Tax consequences of divorce.by Knight, Lee G.
The Tax Reform Act of 1984 made significant changes in the taxation of property transfers pertaining to divorce, dependency exemptions of separated parents and alimony payments. Among the major objectives of TRA 84 was simplification of the system. While it achieved simplification to a substantial extent, it triggered some unanticipated results or "fallout" that the IRS and state appellate courts are only now starting to face.
CONGRESS' ACTION IN TRA
84 AND RELATED
In this act, Congress worked a minor revolution in the tax rules governing the relations between spouces and former spouses. A major part of this change is embodied in Sec. 1041, which details the tax consequences of property transfers between spouses and former spouses. The majority of current guidance on the subject of these property transfers is contained in private letter rulings issued by the IRS. However, tax practitioners must always heed the warning contained in Sec. 6110(j)(3): unless the Secretary of the Treasury otherwise establishes by regulations, a private letter ruling may not be used or cited as precedent. Congress and tax practitioners did not foresee implementation problems from the changes.
A status report on Sec. 1041 and property transfers will serve as background before the discussion of the controversial points of divorce in the state courts is presented.
Fundamentals of Sec. 1041
This section now overrules the 1962 Supreme Court decision in T.C. Davis, wherein the court held that a transfer of property from one spouse to another in consideration of the transferee's surrender of marital rights was a property event for recognition of gain or loss to the transferor. On the theory that the marital rights were worth what was paid for their surrender, gain or loss was measured by the difference between the basis of the property transferred and its fair market value. In the case, an exception was provided for divisions of community or co-owned property.
Sec. 1041 now provides that no gain or loss will be recognized to the transferor in the case of a transfer of property between spouses or between spouses incident to divorce. However, under technical corrections made by TRA 86, gain or loss is recognized on transfers of property to a trust to the extent that the liabilities on the property transferred exceeds its basis.
A transfer of property between spouses or between former spouses incident to divorce under Sec. 1041 is generally treated as a gift for income tax purposes. Under Sec. 102, a gift is excludable from the gross income of the donee. Accordingly, the transferee spouse realizes no gain or other income upon receipt of the property. In effect, this rule does not represent a change from earlier law. Before enactment of Sec. 1041, the IRS took the position that the transferee spouse realized no gain or income, but the theory was not that the transfer was a gift.
The basis of the transferor spouse in the property transferred under Sec. 1041 carries over and becomes the basis of the transferee. This rule differs in one respect from the rule that applies to gifts. Generally, the donee's basis in property received by gift--for purposes of calculating a loss on its subsequent sale or exchange--is the lesser of the transferor's basis or the fair market value of the property at the time of the gift (Sec. 1015). but under Sec. 1041, the transferee's basis is the same as that of the transferor in calculating either gain or loss.
The transferee's holding period for the property includes the holding period of the transferor. For example, if the transferor has held the property for six months and one day when the transfer occurs, the transferee is considered to have held the property for six months and one day immediately upon its receipt. Under earlier law, the transferor's holding period could not be added to that of the transferee.
The temp. Regs. provide that the transferor of property must supply the transferee with records sufficient to determine the adjusted basis and holding period of the property as of the date of the transfer. In addition, the transferor must supply the transferee with records sufficient to determine the amount and period of any investment tax credit recapture potential.
Parties to the Transfer
Numerous transfers between spouses and former spouses are governed by Sec. 1041:
1. Transfers made in connection with proceedings for divorce, separation or annulment;
2. Transfers between spouses who are legally separated under a decree of legal separation and between spouses who are separated pursuant to a written separation agreement;
3. Transfers of property between former spouses incident to divorce and occurring not more than one year following the date upon which the marriage ceases; and
4. Transfers related to the cessation of marriage if pursuant to a divorce or separation instrument defined in Sec. 71(b)(2) and occurring not more than six years after the date on which the marriage ceases.
