Agricultural Land Highly Valued Leads to Equalization Payment Beyond the Means of the Farming Operation
In every marriage dissolution case, marital property must be distributed between the parties. Every state has adopted some form of property distribution which requires courts to determine each spouse’s share of marital assets. This can be either a form of equitable distribution or community property distribution. Separate property of each spouse is not divided between the spouses. Separate property can consist of assets each spouse brought into the marriage, inheritances and gifts received during the marriage for the individual, and proceeds from personal injury awards. In some situations, however, separate property can become marital property if it is commingled with marital property.
In Iowa, when a farming operation is involved and one of the parties wants to continue the operation, the court’s task is to craft a property division that is equitable to both parties but allows the operation to continue. Within certain general statutory guidelines, the courts have wide discretion in fashioning an equitable distribution of the assets between the spouses. However, in this divorce case, the Court significantly handicapped the family farming operation’s economic viability in crafting an equitable distribution in which the only asset in question was agricultural land with a high market value.
Facts of the Case
Stephen and Rachel McDermott were married in 1997. At the time of the marriage, Stephen was 33 and Rachel was 22. She was a college graduate trained in physical therapy, and he was a farmer that had worked in the family’s Century Farm farming operation for many years. When they got married, they lived on Stephen’s parents’ farm. Stephen brought various assets into the marriage including bank accounts, real estate, vehicles, farm equipment, crop and livestock. His assets were valued at $657,885 at the time of the wedding. Rachel brought a bank account containing $34,808 into the marriage.
During the marriage, Stephen continued to work in the family’s farming operation including an adjacent farm belonging to his uncle. Rachel stopped working as a physical therapist in order to raise the couple’s children. During the 12 years of the marriage, six children were born. Stephen supported the family through income generated in the farming activities.
Stephen’s parents ultimately sold their farm to the couple in 1998 for $200,000, which was half the farm’s market value. The sale occurred with the consent of Stephen’s siblings with the understanding that he would inherit nothing further from his parents. The farm was paid off by the time of the divorce. In 2002, Stephen’s uncle sold his farm to the couple for $100,000 (it’s fair market value at the time of the sale was approximately $427,000) and the balance due was forgiven in the uncle’s will at the time he died in 2004.Rachel returned to school to obtain recertification in physical therapy, obtained it, and then filed for divorce. At the time of filing in 2009, the couple had a net worth of $2.5 million. Most of this wealth was attributable to the farmland acquired from Stephen’s family. The couple could not agree to the division of marital assets, the tax consequences resulting from the decree and child support.
Trial Court Decision
The trial court determined that Stephen’s annual income from working on the farm was $55,000 and Rachel’s was $65,520. Rachel was ordered to pay child support of $219 per month for the six children with decreases as the children no longer qualified for support. In the distribution of marital property, the court awarded property valued at $2.1 million to Stephen and $150,000 to Rachel. In addition, the court ordered Stephen to make an equalization payment of more than $1 million to Rachel.
The court calculated the value of the land, crops, and the farm equipment and divided the value in half. The court gave Stephen two options for making the equalization payment. He could pay three installments over three years or make a $500,000 payment and equal payments over the next five years. Stephen made the first payment on the three year plan then appealed.
Court of Appeals Decision
The court of appeals decreased the equalization payment to $250,000. The court held that the trial court failed to take into consideration the tax consequences to Stephen of the property division which resulted in an overvaluation of the assets he received and that Rachel should not have received the full value of the property received by Stephen from Stephen’s family.
Supreme Court Decision
Rachel sought further review with the Iowa Supreme Court, which was granted. The Court held that the land received from Stephen’s family was marital property rather than inherited or gifted property and, as such, it was subject to equitable distribution.
Stephen had argued that the farms were received for less than fair market value and constituted a gift or inheritance and the donative intent of his family was that the farm operation would stay in the family (as it had since 1888) and was necessary for him to support the family. The Court rejected this argument based on previous precedent rejecting family “gifts” during the marriage where there was no evidence one party was meant as the sole recipient. The Court found important that no gift taxes were paid during the years of the supposed gifts (although there was no mention of whether there was evidence of the value of the gifts or whether a gift tax return was actually required to be filed). The Court also found important the fact that the value of the gifts was meant to benefit the entire family, rather than just Stephen. Indeed, the language in the uncle’s will forgiving the balance of the loan for some of the agricultural land clearly expressed that the gift was given to Stephen and Rachel, as husband and wife. The Court then concluded that an equalization payment was preferable because the asset (farmland) could not be divided easily and was not liquid enough to achieve an equitable distribution. The Court also stated that a forced sale was not preferable in the case of a family farm when one party needs to keep the asset in order to continue farming. But, the Court cautioned, the desire to preserve the family farm could not work to the detriment of the other party in determining an equitable settlement.
