[1] Property Settlements [a] Statutory Provisions
[i] Gain / Loss. No gain or loss is recognized on a transfer of property from an individual to a spouse, or a former spouse, if the transfer is incident to the divorce. IRC §1041(a).
[ii] Basis. The transferee spouse takes the same basis in the property it had in the hands of the transferor spouse. IRC §1041(b).
1) If the property being transferred is the personal residence, there is less potential for tax than with other assets, because §121 provides a $250,000 exclusion for gain on sale of a principal residence w hich the seller occupied for at least 2 of the previous 5 years. Unless the principal residence had potential gain of m ore than $250,000, the form er spouse receiving the residence w ould not have tax. Upon rem arriage, the form er spouse w ith the residence could exclude up to $500,000 of gain.
a) Beware, however, that the basis in the house is not necessarily what the now-divorced couple paid for it. For sales prior to May 7, 1997, §1034 provided that gain would not be recog- nized to the extent the taxpayer purchased a replacement residence with a cost greater than the net selling price of the old residence. This was accompanied by a reduction in basis in the new residence by the amount of gain that was realized but not recognized. By this means, the gain was being preserved for recognition at a later time when, if ever, the homeowner replaced a residence with one that cost less, or sold and did not replace it at all. Consequently, in order to know the basis of the house being transferred incident to the divorce, it is necessary to know whether the residence was acquired prior to May 7, 1997, and if it was, whether it was acquired subsequent to the sale of a prior residence on which gain was not recognized under §1034. The tax return for the year of the prior sale should provide the information neces- sary to determine the starting basis in the current residence (the starting basis, of course, would be adjusted for any capital improvements to or depreciation on the residence subsequent to purchase).
b) There also used to be an exclusion under §121 for taxpayers 55 years of age and older. They could exclude up to $125,000 of gain from sale of a personal residence, even if it was not replaced. This was an outright exclusion, rather than a non- recognition, the difference being that with an exclusion there is no accompanying reduction in basis of the replacement asset. With non-recognition, tax attributes are retained, but with an exclusion the taxpayer gets a fresh start. Conse- quently, if the spouses now being divorced had sold their prior residence at a time when at least one of them was 55 years old and were otherwise eligible to and in fact did exclude gain under §121, and then acquired the current residence, the starting basis in the current residence would be
what they had paid for it, without any adjustment to basis for the amount of gain excluded.
c) Even if at the time of the transfer the spread between value and basis in the residence is less than $250,000, there is no telling how long the transferee spouse will stay there, and consequently what the value will be at the time, if ever, it is sold. While the possibility still exists that gain will have to recognized on the sale, the transferee spouse has at least $250,000 and possibly $500,000 of gain that can be excluded, assuming the other requirements of §121 are met.
2) Other assets are not treated so kindly. As to assets other than the principal residence, the transferee spouse takes over the basis the spouses had in the asset.
a) Consequently, if the asset has appreciated, that gain will on a later sale be recognized and taxed to the transferee spouse. b) Assets of equal value may have markedly different tax
consequences, due to differences in basis. This is a factor that should not be ignored in determining the division of property. c) Business or investment property that has been depreciated is, to the extent of the depreciation, subject to recapture, which is taxed as ordinary income (and properly so, since the depreciation was deducted against ordinary income). Recap- ture is triggered either by a sale or exchange of the property or by a change in its use. In the divorce setting, the attorney representing the transferee spouse must recognize that what might otherwise appear to be an asset the sale of which would result in capital gain might in fact have an element of ordinary income in it.
3) Retirem ent assets are the m ost tax-laden assets of all. W hen those assets are distributed, the entire am ount w ill be subject to tax as ordinary incom e. In order for the transfer to be given effect and not to trigger im m ediate tax results, the assignment of retirem ent benefits incident to a divorce should be done through a Q ualified Dom estic Relations O rder (QDRO).
[iii] Incident to divorce. The transfer must occur within 1 year after the date on which the marriage ceases, or be related to the cessation of the marriage. IRC §1041(c).
1) If the transfer is w ithin 1 year after the m arriage ceases, there is no need to inquire as to the purpose of the transfer.
2) If the transfer is m ore than 1 year after the m arriage ceases, but less than 6, it is considered “related to cessation of the marriage” if the transfer is pursuant to a divorce or separation instrum ent, and the transfer occurs not more than 6 years after the date on w hich the marriage ceases. A divorce or separation instrument includes a modification or amendment to such decree or instrument. Tem p. Reg. §1.1041-1T(b), Q&A 14.
3) Any transfer not pursuant to a divorce or separation instrum ent and any transfer occurring m ore than 6 years after the cessation of the marriage is presumed to be not related to the cessation of the m arriage. This presum ption may be rebutted only by show ing that the transfer w as m ade to effect the division of property ow ned by the form er spouses at the time of the cessation of the marriage. Tem p. Reg. §1.1041-1T(b), Q&A 14.