Any transfer of property that is made more than six years after the cessation of marriage (or made more than one year after cessation of marriage but not pursuant to a written divorce or separation instrument) is presumed to be unrelated to the cessation of the marriage. This presumption may be rebutted only by showing that the transfer was made as a division of property owned by the former spouses at the time of the cessation of the marriage. The Temp. Regs. illustrate this rule by stating that the presumption may be overcome by showing that: 1) a transfer of property owned at the cessation of marriage was not made within either the once-year or six-year period mentioned because of factors hampering an earlier transfer--e.g., legal or business impediments or disputes regarding value; and 2) the transfer was made promptly after the impediment to the transfer was removed.
Annulments and other cessations of marriages that are considered to have been void from the beginning are treated as divorces for purposes of SEc. 1041. Accordingly, a decree, judgment or order of annulment will be regarded as a written decree, judgment or order of divorce, as will a written instrument that is incident to a decree, judgment or order.
Transfers to Third Parties
The temp. REgs. provide that a direct transfer of property to a third party by a spouse (the "tranferor") is governed by Sec. 1041 if:
1. The divorce or separation instrument requires it;
2. The transfer is requested in writing by the other spouse or former spouse; or
3. The transfer is ratified or consented to in a written instrument delivered to the transferor by the other spouse or former spouse.
A transfer to a third party is treated as a transfer to the other spouse or former spouse followed by a transfer from the transferee spouse or former spouse to the third party. Only the deemed or constructive transfer to the transferee spouse is subject to Sec. 1041. The subsequent deemed transfer from that spouse to the third party is not subject to Sec. 1041. To effect a consent or ratification by the other spouse or former spouse, the writing must state that the parties intend the transfer to be treated as a transfer to the other spouse or former spouse under Sec. 1041, and it must be received by the transferor before the date of filing of the transferor's first tax return for the taxable year in which the transfer was made.
For transfers after July 18, 1984 and before June 22, 1988, Sec. 1041 did not apply if the transferee spouse was a nonresident alien, but it did apply if the transferee nonresident alien was a former spouse and the transfer was incident to divorce. For transfers after June 21, 1988, TRA 88 amended Sec. 1041 to provide that it does not apply if the transferee nonresident alien is either a spouse or former spouse. The Temp. Regs. state that gain is recognized on an interspousal transfer if the transferee is a nonresident alien--provided that no other nonrecognition provision applies. This goes further than the IRC, which merely states that Sec. 1041 does not apply.
Characterization of Property
Sec. 1041 applies to transfers of "property," a term that is not qualified and may therefore be subject to broad interpretation. Because of this broad scope, Sec. 1041 appears to require the recharacterization of many transactions that appear to be unaffected by it. It is doubtful if Congress intended such a broad scope for this section--but unless and until it is amended, the broad scope must be considered. The following discussion incudels interest payments, imputed payments and compensation to illustrate the related uncertainty and confusion.
Interest payments. If a taxpayer loans money to his spouse or former spouse, or if a taxpayer sells property to a spouse or former spouse on a deferred payment basis, the agreement will typically call for the payment of interest on the loan or deferred purchase price. Is the interest treated as interest for income tax purposes--i.e., is it included in the income of the creditor under Sec. 61(a)(4) and deducted by the debtor under Sec. 163? If the payment is governed by Sec. 1041, the answer is certainly no. Assuming that the interest payments do not meet the definition of alimony under Sec. 71, they are transfers of property (money). On the other hand, if cash payments qualify as alimony, they are included in the income of the payee and are deductible by the payor. However, in the typical deferred payment sale, interest payments will not be terminable upon the death of the payee. Accordingly, they will not qualify as alimony.
If the transfer is either: 1) between spouses; or 2) between former spouses incident to divorce, Sec. 1041(b)(1) provides that the transferee is to be regarded as acquiring the property by gift. Therefore, the payment--which is contemplation of the parties, under state law, and in economic substance may be interest--is not included in the recipient's income as interest income under Sec. 61(a)(4). Rather, it is excluded from income as a gift under Sec. 102. Although Sec. 1041(b)(1) states only that the transfer is treated as a gift by the transferee, it may also be assumed that the transfer is treated as a gift by the transferor. Neither the IRS nor the courts will have great enthusiasm for the payor's deducting a payment that is excludable from the gross income of the payee. If characterized as a gift, it should not be deductible by the transferor, regardless of its characterization by the parties or by state law.