In response, Stephen argued that the equalization payment required a mortgage on the farm in excess of what the farming operation could support and the tax consequences of fulfilling the equalization payment should be considered in setting the amount. The Court rejected consideration of any tax consequences because evidence showed a bank agreed to provide a loan for half the value of the property. The Court reasoned that a bank would not loan money to a borrower that could not repay the loan. The Court also held that several tax deductions, such as depreciation on Stephen’s tax return did not affect his cash flow and that by choosing to spend money to avoid tax liability, Stephen artificially lowered his cash flow. The Court also stated that any mortgage interest would be deductible against income tax liability. The Court found it significant that Stephen and Rachel had paid of the loan to his parents for purchasing the farm nine years early while also paying on the uncle’s land, so the farm had a history of generating sufficient revenue.
Note: The Court is inconsistent with its comments on cash flow. Clearly, depreciation claimed has a positive impact on cash flow for a business. Fixed assets lose their economic usefulness over time. The Court ignored the impact of depreciation on the tax return, but then turned around and noted that mortgage interest would be deductible against income tax liability.
The Court held that the law was well-settled that tax consequences should be considered in making a property settlement, but when the court has not ordered a sale of the property, tax consequences are not to be considered. Because the district court did not order Stephen to sell the property and there was no evidence that Stephen intended to sell the property, the Court held the tax consequences of a sale were not to be considered in this case. That was the result even though the impact of the Court’s decision could very likely result in a portion of the land being sold – a point made by the dissent in the case.
In reviewing the child support requirements, the Court held that the district court erred in failing to adjust Stephen’s § 179 depreciation expenses that averaged $11,204 per year. The Court held that previous cases had stated that for determining child support these deductions should be recalculated under the straight line method to do justice between the parties. The Court did adopt the district court’s calculation, however because a one-time sale of timber was also added to Stephen’s income.
The dissenting opinion. A dissent was filed stating that the Court’s decision forced Stephen into a “Hobson’s choice” creating an inequitable result (this is basically not a choice because there is only one option to “choose”). The dissent found significant that Rachel entered the marriage with comparatively very little, obtained education and training that significantly increased her earning capacity during the marriage, and then exited the marriage with an unencumbered award of more than $1 million. On the other hand, Stephen is left with a substantially impaired earning ability and assets carrying a substantial tax liability.
The dissent noted that the majority opinion left Stephen with no desirable options. He can sell the farm, pay Rachel, and keep the remainder for himself, but he will bear all transaction and tax consequences from this sale, which would likely approach thirty percent of the value. Alternatively, Stephen could sell a large portion of the farm to meet his obligation, which will still bring significant tax consequences (including potential depreciation recapture) to him and will substantially impair the farm operation’s economic viability. The dissent found significant that Stephen would certainly not be able to net the level of income he generated previously, which would be inequitable especially when Rachel’s income will increase substantially. The third option was for Stephen to mortgage the farm and continue operations. Assuming he could obtain a loan for more than $1 million he will have substantial yearly obligations that will lead to a substantial decrease in farm income for him at a time when Rachel’s income increases substantially. The fourth option was for Stephen to mortgage the farm, rent it to a third party, and obtain employment elsewhere. Based on the fact that Stephen has only a high school diploma and has only worked on the family farm, the dissent note that it would be highly unlikely he will be able to find employment that will equal his previous $55,000 annual income.
In effect, the dissent argued, the majority required Stephen to sell the family farm in its entirety, assume an inequitable share of transactions costs or pursue other options that will significantly decrease his ability to maintain his standard of living while Rachel walks away from the marriage a millionaire and takes employment making more than she and Stephen made together as a result of her education that Stephen helped finance during the marriage. The dissent argued that the Court failed to consider the viability of the farm as a factor in its consideration in setting the award, which made the award inequitable. The dissent opined that an equalization award closer to $600,000 would have been more equitable.
Planning to Avoid Inequitable Results
Clearly, the effects of the decision in the case are harsh and seem inequitable. Consideration of planning strategies to protect a family business against the problems incurred on account of divorce should be undertaken by all families regardless of the perceived strength of a marriage. A family business is typically the most valuable asset of a marriage. It is also commonly characterized by illiquid assets, such as the land involved in this case.
It is always difficult for courts to divide family business assets. Utilizing planning techniques in advance of and during the marriage is critical. Techniques and strategies can involve the use of entities and buy-sell agreements, trusts (either third-party spendthrift trusts or self-settled trusts), and pre-marital agreements. A combination of these techniques can also be utilized. In case there is any doubt this is really necessary, this case clearly illustrates the dangers to a family business for failing to plan. In re Marriage of McDermott, No. 11-0045, 2013 Iowa LEXIS 17 (Iowa Sup. Ct. Mar. 1, 2013).
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