Decisions — Dancing with the IRS

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There’s no point dancing around the truth. If you’re a married couple, the tax code treats you as an economic unit. That’s true even when you’re a former married couple, as long as you’re acting “incident to a divorce.” The economic unit designation isn’t all bad. For example, most transfers of property between former spouses “incident to the divorce” are nontaxable.

But there are limits. “Incident to the divorce” generally means the transfer occurs within one year after the date on which the marriage ceases, or is related to the cessation of the marriage. (See internal revenue code section 1041.) “Related to the cessation of the marriage” means the transfer is made under a divorce or separation instrument, and the transfer takes place within six years after the date on which the marriage ceases. (See temporary treasury regulation 1.1041-1(T).)

In T.C. Memo. 2016-113 (Belot), the taxpayer and his wife divorced in 2007. They entered into a settlement agreement at the time of the divorce. Under the terms of the agreement, the taxpayer and his former wife agreed to own and operate, as equal partners, three dancing-related businesses they had formed and run during their marriage.

Later in 2007, the taxpayer’s former wife said the taxpayer had mismanaged the businesses, and she filed a lawsuit against the taxpayer to gain full control over the businesses. In 2008, sixteen months after the initial settlement agreement and divorce, the taxpayer and his former wife entered into a second settlement agreement regarding the lawsuit. The taxpayer transferred his interests in the businesses to his former wife in exchange for payment.

His former wife agreed to purchase all of his interests in the three businesses for a total of $1,580,000, with $900,000 to be paid at closing and the balance of $680,000, evidenced by a promissory note, payable in equal monthly installments on the first of each month beginning June 1, 2008, over 10 years bearing interest at the fixed rate of 5% on the principal amount outstanding. The amount of each monthly payment under the promissory note was $7,212.46.

The IRS says the transfer under the second settlement agreement does not qualify as nontaxable under the regulations.

Here is the relevant tax law

From Internal Revenue Code Section 1041: Provides that:
TRANSFERS OF PROPERTY BETWEEN SPOUSES OR INCIDENT TO DIVORCE.
(a) General Rule.–No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)–
(1) a spouse, or
(2) a former spouse, but only if the transfer is incident to the divorce.
* * * * * * *
(c) Incident to Divorce.–For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer–(1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.

From Temporary Treasury Regulation 1.1041-1T(b): Section, Q&A-7, Temporary Income Tax Regulations, provides the following (Editorial note: The court numbered the sentences to facilitate references to the regulation):

[1] A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in section 71(b)(2), and the transfer occurs not more than 6 years after the date on which the marriage ceases.

[2] A divorce or separation instrument includes a modification or amendment to such decree or instrument.

[3] Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than six years after the cessation of the marriage is presumed to be not related to the cessation of the marriage.

[4] This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage.

[5] For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one- and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.

The IRS makes the following arguments.

Argument 1.

The transfer did not relate to the divorce instrument.

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Argument 2.

The taxpayer did not rebut the presumption as provided in the fourth sentence of the regulation because the taxpayer’s transfer of his interests in the businesses to his former wife under the second settlement agreement was not due to “legal or business impediments that prevented a transfer called for by the divorce decree.”

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Argument 3.

The divorce settlement resolved all of the property issues between the taxpayer and his former wife.

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Argument 4.

In form and in substance, the division of the marital businesses made by the second settlement agreement was a sale.

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Argument 5.

The former wife’s dissatisfaction with the first settlement agreement was a business dispute.

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Argument 6.

The fact that the taxpayer’s former wife filed the 2008 lawsuit in the superior court civil part rather than the family court (which had jurisdiction over the divorce) shows that the lawsuit concerned a business dispute, not a marital dispute.

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Argument 7.

The 2008 settlement agreement did not resolve a dispute concerning the terms and obligations of the 2007 settlement agreement.

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Final Decision

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***

Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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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Right answer!
Sorry, wrong answer :(

For the taxpayer.

We disagree with the IRS’s contention that the division of marital property must relate to the divorce instrument is based on the first, second, and third sentences of the regulation (which refer to the divorce instrument).

The IRS overlooks the fourth sentence. The third sentence of the regulation provides that there is a presumption that section 1041 does not apply to “[a]ny transfer not pursuant to a divorce or separation instrument.” Consistent with section 1041, the fourth sentence makes clear that the presumption may be rebutted “by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage.”

The taxpayer has made that showing here.

Right answer!
Sorry, wrong answer :(

For the taxpayer.

The IRS contends that the taxpayer did not rebut the presumption as provided in the fourth sentence of the regulation because the taxpayer’s transfer of his interests in the businesses to his former wife under the second settlement agreement was not due to “legal or business impediments that prevented a transfer called for by the divorce decree.”

The IRS bases that argument on the fifth sentence of the regulation.

We disagree with this argument because the fifth sentence provides examples and does not create a requirement that the taxpayer must satisfy to rebut the presumption.

Right answer!
Sorry, wrong answer :(

For the taxpayer.

The IRS points out that the divorce settlement resolved all of the property issues between the taxpayer and his former wife. However, neither section 1041 nor the regulations limit application of section 1041 to one, or the first, division of marital property.

Right answer!
Sorry, wrong answer :(

For the taxpayer.

The IRS points out that in form and in substance, the division of the marital businesses made by the second settlement agreement was a sale.

However, neither section 1041 nor the regulations bars application of section 1041 to divisions of marital property accomplished through sales.

Right answer!
Sorry, wrong answer :(

For the taxpayer.

The IRS characterizes the former wife’s dissatisfaction with the first settlement agreement as a business dispute.

It is true that the marital property at issue consists of stock in businesses operated by the taxpayer and his former wife during and after their marriage.

However, section 1041 and the regulations can apply to marital property which consists of business-related property.

Right answer!
Sorry, wrong answer :(

For the taxpayer.

The IRS contends that the fact that the taxpayer’s former wife filed the 2008 lawsuit in the superior court civil part rather than the family court (which had jurisdiction over the divorce) shows that the lawsuit concerned a business dispute, not a marital dispute.

We disagree.

The application of section 1041 to a transfer resulting from the settlement of a lawsuit is not determined by the forum in which the lawsuit is filed.

Right answer!
Sorry, wrong answer :(

For the taxpayer.

The IRS says the 2008 settlement agreement did not resolve a dispute concerning the terms and obligations of the 2007 settlement agreement.

We disagree.

A former spouse alleged shortcomings with implementation of the first settlement agreement by the other spouse, and as a result the parties negotiated a second settlement agreement employing different terms for disposition of their marital assets than were contained in their first settlement agreement. The transfers made pursuant to the second settlement agreements were made (as required by the fourth sentence of the regulation) to “effect the division of property owned by the former spouses at the time of the cessation of the marriage”; and as required by section 1041 were “related to the cessation of the marriage.”

Right answer!
Sorry, wrong answer :(

For the taxpayer.

We conclude that the sole purpose of the 2008 (second) settlement agreement was to transfer property “incident to the divorce” as that phrase is used in section 1041 and the regulations thereunder. Thus, the transfer at issue here qualifies for nonrecognition treatment under section 1041.

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