Case — Taxability of Military Retirement Pension Payments to Former Spouse

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TL Case Summ

THE QUESTION

Are military pension distributions received by a former spouse taxable income to her?

THE DISPUTE

Taxpayer Says: The payments are not taxable because they are the result of a division of property in a divorce proceeding.

Internal Revenue Service Says: While tax is generally deferred on property received due to a divorce, income from the property is taxable. The payments are includable in gross income.

THE LAW

From Internal Revenue Code Section 61(a): Gross income is defined as “all income from whatever source derived” unless otherwise specifically excluded.

From Internal Revenue Code Section 61(a)(11): Specifically included in gross income are amounts derived from pensions.

From Internal Revenue Code Section 1041(a): Generally, no gain or loss is recognized on a transfer of property from an individual to a former spouse if the transfer is incident to the divorce. [Editorial note: This section of the Internal Revenue Code was enacted in 1984, four years after the divorce discussed in this case. However, the Court cited Weir v. Commissioner (T.C. Memo. 2001-184) as follows: Law predating section 1041 establishes that, in the case of an approximately equal division of community property on divorce, no gain is recognized on the theory that no sale or exchange has occurred but only a nontaxable partition, and the basis of the property set aside for each spouse is its basis to the community prior to the divorce.]

THE CAUSE OF THE DISPUTE

When you receive a property settlement as part of a divorce agreement under current federal tax law, the transfer of the property to you is generally tax free. The basis carries over to you along with title, and you don’t have to recognize gain or loss until you dispose of the property in a taxable sale or exchange.

In this case, incident to a 1980 divorce granted in a community property state, the taxpayer received rights to, and an interest in, her former husband’s military retirement pension. Beginning in 1986, payments of her share were made directly to her. She did not include the payments on her tax return. The IRS issued deficiency notices in 2004 and 2005, based on Forms 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc..

Along with other arguments, the taxpayer says she was entitled to the payments as a division of property, and they are not taxable income.

The IRS says a military retirement pension, like other pensions, is a right to receive a future income stream from an employer. The taxpayer had no basis in the pension, and the payments should have been included in income.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 17KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. Taxpayer is correct that the actual transfer of the property right is not a taxable event. Thus, taxpayer recognized no gain (or loss) on receipt of property rights in the military retirement pension. But because taxpayer has no basis in the pension, the income is a taxable distribution on which taxpayer is responsible to pay income taxes. The payments are includable in gross income in the year they are received.
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