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August 1992

Tax court allows exclusion of payments received for community property interest in pension. (Federal Taxation)

by Hill, Frances

    Abstract- The Tax Court's ruling in the Hazel Balding vs Commissioner case provides valuable insight into the applicability of Internal Revenue Code Section 1041. The Tax Court denied Hazel's request that her husband's payments for military retirement pension be made to qualify as alimony based on Sec 1041's rules concerning tax-free transfers that arise from divorce settlements of property. Based on a broad interpretation of Sec 1041, the court asserted that the exclusion from tax-free transfers between spouses or former spouses applies to Hazel, whether her interest in her husband's pension is based on marital rightsor property rights. The Balding case thus provides significant insight for succeeding cases regarding the issue of property transfers between spouses and former spouses in any state.

The taxpayers, Hazel and Joe Balding, were divorced in 1981 after 19 years of marriage. They were residents of California, a community property state. In 1984, after changes in California community property law regarding military pensions, Hazel asked the divorce court to award her a community property share of Joe's military retirement pay. Before the court ruled on this request, the Baldings settled. Hazel relinquished her claim in return for payments to her from Joe in the amount of $15,000 in 1986, $14,000 in 1987, and $13,000 in 1988. This settlement was ordered by the divorce court.

Hazel's claim that these payments were not taxable is based on Sec. 1041 and applies to transfers of property (but not services) between spouses and between former spouses that are incident to divorce. To be "incident to divorce," transfers must either occur within one year after the cessation of the marriage or within six years after the cessation of the marriage and be pursuant to a written separation agreement or a court decree. These time limits will be extended only if the taxpayers prove that they had good reasons for the delay Temp. Reg. 1.1041-1 T(b), Q&A-7. Sec. 1041 specifies that no gain or loss shall be recognized on such transfers, that the property shall be treated by the transferee as a nontaxable gift, and that the transferee shall assume the transferors basis in the property.

Hazel requested a private letter ruling on the taxability of the payments received from Joe. In PLR 8813023, the IRS concluded that the payments were taxable to Hazel because they were received in exchange for her community property interest in her spouse's pension. Consequently, her relinquishment of this future income interest constituted an anticipatory assignment of income. Interpreting Sec. 1041 narrowly, the IRS maintained that an assignment of income is not a Sec. 1041 gain.

The Tax Court in Balding first noted that the IRS' position would be correct outside the marital context. However, citing the language of Sec. 1041, the temporary regulations, and the legislative history, the court held that the nonrecognition of gains and losses broadly applies to both the transferor and transferee regardless of the type of property transferred. Moreover, the court pointed out that whether Hazel's interest in Joe's pension is viewed as property or as marital rights, the Sec. 1041 exclusion applies.

The court emphasized that Congress, in enacting Sec. 1041, wanted to make the tax law as unintrusive as possible for transfers between spouses or former spouses. The temporary regulations also support this broad interpretation of "property" and of Sec. 1041. Property includes "marital rights or other consideration." In addition, the exclusion applies whether property is "separately owned by the transferor or is a division (equal or unequal) of community property Temp. Reg. 1.1041- 1t(d), Q&A-10.

Another point noted by the Tax Court in Balding is that Joe's payments would not qualify as alimony under Sec. 71. Unlike Sec. 1041 property settlements, alimony is deductible by the payor and income to the payee. The court did not explain why the payments would not qualify as alimony. Presumably, the reason is that the payments were designated as a property settlement. As such, they do not qualify as alimony under Sec. 71(b)(1)(B).

Importance of Balding

The Tax Court in Balding ruled that the assignment of income doctrine does not apply to the relinquishment of an interest in a government pension to a former spouse. Since the court interpreted Sec. 1041 broadly, Balding is also arguably applicable to transfers of such property as deferred compensation and accounts receivable of a cash basis sole proprietorship or partnership. (Transfers involving interests in qualified pension plans are immune from the assignment of income doctrine under the Retirement Equity Act.) These transfers are most likely to occur in community property states because in other states the spouse who is not active in the business usually has no ownership interest in the business. Nevertheless, Balding's broad interpretation of Sec. 1041 serves as an important precedent for any question raised by the IRS concerning transfers of property between spouses and between former spouses in all states. Also, the nine community property states include some of the most populous states. The nine states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

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