounter a plan that is not governed under ERISA. Importantly, non-ERISA plans are subject to their own set of rules that may limit or even prohibit the assignment of benefits to a former spouse. 

For attorneys in Ohio and Kentucky, there are certain retirement plans out there you should be on the lookout for that are “non-ERISA” and/or “non-qualified”.  THESE PLANS MAY NOT BE ABLE TO BE DIVIDED VIA QDRO OR SIMILAR COURT ORDER. For instance, if your client (or his/her spouse, or former spouse) has a retirement plan with the City of Cincinnati, listen up. City of Cincinnati pension benefits cannot be divided by QDRO. The same may be true if one of the parties is an executive with Procter & Gamble, or General Electric, to name only  a very few local employers with supplemental executive retirement plans. 

You are thinking, “What’s the big deal Eileen?” That is because you are ahead of the bell curve. You are one of the lucky who discovered pre-decree that you could not divide the pension via QDRO. You were able to instead negotiate an alternative equitable distribution of the pension; perhaps an offset with the parties' much coveted rare, mint condition first edition Princess Diana Beanie Baby collection. You saved yourself and your client a lot of time, money, and heartache by not simply having the parties sign off on a property agreement “splitting the pension via QDRO”, only later to find out post-decree that the pension could not be divided via QDRO. I bet you were a ‘hand-raiser’ in law school too. As for the rest of us...

Background: Assignment of Retirement Assets via QDRO

There is a lot to learn from Kelly, but first, a little background. A QDRO is primarily used to assign retirement benefits to a former spouse. QDROs are mainly targeted at qualified ERISA-based plans. A qualified ERISA-based plan is an employee benefit plan that consists of a “qualified trust” as defined in IRC § 401(a)(13). Think 401(k), pension, profit sharing, employee stock ownership plans, etc. QDROs may also be used to divide employee plans such as 403(b) and 457(b) plans. See IRC §414(p). Plans sponsored by religious and governmental organizations do not have to accept QDROs, unless the terms of the particular plan permit them to do so. See IRC §414(p). 

Only a QDRO may divide a retirement plan without penalty. IRC § 401(a)(13)(B), § 402(e)(A), § 404(p). For income tax purposes, a distribution pursuant to a QDRO is essential because it makes the non-employee spouse (or former spouse, referred to as the “alternate payee”) subject to the income tax liability for his/her proportional marital share of the benefit. Simply put, an alternate payee who is the former spouse of the plan participant must be treated as a distributee, for tax purposes, if the distribution is made pursuant to a QDRO (or similar court order). See IRC § 402(e)(1)(A).

Tax Rule: The Plan Issues the 1099-R to the Plan Payee(s)

The payee of any distribution from a retirement plan gets a 1099 from the plan’s administrator. For this reason, when retirement asset transfers are made via QDRO, each party receives a 1099-R for the amount paid to each from the plan (i.e., as each party is treated as a payee). 

When there is no QDRO, the plan pays the participant all distribution proceeds directly, including any marital portions subject to division pursuant to decree. The 1099-R is then issued by the plan to the sole payee, the plan participant.  

When There is No QDRO, Income Tax Liabilities and Reporting Obligations Must Be Negotiated, Allocated and Structured Between the Parties

Now back to Kelly. Husband was retired and receiving a monthly pension benefit from the Kentucky Retirement System (KRS). At the time of divorce, KRS did not accept QDROs. Therefore, in order to provide Wife her marital portion of the benefit, the parties agreed that Husband would make direct payments to Wife from the net payments he received from KRS. (Side Bar: The issue on appeal was whether the agreement was ambiguous as to what Husband was to pay Wife, the gross or net amount; suffice to say for this post that the Court of Appeals found no ambiguity existed). The parties also agreed that they would seek the assistance of a financial professional to properly apportion the tax liability between the parties. The parties’ agreement was duly incorporated into the decree of dissolution. 

After the divorce, Husband began making direct payments of the monthly net pension benefit to Wife, pursuant to their agreement. KRS then subsequently issued the 1099-Rs to Husband only, as the sole payee from the Plan. 

Here lies the heart of this blog post and the reason I brought you all here today. If the plan won’t pay the former spouse via QDRO, or similar court order, the participant must pay the former spouse his/her marital share of the retirement benefit directly (unless other marital assets are offset in lieu of the marital retirement benefits; of course, using the offset method as an alternative distribution scheme has a whole host of pros/cons in its own right... is that a future blog post I smell?). In such case, the plan will issue the 1099-R to the participant only. Therefore, income tax liabilities, and equalization thereof, must be allocated between the parties themselves. Further, the payments must be appropriately structured, and the parties’ mutual income tax reporting obligations must be determined.

