Using QDROs to Fund a Divorce

Recent Decisions Illustrate the Opportunities and the Pitfalls of QDROs

by William J. Kluwin

In the domestic relations arena, finding a source of funds to make the process of getting divorced work efficiently from an economic standpoint is a fundamental challenge. Typically, a qualified domestic relations order (QDRO) does not enter into the equation until the divorce is final.¹ In part, this pattern occurs because there is a basic misconception that a QDRO can only be issued after the divorce. However, a QDRO can be used for a number of purposes, including funding pre-divorce financial activities.

In 1984, Congress created the QDRO to resolve the administrative problems of dividing retirement benefits in a divorce. With a properly worded QDRO, the spouse of a retirement plan participant can receive all or a portion of the participant’s retirement benefits. A QDRO is also an effective tool for providing child support or dealing with other marital property rights. In addition, a QDRO can be used to pay attorneys’ fees.

Since 1984, the stakes, in terms of both funding opportunities and malpractice liability, have increased annually for domestic relations lawyers in dealing with QDROs. For example, for many individuals, retirement benefits now exceed life insurance proceeds as the largest asset in the individual’s probate estate. As the largest asset in an estate, it follows that retirement benefits can also constitute a significant asset in a divorce. Moreover, as long-term marriages end in divorce, the opportunity to use retirement benefits to fund a divorce becomes more immediate and more practical.

This article examines the opportunities to use QDROs for purposes other than the mere division of community property. It also discusses judicial decisions that illustrate the risk of lost opportunity in not issuing and perfecting a QDRO in a timely manner. This article should cause the domestic relations lawyer to reassess his or her current use of QDROs. It should also clarify several misconceptions about QDROs.

Definition of a QDRO
A QDRO is defined as a judgment, decree, court order or court-approved property settlement that creates or recognizes the existence of a non-participant’s right to receive all or a portion of a participant’s retirement benefits.² The QDRO is the only allowable method of assigning retirement benefits to a non-participant. In order to be a valid QDRO, the order must meet the specific criteria set forth in Section 414(p)(2) of the Internal Revenue Code of 1986 (the "Code"). However, within the basic definition of a QDRO, there is the opportunity to issue and perfect a QDRO in circumstances other than a divorce. For example, a non-participant spouse could receive retirement benefits under a QDRO in a legal separation.

There are a number of specific rules that must be understood in order to properly prepare a QDRO. First, the QDRO must: (1) relate to the provision of child support, alimony payments or marital property rights to a spouse, former spouse, child or other dependent of a participant; and (2) be made pursuant to state domestic relations law (including community property law).³ Thus, the basic rules contemplate the use of a QDRO to satisfy spousal maintenance or child support obligations, not just to divide retirement benefits.

The non-participant spouse is referred to as the "alternate payee."⁴ The term "alternate payee" technically means a spouse, former spouse, child or other dependent of a participant who is recognized by the order as having a right to receive all or a portion of the benefits payable under the participant’s retirement plan. This article focuses solely on payments to a current spouse or a former spouse.

The Importance of Starting Early
During the discovery process, an effort must be made to protect the non-participant spouse from the loss of retirement benefits. A retirement plan must provide reasonable procedures, in writing, to determine the status of a QDRO and to administer QDROs.⁵ Most plans have elected to adopt procedural rules separate from the plan document. It is important for the domestic relations lawyer to obtain a copy of the plan provisions relating to QDROs as well as these separate, written administrative procedures for preparing a QDRO.

Despite the adoption of written procedures, there are often gaps in the administration of QDROs. For example, many plans provide for an informal hold on retirement benefits once there has been a determination that a QDRO is being sought, but this procedure is often not in writing. If the participant’s benefits are not "frozen" in a timely manner, potential financial opportunities for an alternate payee could be lost pursuant to a participant loan, a hardship withdrawal or an imprudent investment direction. Therefore, it is important to place the retirement plan on clear written notice that an order is being sought, identifying a timeframe for receipt of the order, and stating that a hold is requested.⁶

Multiple QDROs
A divorce decree typically contains a formula that provides the non-participant spouse with a share of the retirement benefits earned during the marriage. It is a common misconception that the non-participant spouse is only entitled to half of the participant’s retirement benefits. If the QDRO provides for 100 percent of the retirement benefits, then the plan administrator is obligated to follow the terms of the QDRO.