However, the IRS has issued a private letter ruling in which a taxpayer was advised about interest paid in connection with a divorce property settlement. Under a "consent judgment of divorce" entered on June 28, 1985, H was required to pay X dollars to W, with accrued interest from May 19, 1985, for W's equity in the martial estate and other marital rights. The amount was paid in a lump sum. In the letter ruling, the IRS held that interest paid with respect to the lump-sum property settlement was includible in W's gross income. Sec. 1041 unquestionably applies to property transfer after July 18, 1984, under divorce or separation instruments taking effect after that date. Therefore, if applicable to interspousal payments characterized. By the ruling as interest, Sec. 1041 should be applied, and any "interest" payments by H should have been excluded from W's gross income as gifts. The letter ruling aid not address the application of Sec. 1041. Thus, it seems likely that the IRS was not asked to, and did not, consider the question.
Imputed payments. If stated interest is property under Sec. 1041, imputed interest also should be property under Sec. 1041. Sec. 483 and 1274 are concerned with characterizing transfer of wealth from the purchaser to the seller of property in a case where the wealth represents the deferred portion of the purchase price. Sec. 483 applies to transactions that are specifically excepted from the application of Sec. 1274--e.g., sales of farms and principal residences. These provisions address the question: What portion of the wealth transfer is a payment of the deferred purchase price and what portion is a payment of interest on the purchase price? Sec. 7872 is concerned with transfers of wealth between a lender and a borrower under circumstances in which neither Sec. 483 nor 1274 applies--i.e., with an indebtedness which: 1) does not represent the deferred purchase price of property; or 2) has a stated interest rate below the market rate. In short, Sec. 7872 treats a below-market loan as economically equivalent to one bearing interest at the market rate, coupled with a payment by the lender to the borrower of an amount that is sufficient to fund all or a part of the payment of interest by the borrower. Thus, Sec. 7872 recharacterizes a below-market loan as two transactions: 1) an arm's- length transaction in which the lender makes a loan to the borrower in exchange for a note requiring the payment of interest at the market rate; and 2) a transfer of funds by the lender to the borrower (an "imputed transfer"). The characterization of the imputed transfer is determined by the economic substance of the transaction--e.g., interest, gift, or compensation.
Secs. 483, 1274 and 7872 are invoked only if the transfer in question is incident to a substantive seller-purchaser and/or debtor-creditor relationship. However, Sec. 1041(b)(1) characterizes as a gift any wealth transfer between spouses or between former spouses incident to divorce. The Temp. Regs. find that Sec. 1041 applies to any wealth transfer regardless of the manner in which the transfer is treated by the parties or by state law and regardless of the economic substance of the transfer. Thus, an example in the regulations illustrates that a sale by a husband to his wife in the ordinary course of the husband's business is subject to the right of Sec. 1041. The Temp. Regs. also point out that--even in the case of a "bona fide sale" between spouses or former spouses--the basis of the property carries over to the transferee.
Obviously, if a transfer of wealth is characterized as a gift, it cannot also be characterized as a loan, repayment of a loan, interest on a loan, purchase price, or anything else. Furthermore, the legislative history of Sec. 1041 evidences Congress' intent to "make the tax laws as unintrusive as possible with respect to relations between spouses"--an intention that would be frustrated by application of Secs. 483, 1274 and 7872. Thus, Secs. 483, 1274 and 7872 should not apply to Sec. 1041 transfers--the same conclusion reached by the IRS in a private letter ruling. In addition, Prop. Regs. under Sec. 483 provide that it does not apply to Sec. 1041 transfers.
Compensation. It is not uncommon for one spouse to be employed by the other and to receive compensation for services. If Sec. 1041 is interpreted literally, there are some unexpected and unusual results involving interspousal compensation. It is unlikely Congress intended them, but they are the results that appear under the plain language of the statute.