Unfortunately, in Kelly, the parties failed to communicate with one-another post-decree, or consult together with a financial advisor, as contemplated by their agreement. As a result, each party inaccurately reported – or failed to report – the pension income paid to Wife. The Court of Appeals aptly observed that is what then caused both parties to encounter a number of tax-related complications and experience IRS scrutiny. More specifically, Wife received notice that she had failed to report her portion of Husband’s retirement proceeds as income, and she thereafter owed significant amounts in federal taxes, penalties, and interest. Husband filed his income taxes incorrectly, in that he reported the amounts paid to Wife as alimony instead of retirement distributions on his returns. Husband was thereafter assessed 100% of the income tax paid on all retirement distributions, including amounts he paid to Wife and amounts he kept, during various years between 2005-2010.

Watch Out: Retirement Plans That Should Raise a Red Flag

As mentioned above, a former spouse of the plan participant must be treated as a distributee, for tax purposes, if the distribution is made pursuant to a QDRO (or similar court order). See IRC § 402(e)(1)(A). When there is no QDRO, the plan participant must pay the former spouse his/her marital share of the retirement benefit directly (unless other marital assets are offset in lieu thereof). In such case, income tax liabilities must be negotiated and allocated between the parties themselves, and the payments must be appropriately structured for income tax reporting purposes. 

To prevent income tax problems post-decree, a practitioner must properly identify the retirement assets early in negotiations and determine whether an assignment can be accomplished via QDRO (or similar court order). When the plan will not permit division via QDRO, this allows the practitioner to determine if an alternative distribution of assets might be made to offset the retirement benefits, and if not, to address in the decree the proper allocation for income tax liabilities and to determine individual income tax reporting obligations.

So what types of plans should practitioners be on the lookout for in Ohio and Kentucky? Let’s start with qualified state government plans. Such plans are non-ERISA, and therefore, are not governed by QDRO rules. Qualified state plans may restrict or prohibit certain benefits that would otherwise typically be assignable under a qualified ERISA-based plan. State statute, however, may permit the assignment of benefits through the creation of a statutory Domestic Relations Order, QDRO, Division of Property Order (DOPO or DPO), or similar vehicle. 

For practitioners in Ohio and Kentucky, legislative changes have obviated some of the income tax problems associated with dividing retirement assets without a QDRO (or similar order). For example, in 2002, the Ohio legislature passed HB 535, requiring Ohio public retirement programs to accept DOPOs. The Kentucky legislature passed HB 289 in 2010, requiring both Kentucky Retirement Systems (KRS) and Kentucky Teachers Retirement Systems (KTRS) to recognize QDROs (KRS actually accepted QDROs until 2000 when a law was passed that exempted those pension benefits in the event of divorce; that law was repealed in 2002, but KRS still refused to honor QDROs because the revised law did not include specific language that allowed them). However, despite these changes to the state plans, practitioners in both Ohio and Kentucky are still not out of the woods. 

For instance, in both Ohio and Kentucky, statutorily mandated property division orders are required to be used as-is, and therefore, a division by DPO or QDRO simply cannot be made in accord with the parties’ desired intent in some circumstances. For example, in Ohio, the DPO form will only allow a percentage method of division, incorporating a coverture fraction, to divide the Member Directed benefit (a defined contribution plan) "if, as, and when" the participant commences benefits.  In Kentucky, if the parties want to employ a coverture fraction, the QDRO form requires that the benefit must be divided 50-50%.

Further, as mentioned above, Chapter 203 of the Cincinnati Municipal Code does not currently authorize the Cincinnati Retirement System (CRS) to accept QDROs, DOPOs, or any other request or court order for the division of the pension benefit asset assigned to CRS members. Accordingly, the CRS cannot pay a member’s former spouse any amount from the member’s retirement benefit as property division, even pursuant to a court order. Also, military retired pay cannot be paid to a former spouse by the Defense Finance and Accounting Services (DFAS) if the ‘Killer 10/10 Rule’ is not met. Federal civil service employment and railroad pensions can both be divided via court order. However, both plans are subject to strict statutory schemes and require certain language that may frustrate the intent of the parties, much in the way that the Ohio and Kentucky state-sponsored forms may do.