A related misconception relates to the number of QDROs that may be issued and perfected against a retirement plan. A participant’s benefits in a retirement plan are not limited to one QDRO for the same alternate payee. For example, QDRO One could be issued and perfected, calling for the division of community property. Later, QDRO Two could be issued, calling for a fixed dollar amount to pay off an obligation of the participant, such as child support arrearages.

Alternatively, a single QDRO could be drafted that calls for multiple payments. First, the QDRO could carve out the community property share belonging to the non-participant spouse, and then the QDRO could call for some other payment, such as the payment of attorneys’ fees.

The Risk of Using the Divorce Decree as a QDRO
The best and only appropriate practice for the domestic relations lawyer is to draft a stand-alone, valid QDRO. However, since considerable time can elapse between the date of divorce and the time that the QDRO is issued and perfected, the use of a divorce decree that contains some QDRO magic language is recommended as a defensive, risk management measure. The term "defective" QDRO is used to describe this defensive document because it is unlikely in most cases that the divorce decree alone, even with the inclusion of some QDRO magic language, will satisfy the typical retirement plan administrator. However, a "defective" QDRO should provide some protection in the event of the death of either the non-participant or the participant because the divorce decree shows an intent to deal with the issues and provides some basis to formalize a valid QDRO.

Hawkins v. Commissioner⁷ demonstrates that a divorce decree can function as a valid QDRO even when no special effort is made to draft a QDRO. However, Hawkins is cited only to demonstrate the concept of a "defective" QDRO; it is not the recommended practice. The participant was the president and sole owner of a professional corporation. Pursuant to a separation agreement, the participant’s retirement plan paid the non-participant $1 million. The IRS became concerned when neither party reported the $1 million payment as income. The IRS issued deficiency notices to both parties, and they contested the deficiencies. The Tax Court ruled that the separation agreement and the related divorce decree together did not constitute a valid QDRO. Thus, the Tax Court required that the participant include the payment in the participant’s gross income.⁸

The Tenth Circuit reversed, holding that the divorce decree and the separation agreement could be read together to create a valid QDRO since they satisfied certain (even though not all) statutory criteria for a QDRO. The non-participant spouse ended up with the tax liability under the general taxation rules for a QDRO. As a result, approximately $400,000 in tax liability was shifted from the participant to the non-participant.

Hawkins has not eliminated the malpractice risk of a poorly worded QDRO, nor does it assure the domestic relations lawyer that every divorce decree can serve as a "defective" QDRO. For example, In re Michael D. Boudreau⁹ involved a transfer that took place without a QDRO. In Boudreau, the divorce decree ordered a lump sum payment from a retirement plan in the amount of $103,000 to the non-participant spouse. The participant received the entire account balance from the plan and then gave $103,000 to the former spouse. The participant took the remaining balance as income, but the participant did not pay taxes on the $103,000 transferred to the former spouse. The participant then filed bankruptcy, and the IRS filed a proof of claim. The IRS successfully asserted that the divorce decree was not a valid QDRO, and the participant was liable for the taxes on the entire $103,000. Accordingly, Hawkins stands on its own facts.

An adverse result can also occur if the divorce decree states that a QDRO will be prepared in the future. Compare the result in Hawkins to Karem v. Commissioner.¹⁰ Karem was cited in Hawkins as an example of a situation where a divorce decree does not qualify as a valid QDRO. In Karem, the divorce decree made the mistake of stating that a QDRO would be drafted. The Tax Court ruled that the divorce decree by its own terms could not be considered a valid QDRO. This language continues to appear in divorce decrees, but it may be fatal to the non-participant spouse’s interest if a death or distribution occurs before a QDRO can be issued and perfected. Such language also may constitute malpractice.

