Creative Divorce Planning: Applying the QDROtic Equation

November 2011Newsletters For Your Benefit

Tax-qualified retirement plans such as defined benefit pension plans and 401(k) plans are granted substantial tax benefits by the federal government in order to encourage private retirement savings. This is why employers sponsoring those plans are entitled to a tax deduction for the year in which they make contributions to the plans while employees who will ultimately benefit from these contributions are not taxed until the benefits are actually paid to them from the plans, even if the employees are fully vested in their plan benefits many years before they receive distributions.

In order to help ensure that plan benefits are used for their intended purposes—i.e., to provide employees with retirement benefits—the Internal Revenue Code imposes a 10 percent penalty tax for benefits distributed prior to age 59-1/2, theorizing that distributions made at an earlier date are not being used by the employee for retirement purposes and, therefore, are to be discouraged. Similarly, the Internal Revenue Code institutes mandatory minimum distributions to employees when they attain age 70-1/2 in order to discourage employees who can afford to do so to leave all of their retirement benefits to their heirs, thereby again subverting the intent of the retirement plan legislation.

The recently decided Fifth Circuit decision, Brown v. Continental Airlines, Inc., demonstrates how nine airline pilots and their spouses creatively used qualified domestic relations orders (QDROs) and state domestic relations law to circumvent the retirement plan rules. In Brown, the pilots, all married and over the age of 50, became concerned that Continental’s pension plan might be adversely affected by financial troubles in the airline industry and therefore wanted to get their benefits distributed to them immediately rather than having to wait until retirement.

A QDRO is a domestic relations order (DRO) that creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of a participant’s retirement plan benefits and meets certain other requirements. Among those requirements is not requiring the plan to pay a benefit not otherwise provided under the plan and not requiring the plan to provide increased benefits. A DRO is a judgment, decree or order, including the approval of a property settlement agreement, that relates 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 is made pursuant to a state domestic relations law.

In Brown, the pilots learned that under Continental Airlines’ plan, alternate payees under a QDRO (in this case, the pilots’ spouses), where the plan participants had attained age 50, could immediately be paid in a lump sum equal to 100 percent of the pilots’ retirement benefits earned to date. Accordingly, the pilots filed for divorce in state court and the court issued a DRO stating that as part of the divorce, the spouses were to receive an immediate distribution of 100 percent of the plan benefits earned by the pilots.

Apparently the pilots and their spouses continued living together despite filing for divorce and remarried shortly after the spouses received their plan distributions. Additionally, the pilots continued working for Continental Airlines throughout this entire process. Perhaps the outcome here would have been different had the committee administering the Continental Airlines plan taken the position that the state court orders were not QDROs because these were sham divorces. However, the committee approved the DROs as QDROs and only later sued the pilots and their spouses for equitable relief in the federal district court in the Southern District of Texas, seeking restitution of the sums paid to the spouses.

The district court and, later, the Fifth Circuit Court of Appeals, held the committee may not refuse to treat a DRO as a QDRO unless the refusal is based on reasons set forth in the statute dealing with QDROs. Essentially, this means a plan administrator must treat a DRO as a QDRO unless the form of the DRO does not meet the requirements for a QDRO or if: (1) the DRO requires the payment of a type of benefit not provided by the plan; (2) the DRO requires the payment of an increased benefit; or (3) the DRO conflicts with a previously issued QDRO. Since none of these exceptions were present in this case, the district and circuit courts held the committee had no basis to seek restitution from the pilots and their spouses as the initial determinations that the DROs constituted QDROs were correct and there was no basis to challenge those determinations.

The courts recognized these divorces might be sham divorces but ruled the plan administrator was not obligated or entitled to question the decision of the state family law courts. Once the family law courts issued the DROs, it was the job of the committee simply to apply the rules of the Internal Revenue Code to determine whether the DROs were or were not QDROs.

There are two interesting side notes to Brown. First, the case would suggest that other creative ways to avoid some of the pension laws are now available. Many states, such as California, allow for a bifurcation of marital and property rights. In other words, a couple can file for divorce immediately and determine their property rights several years later. The opposite is also generally true in these jurisdictions: a couple can divide up their assets now and have the divorce ruling take place in the future.

Let us assume that a California couple in their 40s would like to make immediate use of their pension monies but do not wish to leave their jobs and are participants in retirement plans that allow lump sum distributions to an alternate payee at any time irrespective of the age of the participant. They could file for divorce but ask the judge to rule only on the division of their marital assets immediately and obtain a DRO giving each spouse 100 percent of the other spouse’s pension benefits. They could then simply put off getting the determination of the dissolution of their marital status forever. Under Brown, a plan administrator would not be able to challenge this strategy. In addition to getting their money at a very young age, they also would not have to pay the 10 percent penalty tax on early withdrawals because payments under a QDRO are not subject to the penalty.

The second interesting side note to this case is that what these pilots did is nothing new. Twenty-one United Airlines pilots and their spouses did virtually the same thing in the mid-1990s after reading a pamphlet titled “Retirement Liberation Handbook.” The pamphlet advocated, as a method of acquiring a distribution of pension plan benefits before retirement age, that participants and their spouses obtain a divorce for the sole purpose of securing a court order assigning pension plan benefits and then remarrying. The United Airlines plan administrator approved five of the applications and then became suspicious when the same law firm handled most of the applications and, in one case, two applications were submitted in the same envelope.

The United Airlines plan administrator sought an advisory opinion from the Department of Labor requesting guidance as to how the administrator should treat a DRO if there is reason to believe it is a sham or questionable in nature. The DOL ruled the plan administrator should notify the state courts of its suspicions. If, within the time period for making a QDRO determination (18 months from the date the DRO is received by the plan administrator), the state court does nothing, then the plan administrator must approve the application. The plan administrator cannot independently conclude the DRO is a sham and, therefore, not a QDRO.

If an employer wishes to avoid these issues, it can either design its retirement plans in a manner that does not allow lump sum QDRO distributions or that defers all plan distributions to age 65, regardless of whether the participant separates from service at a younger age. However, once the provisions for lump sum QDRO distributions at an early age are in a plan, they probably will be considered the type of accrued benefits that cannot be reduced or eliminated.

For more information regarding this topic, please contact Mark H. Hess at 310.598.4152 or [email protected] or any member of Fox Rothschild’s Employee Benefits & Compensation Planning Practice Group.