However, the IRS in recent letter rulings has ignored the possible impact of Sec. 1041. In PLR 8601301, the IRS held that an individual who operated his insurance agency as a sole proprietorship was entitled to deduct compensation paid to his wife in determining his net earnings for purposes of the self-employment tax. In PLR 8753003, the IRS held that alleged salary payments by a sole proprietor to his wife were not deductible because of a lack of substantiation. Neither ruling mentioned Sec. 1041.
If Congress had considered the matter, it is doubtful that it would have permitted Sec. 1041 to apply to interspousal compensation. Nevertheless, compensation is literally subject to the provision. The fact that the IRS has not addressed the issue of Sec. 1041's applicability probably indicates that the issue has not been raised in the ruling requests nor has it been independently recognized by the IRS.
In PLR 8719007, the IRS held that no investment credit or depreciation recapture will be recognized upon the proposed transfer of certain "business interests" in a transaction governed by Sec. 1041. The conclusion regarding investment credit recapture is provided by Sec. 47(e). There is no direct statutory provision, but each of the IRC recapture provisions except the loss recapture provision of Sec. 1231(c) contains an express exception for dispositions that are gifts. As noted earlier, Sec. 1041 provides that a transfer of property incident to divorce is to be treated as a gift for income tax purposes. Thus, transfers governed by Sec. 1041 will not trigger recapture for the transferor. Upon a non-exempt disposition of the property by the transferee, recapture will occur.
The recapture of Sec. 1231 net losses under Sec. 1231(c) is triggered only by a sale, exchange or involuntary conversion. If the property is also Sec. 1231 property in the hands of the transferee spouse or former spouse, its subsequent sale, exchange or involuntary conversion may trigger recapture of net Sec. 1231 losses of that spouse. There is no provision that requires the transferee spouse to take into account net Sec. 1231 losses of the transferor spouse.
Transfers in Trust
Sec. 1041 applies not only to transfers of property between spouses or between former spouses incident to divorce, but also to a transfer of property in trust for the benefit of a spouse or a transfer in trust incident to divorce for the benefit of a former spouse. Under a 1986 amendment to Sec. 1041 (effective with the original enactment of Sec. 1041), nonrecognition of gain for transfer in trust does not apply to the extent that the sum of: 1) liabilities assumed by the trust; and 2) liabilities to which the transferred property is subject exceed the total adjusted basis of the property transferred. An appropriate adjustment to the transferee's baiss must be made to account for the gain recognized.
PLR 8644012 addresses the consequences of a transfer of a partnership interest held by an individual (H) to a "grantor" trust of the individual's spouse (W) and of a transfer of partnership interests held by a "grantor" trust of H to a "grantor" trust of W. H was the grantor and trustee of one trust and W was the grantor and trustee of the other. Each trust was revocable by the grantor at any time during the grantor's lifetime. Accordingly, each grantor was considered to be the owner of his or her trust under Sec. 676--thus, the term "grantor trust" is used to describe each trust. Because the property of a grantor trust is treated a sowned by the grantor individually, the IRS held that either of the transfers would be regarded as a transfer of property from the individual to his or her spouse. Accordingly, Sec. 1041 was determined to apply, and no gain or loss was recognized to H--regardless of whether the transfer was executed in his individual capacity or his capacity as a trustee. In addition, the IRS held that the basis of the partnership interests in the hands of W as a trustee or as an individual taxpayer would be the same as their basis in the hands of H as grantor, trustee and/or individual taxpayer.
The ruling was issued before the enactment of TRA 86. Consequently, the retroactive amendment regarding liabilities in excess of basis was not in effect. The IRS did not that H's share of the liabilities of many of the partnerships exceeded the adjusted basis of his interest of the partnerships, but it held this to be irrelevant. The ruling would have been the same even if the TRA 86 amendment had been in place when the letter ruling was issued. This conclusion is supported by the explanation of the Joint Committee on Taxation regarding the technical corrections provisions of the TRA 86 which states that the amendment is "not intended to apply where any gain will be taxed to the transferor under the grantor trust rules." Presumably, this means that the amendment will not apply in cases where a gain will be taxed to the grantor but for the application of Sec. 1041.