A Plan Administrator has Broad Discretion to Accept a QDRO
Another case dealing with the form of a QDRO is Hullett v. Towers, Perris, Forster & Crosby, Inc.¹¹ Hullett underscores the broad discretion of the plan administrator in accepting or rejecting a QDRO. In Hullett, a final property settlement provided the non-participant spouse with 50 percent of the participant’s retirement benefits. Although the property settlement agreement was not designated a QDRO, the plan administrator, pursuant to the plan’s procedures, determined that it was a valid QDRO. Ironically, the participant then sued to have the QDRO declared invalid.¹² The Court agreed with the plan administrator’s decision and held that the divorce decree incorporating the settlement agreement was a valid QDRO. It is important to note that the Court would probably have supported a decision by the plan administrator to reject the property settlement agreement.

Pre-Divorce Uses of a QDRO
Another common misconception about a QDRO is that its issuance and perfection must await the divorce decree. In 1996, a New York Court imposed a pre-divorce judgment QDRO that covered multiple needs of the non-participant spouse. In Renner v. Blatte,¹³ the non-participant spouse filed an "enforcement action" directing the participant’s retirement plan to transfer $119,425 pursuant to a QDRO, chargeable solely against the participant’s account, to cover a number of matters related to the divorce proceedings. The Court held the participant in contempt. The Court ruled that the non-participant spouse was entitled to: (1) $20,825 in direct maintenance and child support arrearages; (2) $7,600 for third-party payment arrearages; (3) $15,000 for attorneys’ fees arrearages; (4) $5,000 for attorneys’ fees awarded in the enforcement action; (5) $41,000 for income taxes that the non-participant will have to pay upon receipt of the funds; and (6) $20,000 as security for future payments or to cover future arrearages.

The Court also listed a number of other areas where courts have ruled on the use of QDRO’s, including defaults in post-divorce spousal maintenance, money judgments for attorneys’ fees to compel compliance with child support orders that were not merged in the final divorce decree, and the payment of child support arrearages even though the child at issue has become emancipated.

Welfare Benefits and QDROs
Another misconception is that QDROs are only available for retirement plans. Despite an apparent statutory exclusion of welfare plans from the QDRO rules, there is authority to support the use of QDROs for dealing with welfare plan benefits.¹⁴ In Metropolitan Life Insurance Co. v. Wheaton,¹⁵ a divorce decree required that the husband carry the children of his prior marriage as his primary beneficiaries under his ERISA life insurance plan. The husband remarried and designated his second wife as the primary beneficiary. The Seventh Circuit held that the divorce decree was a valid QDRO and was not preempted by ERISA. Therefore, the interests of the children were protected. It is interesting to note that the QDRO technicalities were largely ignored.

Wheaton demonstrates the importance of due diligence by the domestic relations lawyer in seeking to determine all employee benefits that are available to the participant spouse and the importance in clearly specifying what the rights of the non-participant spouse are in all types of employee benefit plans. Because life insurance plans maintained by employers often have more favorable insurability requirements than standard policies, the need for and availability of a life insurance plan should be explored by the domestic relations lawyer. Therefore, the domestic relations lawyer may need to consider the use a QDRO when significant welfare plan benefits are at stake.¹⁶

A QDRO Cannot Determine Tax Treatment
A QDRO cannot change how the federal taxes are to be paid. In Clawson v. Commissioner,¹⁷ the divorce decree provided that the alternate payee would receive $35,000 from the participant’s plan. Thereafter, a supplemental order in the form of a QDRO was issued that stated any federal tax would be the responsibility of the participant. The Tax Court held that the QDRO could not relieve the alternate payee of liability for the tax. Accordingly, the distributions were included in the alternate payee’s income under Section 402 of the Code.