[b] Installment Contracts
[i] In general, the holder of an installment obligation cannot transfer the installment note without triggering all deferred gain. IRC §453B. A common situation is the sale of real estate under a contract for deed. If the seller of the property subsequently makes a transfer of the right to receive payments under the contract, then any gain on the sale that has not yet been recognized will be accelerated and recognized in the year of the disposition.
[ii] An exception is provided for transfers incident to divorce. §453B(g). As long as the transfer complies with §1041, the deferred gain will not be accelerated.
[iii] The transferee spouse, assuming the transfer complies with §1041, will then take over all tax attributes of the contract, including the character and timing of gain or loss under the contract.
[c] Corporate Stock
[i] Transfer of stock in a corporation pursuant to §1041 receives the same treatment as the transfer of any other asset: the transfer does not trigger recognition of gain or loss, and the transferee spouse takes over the transferor spouse’s basis.
[ii] If a redemption of stock is being considered, it may be advisable to wait until after the divorce to carry out the redemption.
2) Redem ptions of stock by a corporation from a shareholder also result in capital gain or loss but only if certain conditions are m et.
3) The redem ption should not be essentially equivalent to a dividend. For exam ple, if a corporation had one shareholder, and it redeem ed half the stock ow ned by that shareholder, the shareholder w ould still ow n 100% of the corporation’s stock. There has been no substantive change in the ownership of the corporation, and under §302, this w ould be taxed as a dividend, that is, as ordinary incom e. 4) Under §302, the redem ption w ill not be treated as essentially equivalent to a
dividend if there is a substantially disproportionate redem ption of the share- holder’s stock, or a complete term ination of the shareholder’s interest in the corporation.
5) For purposes of determining w hether the tests for substantially disproportionate distributions or com plete termination have been met, attribution rules apply, under w hich one w ill be considered to ow n the stock ow ned by one’s spouse. For this reason, a redem ption w ould be more likely to m eet the §302 tests if the redem ption occurred subsequent to the divorce. Then there w ould be no attribution to the redeem ed shareholder of the stock ow ned by the form er spouse who continues to ow n stock in the corporation. Consequently, it w ould be more likely that cash could be obtained from the corporation at capital gain rates rather than ordinary incom e rates.
[d] Partnerships / LLC’s
[i] Partnerships have unique provisions under §736 allowing a choice of tax treatment for payments made to a deceased or retiring partner, but this flexibility means that extra care must be taken in planning.
[ii] This discussion also pertains to limited liability companies taxed as partnerships. For simplicity, all references will be made to partners and partnerships, with the understanding that the references would also apply to members and LLC’s for LLC’s that are taxed as partnerships.
1) A multiple mem ber LLC is taxed as a partnership, unless it elects to be taxed as a corporation. Reg. §301.7701-2(a), -2(c)(1), and -3(a).
2) A one mem ber LLC is taxed as a sole proprietorship, unless it elects to be taxed as a corporation. Reg. §§301.7701-2(a), -2(c)(2)(i), and -3(a).
[iii] Under §736(a), the portion of the payments made to a withdrawing partner for his or her share of unrealized receivables, good will (in the absence of an agreement to the contrary), or otherwise not in exchange for his or her interest in assets will be considered either: (1) a distributive share of partnership income, if the amount of payment is determined with regard to partnership income; or (2) a guaranteed payment under §707(c), if the amount
of the payment is determined without regard to partnership income.
[iv] Payments, to the extent considered as a distributive share of partnership income under §736(a)(1), are taken into account under §702 in the income of the withdrawing partner and reduce the amount of the distributive shares of the remaining partners. Payments, to the extent considered as guaranteed payments under §736(a)(2), are deductible by the partnership under §162(a) and are taxable as ordinary income to the recipient under §61(a). See §707(c). [v] Payments made in liquidation of the entire interest of a retiring partner or deceased partner are, to the extent made in exchange for the partner's interest in partnership property (except for unrealized receivables and good will as provided in §736(b)(2) and (3)), considered as a distribution by the partnership (and not as a distributive share or guaranteed payment under §736(a)).
[vi] Payments made to a retiring partner or to the successor in interest of a deceased partner for his or her interest in unrealized receivables of the partnership in excess of their partnership basis, including any special basis adjustment for them to which the partner is entitled, are not considered as made in exchange for the partner's interest in partnership property. Those payments are treated as payments under §736(a). Unrealized receivables are defined in §751(c).
[vii] For the purposes of §736(b), payments made to a retiring partner or to a successor in interest of a deceased partner in exchange for the partner’s interest do not include any amount paid for the partner's share of good will in excess of its partnership basis, including any special basis adjustments for it to which the partner is entitled, except to the extent that the partnership agreement provides for a reasonable payment for the good will. Those payments are considered as payments under §736(a).
[viii] Payments made to a retiring partner or to a successor in interest of a deceased partner for his or her interest in inventory are considered as made in exchange for the partner's interest in partnership property for the purposes of §736(b). However, payments for an interest in substantially appreciated inventory items, as defined in §751(d), are subject to the rules provided in §751(b). The partnership basis in inventory items as to a deceased partner's successor in interest does not change because of the partner’s death unless the partnership has elected the optional basis adjustment under §754.
