A cautionary tale

In each of these articles, I tell you a story about how I help women with the financial side of divorce. That’s usually the case.

This time, it isn’t.

This story is about how I was recently called in to help the husband in the divorce, after the decree had been signed.

Spoiler alert: I should’ve been brought in before the decree was signed.

I’m not a legal expert; you are. But I’m a CPA. A numbers nerd and a tax expert. And when I see stuff—like I’m about to relate—that will cost my clients money, generate unnecessary headaches and stress, and expose both them and their attorneys to undue risk (from the feds, no less), I really have to put the word out.

The negative result you’re about to learn about could have been avoided! Easily, no less!

Here we go.

QDRO vs. DRO

You know all about the QDRO, or qualified domestic relations order. And you’re familiar with the DRO, which is basically the QDRO without the “Q.”

A QDRO is required to allocate a portion of an employer-sponsored ERISA plan, such as a 401(k) or company pension plan, to an alternate payee (the former spouse). A DRO is used for non-ERISA plans, such as government plans (e.g., 403(b), PSP) and stock option plans. Sometimes (such as in this case), the DRO gets overlooked. That can be costly.

How costly?

Well, there’s $2 million at stake in this story.

It goes like this: Shortly after the divorce decree was signed, the husband left his long-time employer for another job. “Employer” is misleading: the husband was an executive with this company. He had stock options worth more than $2 million.

Now, a termination of employment triggers an expiration date for the options; in this case, the husband had 90 days to exercise. If he missed that deadline—you guessed it—the $2 million simply evaporates. Suffice to say, the husband was motivated.

But the same couldn’t be said about the Special Master QDRO attorney who had been brought into this case… before I was brought onto this case.

There are a zillion details here (and all of them make me cringe!), but to make the story quickly digestible for you, it boils down to this: The QDRO attorney sat on the drafting of his documents for two full months, and then there was no time for things to be done properly.

And when I say “his documents,” that’s only the QDRO. Yeah: the doc that covers the retirement accounts. And get this: There was no DRO. None. Zip. Nada. I could simply pin this on the QDRO attorney, but it’s the timing that makes this tale so cautionary: Had I been brought in earlier, I would’ve helped with some key phrasing, upstream, in the divorce decree. Instead of saying things like “at the QDRO attorney’s discretion,” I would have advised language more like “the QDRO attorney will draft a QDRO for the 401(k) retirement account, and a DRO for the stock options—and do so by a deadline which we specify.”

Fallout, no shelter

The husband was frantic to get this $2 million before it evaporated. But while a DRO would have officially had the custodian split the funds and issue proper tax documents to each party, that didn’t exist. Then the “suggestions” from the different parties here played out like a comedy of errors:

The QDRO attorney suggested that the husband “nominee” the wife’s portion of the money on his tax return. That’s right: add a line at the bottom which says “Negative One Million Dollars.” That won’t cause the IRS to come stampeding with an audit now, would it?

(This guy also, initially, suggested that the husband “simply issue a 1099” to his ex-wife—until I gently reminded him that a 1099 is only issued in the course of a trade or business… which didn’t apply in this situation.)

Oh, and what about the taxes? I’ll spare you the gory details (there are tons), but I’ve calculated that the wife will really end up with about $550k after taxes, as opposed to the $800k which was half the proceeds after the mandatory tax withholding. The wife’s attorney wants her to get the $800k up front and invest it until she needs to repay the $250k difference to the husband, so she can profit during the time she’s holding it all.

Not so smart. Doesn’t he know that investments can also lose value?

If I got into the details of the W-2 income reporting, the federal tax withholding, the Medicare tax withholding, the additional Medicare tax withholding, the income tax laws that lower the wife’s lower tax bracket and could penalize the husband even more, the likelihood that the wife will now get audited, too, not to mention all of the state tax implications, your head would spin—and your eyes would glaze over. This is why you need someone like me on your team, and early, to avoid playing a part in a cautionary tale like this one.

Parting shot: The IRS generally has three years to initiate an audit after the tax return is filed. In this case, neither the husband nor the wife will get one good night’s sleep for a long, long time.