The alternate payee may be entitled to reimbursement by the participant for the taxes paid if the divorce decree and the QDRO so provide, but this result is a separate matter that does not change the alternate payee’s tax liability. As a result of Clawson, it would appear that a QDRO needs to be "grossed up" if the intent of the distribution is to limit the tax impact on the alternate payee. Clawson also illustrates that the tax impact on the non-participant can be considered in a QDRO, although it cannot be altered.

Obtain a Valid QDRO Before Death of Alternate Payee or Participant
When a participant is several years away from retirement, the non-participant spouse may procrastinate with respect to getting a QDRO issued and perfected. There is a misconception that the process can wait until the participant’s retirement. The Supreme Court ruled in Boggs v. Boggs¹⁸ that ERISA preempted state law which allowed a non-participant spouse to transfer by testamentary instrument an interest in undistributed retirement benefits. The facts in Boggs are informative. Isaac Boggs worked for South Central Bell from 1949 until his retirement in 1985. Dorothy Boggs, his first wife, died in 1979. Isaac and Dorothy had three sons. In 1986, Isaac married Sandra Boggs.

Upon retirement, Isaac received various retirement benefits. First, he received a lump sum benefit from a savings plan, which he rolled over into an individual retirement account (IRA). No withdrawals were made from the account, and it grew from $150,000 to $180,000 at the time of his death in 1989. Second, Isaac received 96 shares of AT&T stock. Third, Isaac received a monthly annuity with survivor rights in the amount of $1,777.67 from the Bell pension plan.

After Isaac’s death, Sandra and Isaac’s sons disputed the ownership of those retirement benefits. Dorothy left Isaac one-third of her estate outright and granted Isaac a life estate in the remaining two-thirds. Under Louisiana law, the three sons were entitled to Dorothy’s community property interest in Isaac’s undistributed pension benefits. The District Court granted summary judgment in favor of the three sons, and the Fifth Circuit affirmed.

The Supreme Court reversed, basing its decision on ERISA’s preemption clause.¹⁹ The Supreme Court ruled that Sandra was the sole beneficiary of the survivor annuity that was part of the Bell pension plan. The Court stated that the intent of ERISA to protect surviving spouses would be undermined if heirs and legatees would have a community property interest in a survivor annuity. With respect to the IRA account and the AT&T stock, ERISA preemption again cut off any rights of the heirs and legatees. The Supreme Court noted that the QDRO rules represent a very limited exception to the general rule that ERISA does not confer beneficiary status on non-participants by reason of their marital or dependent status. Accordingly, the attempted testamentary transfer constituted an ERISA-prohibited assignment or alienation.

As a general matter, this opinion does not change the law in the Ninth Circuit, where it is clear that a QDRO must be perfected before the death of the non-participant spouse.²⁰ Probate court cannot be used to rescue the non-participant spouse who has not perfected retirement rights before the non-participant spouse dies.²¹ Only a "spouse, former spouse, child or dependent of the participant" can have a QDRO. A former spouse does not include a deceased former spouse.

As a practical matter, a plan might accommodate the non-participant spouse’s heirs, but the plan administrator has considerable discretion to accept or reject the divorce decree or other evidence that the parties intended to create a QDRO.

Obtain a Valid QDRO Before Participant Enters Pay Status
The rights of the non-participant spouse to retirement benefits may not only be cut off or diminished by death, but by procrastination. In Hopkins v. AT&T Global Information Solutions Co.,²² a former non-participant spouse sought to have alimony arrearages paid by means of a QDRO. The original decree in 1986 provided the former non-participant spouse with alimony and left the retirement benefits in the participant’s hands. The participant remarried and retired before the action commenced. The participant and the participant’s "second" spouse elected and received a 50 percent joint and survivor annuity. In view of alimony arrearages, the divorce court ordered that the former "first" spouse be made an alternate payee and the surviving spouse under the plan. AT&T argued that the order was not a QDRO because it divested a non-participant, i.e., the "second" spouse, of pension rights. The federal court agreed, reasoning that the survivor benefit had now vested in the "second" spouse and could not be taken from her.