[e] Retirement Benefits
unless they are distributed to an alternate payee pursuant to a qualified domestic relations order, and then they will be taxed to the alternate payee. [ii] An “alternate payee” is defined in IRC §414(p)(8) as any spouse, former spouse, child or other dependent of a participant who is recognized by a domestic relations order as having a right to receive all, or a portion of, the benefits payable under a plan with respect to such participant.
[iii] Absent this rule, the payment of the benefits would be taxed to the participant spouse, even though the payments are being made to someone else.
[iv] If upon the death of the alternate payee, the remaining benefits were to become payable to someone who did not come within the class of permissi- ble alternate payees, the payment of benefits would then be taxable to the participant spouse.
[v] To address this concern, either the QDRO could provide that the benefits would have to continue to a child or other qualifying “alternate payee,” or the marital settlement agreement could provide that the recipient will pay all income tax arising out of the assigned benefits, specifically including any income that may be taxed to the participant on the assigned portion.
A “domestic relations order” is any judgment, decree, or order (including approval of a property settlement agreement) which:
[vi] 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
[vii] is made pursuant to a State domestic relations law (including a community property law).
A “qualified domestic relations order” is defined in IRC §414(p) as a domestic relations order:
[viii] which 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 the benefits payable with respect to a participant under a plan, and
[ix] which clearly specifies:
1) the nam e and the last known mailing address (if any) of the participant and the nam e and mailing address of each alternate payee covered by the order,
2) the am ount or percentage of the participant's benefits to be paid by the plan to each such alternate payee, or the m anner in w hich such am ount or percentage is to be determ ined,
3) the num ber of paym ents or period to which such order applies, and 4) each plan to which such order applies; and
[x] which may not alter amount, form, etc., of benefits, by which is meant the order:
1) does not require a plan to provide any type or form of benefit, or any option, not otherw ise provided under the plan,
2) does not require the plan to provide increased benefits (determ ined on the basis of actuarial value), and
3) does not require the payment of benefits to an alternate payee which are required to be paid to another alternate payee under another order previously determ ined to be a qualified dom estic relations order.
[2] Maintenance Payments
Alimony or separate maintenance payments are deductible to the payor and income to the recipient. IRC §§215, 71.
The term “alimony or separate maintenance payment”is defined in IRC §71(b).
[i] The first requirement is that the payment be made in cash. Payments in goods or services will not qualify.
[ii] Second, the payment must be received by (or on behalf of) a spouse under a divorce or separation instrument.
1) Voluntary paym ents do not qualify.
2) A “divorce or separation instrum ent” is defined in IRC §71(b)(2) as:
a) a decree of divorce or separate maintenance or a written instrument incident to such a decree, or some other decree requiring a spouse to make payments for the support or maintenance of the other spouse, or
3) The paym ent could be m ade to a third party on behalf of the recipient spouse. The regulations indicate that the paym ent must be pursuant to the w ritten request, consent or ratification of the payee spouse, and that such request, consent or ratification must state that the parties intend the payment to be treated as an alim ony or separate maintenance paym ent to the payee spouse subject to the rules of §71, and m ust be received by the payor spouse prior to the date of filing of the payor's first return of tax for the taxable year in w hich the payment w as m ade. Tem p. Reg. §1.71-1T, Q&A 7.
[iii] Third, the divorce or separation instrument must not designate such payment as a payment which is not includable in gross income under §71 and not allowable as a deduction under §215.
1) Consequently, it is possible to change the tax effect of alimony payments. The parties can agree that the party receiving the alim ony does not have to include the paym ent in income and the paying party w ill not take a deduction.
2) It is probably advisable in any event to be specific as to the intended tax im pact, even if the parties intend the usual rules to apply.
[iv] Fourth, in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made.
1) It is possible for paym ents prior to divorce to constitute alim ony or separate m aintenance paym ents, but the spouses usually cannot be living together.
a) A dwelling unit formerly shared by both spouses shall not be considered two separate households even if the spouses physically separate themselves within the dwelling unit. Temp. Reg. §1.71-1T, Q&A 9.
b) The spouses will not be treated as members of the same household if one spouse is preparing to depart from the household of the other spouse, and does depart not more than one month after the date the payment is made. Temp. Reg. §1.71-1T, Q&A 9.
2) If the paym ents are made under a decree of divorce or separate maintenance, the spouses have to be legally separated for the paym ents to be deductible by the paying spouse.
3) If the paym ents are made under a separation agreem ent or an interim agreem ent for support, rather than under a final decree, they may qualify as an alim ony or separate maintenance paym ent notw ithstanding that the payor and payee are
m em bers of the sam e household at the tim e the paym ent is m ade. Tem p. Reg. §1.71-1T, Q&A 9.
[v] Fifth, there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.
1) If the payments continue beyond the death of the payee, they are treated as property settlem ents, w hich are not deductible.