Sale of Marital Residence
The Temp. Regs. state that Sec. 1041 applies to transfers between spouses that would otherwise be governed by another nonrecognition provision of the IRC. In PLR 8502027, the IRS advised a taxpayer on the tax consequences of a sale of his principal residence to his spouse under Sec. 121. The taxpayer was the sole owner of the residence and was age 55. Sec. 121 allows a taxpayer who is over age 55 to exclude up to $125,000 of the gain on the sale of his principal residence if certain conditions are met. For a married taxpayer filing a separate return, the limit is $62,500. The taxpayer satisfied the other conditions of Sec. 121 and was informed that he could exclude up to $62,500 of the gain. However, the IRS cautioned that the ruling should be disregarded if the transfer occurred after July 18, 1984--i.e., the effective date of Sec. 1041. The IRS pointed out that no gain or loss would be recognized on the transaction after that date.
PLR 8833018 involves parties who were divorced in May 1985. W (the wife) was awarded the marital residence as part of the property settlement. H (the husband) was given a lien on the property to secure his interest. Under the property settlement agreement, W was required to sell the property not later than June 16, 1988. However, H was given a "right of first refusal"--by which he could match the highest offer by a third-party buyer and thereby acquire the residence. H exercised this right and acquired the property on or before June 16, 1988. The IRS held that the sale by W to H was governed by Sec. 1041 according to the Temp. Regs. Accordingly, a transfer of property between former spouses incident to divorce is subject to Sec. 1041, regardless of whether it is an arm's-length sale or exchange, a transfer in exchange for a release of marital rights, or an exchange otherwise governed by another nonrecognition provision of the Code (e.g., Sec. 1034). The transfer was "incident to divorce" because it was pursuant to a divorce or separation instrument and took place not more than six years following the date of divorce. In addition, the ruling notes that Sec. 1041 applies regardless of whether the property transferred is separately owned by the transferor or is part of an equal or unequal division of community property in a community property state.
ADDITIONAL PROBLEMS IN
Sec. 1041 generally provides for a carryover basis on property transferred during marriage or incident to divorce. Sec. 152(e) generally permits the custodial parent to claim dependency exemptions for qualifying children. However, a noncustodial parent may take the dependency exemption if the custodial parent executes a waiver in accordance with Sec. 152(e(2). Sec. 71(b)(1)(B) permits the divorce instrument to reclassify otherwise qualifying Sec. 71 alimony payments as non-deductible by the payor, and nontaxable to the recipient.
However, none of these sections directly address how state courts are to interpret these provisions. As a result--particularly in the case of custodial parent dependency exemptions for children--state litigation is appearing at the appellate levels, often with contradictory results. Significant questions are also being generated regarding the basis in property divisions--previously a factor primarily in community property estates, which had long had the carryover basis as the general rule. However, the right of a state court to determine that an otherwise qualifying Sec. 71 payment will be treated as non-qualifying is not yet a problem--and apparently will not likely be a problem.
Sec. 71 Alimony Payments
One of the early proposals made to simplify Sec. 71 was to allow the parties to agree that a non-qualifying payment would be deductible to the payor and taxable to the recipient. The statute did not adhere to this proposal and, ultimately, took the opposite approach. If the divorce instrument specifies that a payment, in while or in part, is non-qualifying, then the parties must treat it as non-qualifying for tax purposes.
The legislative history of the statute and the temp. Regs suggest that this was something the parties would determine. In particular, Temp. Regs. Sec. 1.71-1t(b), Q&A-8, explains how the spouses can designate the payments to avoid the normal Sec. 71 rules of deduction from gross income and inclusion in gross income. However, the statute mentions only the "divorce instrument" Sec. 71(b)(1)(B). Since a "divorce instrument" may be a court decree, it follows that not only the parties, but also a divorce court, can order the non-deduction (from gross income) and non-inclusion (in gross income) treatment.
To date, no reported federal cases or state appellate courts have addressed this apparent conflict between the statute, the regulations, and the legislative history of the statute. It is likely the statute will prevail, leaving divorce tribunals free to make part, or all, of an otherwise qualifying payment immune from the regular Sec. 71 rules.