The partial good news is that the federal court noted that a valid QDRO could still award a portion of the participant’s current retirement benefits to the non-participant "first" spouse via a QDRO. However, at the death of the participant, the rights of the "first" spouse will end. If the payments at that time have not been sufficient to satisfy the alimony arrearages, then the "first" spouse is out of luck from a QDRO perspective.

Enforcement of Divorce Decree if Retirement Plan is Terminated
Boggs does raise a troubling issue. The savings plan benefits of Mr. Isaac Boggs were transferred to an IRA. An IRA is not subject to ERISA. Yet Justice Kennedy appears to be saying that the money somehow retained its ERISA nature despite the asset transfer, and that the ERISA preemption followed the asset even though its form had changed.

The troubling issue is how should a divorce decree be handled if the retirement benefits were paid to the participant before a valid QDRO was issued and the plan was then terminated? When the participant has taken an action that deprives the non-participant of his or her retirement plan rights, then an enforcement action directly against the participant is merely effecting the proper transfer of community property.²³ However, Boggs and Ablamis appear to suggest that a QDRO is the only way to get at plan assets even though the plan assets may be in a different form, such an IRA, cash or other property. Perhaps, Boggs and Ablamis need to be read as being limited to testamentary transfers, not enforcement actions by a non-participant spouse while the participant is still alive. Otherwise, in the case of a plan termination, there may be no remedy for the non-participant spouse if benefits are distributed before a valid QDRO is issued.

Take Care of Beneficiary Designations and Spousal Waivers in Second Marriages
Subsequent marriages can create a number of problems in attempting to deal with a QDRO. In fact, there may be a malpractice risk even if the participant is awarded all of the retirement benefits and no QDRO is needed. If the participant who retains 100 percent of the retirement benefits pursuant to a divorce decree should fail to change his or her beneficiary designations, the former spouse may still have rights to the survivor benefits under the plan.²⁴ This result is probably not what the participant wanted. Therefore, the domestic relations lawyer may need to prepare a file closing letter advising the client of QDRO-related risks even in a situation where no QDRO will be issued.

Conclusion
The domestic relations lawyer is perhaps the last of the generalists, having to deal with a myriad of property and tax issues during a divorce. It is understandable that QDRO issues often have a lower priority than other, apparently more pressing, matters. However, early due diligence regarding the availability of retirement benefits and welfare benefits as well as early strategy sessions to discuss the potential uses of retirement benefits and welfare benefits can pay large dividends for the non-participant spouse. On the flip side, procrastination can be fatal to the non-participant spouse so that, at a minimum, the client needs to be advised of the risks of not dealing with these issues promptly and adequately.

William J. Kluwin is a sole practitioner licensed in Arizona, California and the District of Columbia. He advises businesses, fiduciaries and individuals on ERISA and employee benefit matters, frequently consulting in domestic relations property settlements and QDROs.

ENDNOTES:

1. IRC § 414(p); 26 U.S.C. § 414(p).
2. IRC § 414(p)(1)(B); 26 U.S.C. § 414(p)(1)(B).
3. IRC § 414(p)(1)(B)(i) & (ii); 26 U.S.C. § 414 (p)(1)(B)(i) & (ii).
4. IRC § 414(p)(8); 26 U.S.C. § 414(p)(8).
5. IRC § 414(p)(6)(B); 26 U.S.C. § 414(p)(6)(B).
6. See Schoonmaker v. The Employee Savings Plan of Amoco Corporation and Participating Companies, 987 F.2d 410 (7th Cir. 1993).
7. 86 F.3d 982 (10th Cir. 1996), rev’g. 102 T.C. 61 (1994).
8. IRC § 402(e)(1); 26 U.S.C. § 402(e)(1). As a general rule, an alternate payee who is a spouse or former spouse of the participant is treated as the distributee for pension plan distributions received under a valid QDRO. With an invalid QDRO, the participant is taxed on the distribution even if it is paid to the non-participant. See also, Lewis Darby, 97 T.C. 51 (1991).
9. 1995-1 U.S.T.C. ¶ 50,115 (M.D. Fla. 1995).
10. 100 T.C. 521 (1993).
11. 38 F.3d 107 (3rd. Cir. 1994).
12. Frustrating the implementation of a QDRO can lead to additional liability for the participant. In Stephen Allen Lynn, P.C. Profit Sharing Plan v. Stephen Allen Lynn, P.C., 25 F.3d 280 (5th Cir. 1994), a divorce court ordered the participant to withdraw $50,000 of community property from the retirement plan in order to pay interim attorneys’ fees. The participant/owner then amended the retirement plan so that no distributions could be made from the plan until the participant reached age 65, which was in 20 years. The non-participant spouse sued under Section 510 of the Employee Retirement Income Security Act (ERISA). The Court held that the participant violated ERISA. The scorched-earth policy backfired on the participant because ERISA permits the payment of compensatory damages and the award of attorneys’ fees for Section 510 violations. See also, Brotman v. Commissioner, 105 T.C. 141 (1995)(participant collaterally estopped from claiming a state court divorce order was a QDRO).
13. N.Y.L.J., p.24, col. 4 (Oct. 25, 1996).
14. ERISA § 201; 29 U.S.C. § 1051. See Carland v. Metropolitan Life Insurance Co., 935 F.2d 114 (10th Cir.), cert. denied, 502 U.S. 1020 (1991).
15. 42 F.3d 1080 (7th Cir. 1994).
16. Wheaton can be cited for the proposition that a QDRO can be drafted as an alternative to a qualified medical child support order ("QMCSO").
17. T.C. Memo 1996-446 (1996); See also, Commissioner v. Lester, 366 U.S. 299, 304-05 (1961).
18. No. 96-79,1997 WL 284816, 21 EBC 1041 (June 2, 1997).
19. ERISA § 514; 29 U.S.C. § 1144.
20. Ablamis v. Roper, 937 F.2d 1450 (9th Cir. 1991).
21. Ablamis dealt with the death of the non-participant. In re Marriage of Norfleet, 612 N.E.2d 939 (Ill. Ct. App. 1993), cited Ablamis for the proposition that rights also need to be perfected before death in the case of a participant. In Norfleet, the participant was ordered to pay $50,000 out of an IRA or other retirement benefits. When the participant refused to pay, a hearing was set to order the participant to pay the money pursuant to a QDRO. The participant died before the hearing. The plan administrator stated that no valid QDRO was on file on the date of death and refused to pay the funds to the non-participant spouse. The Court upheld the plan administrator’s decision.
22. 914 F. Supp. 1362 (S.D.W.V. 1996).
23. See Powell v. Commissioner, 101 T.C. 489 (1983). In Powell, the former wife was awarded approximately 50 percent of the pension plan benefits. The husband withdrew the entire amount in the form of stock, sold the stock, and then gave his former wife her share. The Tax Court held that the amounts transferred to the former wife as mandated by the California divorce decree were taxable to the wife as a distributee. The Court ruled that, by virtue of California community property law, the divorce decree did not transfer any rights to the wife but simply accomplished a division of preexisting community ownership of the pension benefits. This decision was entered before 1984 when the QDRO rules came into effect.
24. See NADA Retirement Trust v. Arbeitman, 89 F.3d 496 (8th Cir. 1996). See also Metropolitan Life Insurance Co. v. Pressley, 82 F.3d 126 (6th Cir. 1996). In Lasche v. George W. Lasche Basic Profit Sharing Plan, No. 96-4277, May 6, 1997 (11th Cir. 1997), the literal and rigorous nature of these statutory requirements relating to survivor rights is demonstrated. The second spouse signed a prenuptial agreement specifically waiving any interest to the participant’s retirement benefits. When the plan terminated after the marriage and the plan assets were transferred to another trustee, the second spouse signed a form that designated the participant’s three daughters from a previous marriage as the beneficiaries and signed the spousal waiver form. However, the form was never signed by the employer nor was it notarized as required by ERISA. The failure to notarize the form cut off the rights of the three daughters.