There are a few other types of retirement plans you may encounter as a practitioner in Ohio and Kentucky that may not accept QDROs. For instance, non-qualified Section 457(f) Plans (which usually only apply to employee participants in senior management) cannot be divided by QDRO, but they may have their own procedure for division incident to divorce. Moreover, supplemental executive retirement plans (SERPs, often referred to as “top hat” plans) are non-qualified and most will not pay a member’s ex-spouse any amount from the member’s retirement benefit as property division. Also, keep in mind that IRAs are non-qualified and non-ERISA plans, therefore QDROs are inapplicable. 

Solution:  What to do When There is No QDRO

There are multiple ways to negotiate, allocate and structure tax obligations associated with the participant making direct payments to a former spouse for his/her allotment of retirement benefits incident to divorce.  Of critical importance is that the parties’ mutual tax returns complement one another. That is, once the tax burdens are negotiated and allocated between the parties, the payments themselves must be appropriately structured for purposes of mutual income tax reporting.

[Insert SUPER SIZE tax advice disclaimer here. Let me be very clear:  I am not a tax attorney nor financial advisor. To the contrary. On my way home from the Bar Exam, I could literally see the little bit of tax knowledge I had managed to cram into my brain streaming out from both ears, fleeing the scene of the crime. Tip of the hat to Chase College of Law Professor Ljubomir Nacev, for his herculean efforts.]

One option may be for the plan participant to pay directly to the former spouse the net amount of the assignment and then treat him/herself as a nominee recipient, reporting to the former spouse on a Form 1099-R, showing the former spouse’s portion of the gross amount of the distribution and the portion of the taxes withheld. In such case, the participant must also send a copy of the Form 1099-R to the IRS along with Form 1096. By doing so, the participant will transfer the income and the tax withholding to the former spouse and it will be reportable on the former spouse’s tax return. The participant will show 100% of the income reported on the 1099-R on his/her individual return, but will also show a negative amount, reflecting the nominee 1099-R issued to the former spouse on line 21 of form 1040.

Another option may be to structure the payment as alimony to the former spouse, pursuant to applicable state law and IRC Section 71, (i.e., the participant pays directly to his/her former spouse the gross amount of the assignment and then such gross payment is treated as income to the former spouse and deductible to the participant).

Yet another option would be for the participant to pay benefits assigned to the former spouse net of the participant’s estimated tax liability based on previous year’s taxes. Then, when the tax liability is finalized for the current year, the difference between the estimated tax liability and the actual tax liability would be adjusted between the parties. If the estimated tax liability is greater than the actual tax liability, the participant owes the former spouse his/her proportionate share. If actual tax liability exceeds estimated tax liability, the former spouse owes the participant his/her proportionate share. A variation may be to instead ascertain what the participant’s total tax liability would be if (1) the participant received the full retirement distribution amount, and then do the same as if (2) the participant only received his/her share of the retirement distribution. The difference between the two liabilities would be the adjustment owed to the former spouse.

There are pros and cons to each approach above, and the practicability and viability of any option should be thoroughly and carefully examined by the parties, along with their counsel and financial professionals. Whatever the chosen method, if direct payments are made by the participant to the former spouse ‘if, as, and when’ the participant receives them, then the parties’ mutual income tax liabilities and reporting obligations must be addressed and resolved before the first direct payment is made (and preferably before the ink on any agreement or court order is dry). A practitioner can accomplish this by properly identifying the retirement assets early in negotiations and determining whether division thereof can be accomplished via QDRO (or similar court order).

Ms. Tasha Scott Schaffner, Esq. (Tasha Scott Schaffner, PLLC, in Florence, Kentucky) said it best when I spoke to her about Kelly (of note, she successfully represented the KRS Member on appeal):  “Both parties could have avoided unnecessary stress, expense, and IRS penalties, had they just been ‘on the same page’”. 

I know.... I know... Easier said than done in divorce, right? 

* Author’s Note:  Income tax issues are only one among many considerations that must be addressed when direct payments from retirement assets are made by a participant to a former spouse incident to divorce.  Payment delivery logistics, remedial measures, survivorship protections, etc., must also be contemplated by the parties and counsel.  This post cannot possibly explore all of these issues in detail, and is meant only to bring awareness of potential income tax considerations and as fodder for further research by practitioners. 

Disclaimer: The foregoing contains general statements of the tax treatment of retirement account transfers or distributions. It is not individual tax advice, which requires an analysis of any individual financial circumstances. One must consult a CPA, tax attorney, or other qualified tax advisor regarding any questions about the specific tax treatment of any retirement account transfer or distribution. Any tax advice set forth in this communication: (1) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed by tax laws; and (2) cannot be used in promoting, marketing, or recommending to another person any transaction or matter addressed herein.