Basis Upon Division Property
The consideration of basis as part of a property division is a separate issue. This is purely a matter of state property law, and authority already exists to the effect that state courts generally may not take basis considerations into account in dividing or awarding property pursuant to divorce or separation.
Sec. 1041(b) gives the transferee of property, during marriage or incident to divorce, the same income tax basis as the transferor. Prior to enactment of this provision, similar rules applied to the allocation of specific properties held in a form of co-ownership, such as community property. Whatever income tax basis the property had prior to transfer became the basis of the property in the hands of the recipient.
In an equal division of property by value, each spouse is awarded property of equal worth, will receive an equal share of the property's basis, and thus an equal responsibility for tax upon the gain from a later disposition of the property. But if one spouse receives cash and the other a low basis-high value asset, the potential liability to the latter spouse for income tax gain upon sale of the property will be quite significant and perhaps inequitable.
The general rule has been that potential income tax impact is not to be considered unless the impact is immediate. For instance, in the early community property cases, this was clearly the rule. In most recent cases, including at least one case from a non-community property state which applied new Sec. 1041(b), the same result occurs. In short, the trial court may not take income tax basis into consideration in allocating property unless it is clear the property will be disposed of and an immediate income tax detriment will occur.
The question then becomes whether a potential income tax result is immediate or speculative when low basis property is awarded to one spouse. An early Wisconsin state court case found such immediacy (certainty of tax detriment) in a pension plan allocation. The decision rested, in part, on a Wisconsin statute which directed courts to take into consideration the tax consequences to each party in dividing marital property.
More recent New Mexico appellate court cases, also dealing with pension plans, reached the opposite result. However, dicta in a slightly earlier New Mexico case suggests that in appropriate instances- -with a proper showing of basis problems outside of the pension area--a contrary result might occur. Indeed, both New Mexico cases permit tax consequences to be considered in marital property divisions, but the cases do not spell out what is required for such a result.
In the allocation of property and basis situation, the state courts appear to be addressing the problem on a case-by-case basis. The result in a given case in any particular jurisdiction is not certain.
Waiver of Dependency
Exemption by Custodial
The trial court's power to require a custodial spouse to sign the appropriate waiver allocating child dependency exemptions to a non- custodial spouse, has been an issue in a number of recently decided cases, with contradictory results. Under prior law, a state court clearly had the power to allocate the dependency exemption to the non- custodial spouse assuming a minimum yearly child support payment of $600 was made. The present statute and the applicable regulations give the allocation power only to the custodial spouse, who must sign an appropriate waiver which must be attached to the income tax return of the non-custodial spouse.
Some state appellate courts have ruled that a trial court can require the custodial spouse to sign a waiver, believing that the allocation does not interfere with Congressional intent in enacting new Sec. 152(e)(2). An Illinois appellate court shares that view, noting the diversity of results in other states' courts--some permitting a forced waiver, others refusing to require such action.
One of the most recent contrary pronouncements, from the Florida Court of Appeals, contains an exhaustive list of authorities, both pro and con. The Florida court ultimately decided that Florida courts, at least, did not have the authority to require a waiver.
Here, unlike the issue of whether state courts can take basis into consideration in dividing property, the federal preemption issue--i.e., once Congress decides on an issue the states must follow--is clearly a factor. It may well be that this particular problem will be resolved by clarifying federal legislation or by the U.S. Supreme Court at some future date.
While the 1984 legislation resolved many of the complexities and issues involving property transers, dependency exemptions and alimony payments, it clearly did not resolve the problems in applying the new rules. Continuing controversy and litigation on these problems is the ultimate result. Practitioners must be alert to the controversy to save their clients unforeseen difficulties.
Ray A. Knight, JD, CPA, is a Professor and member of the Graduate Faculty at Mississippi State University. Mr. Knight has previously published articles in professional publications, including The CPA Journal.
Lee G. Knight, PhD, is a Professor and member of the Graduate Faculty at Mississippi State University. Dr. Knight has previously published articles in professional publications, including The CPA Journal.
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