By Donald Paris, CPA MST CDFA
Today we look at the Tax Court case of Belot, TC Memo 2016-113, which held that the taxpayer’s sale of his interests in marital businesses to his ex-wife in accordance with their marital settlement agreement did qualify for non-recognition treatment of the gain under Internal Revenue Code (IRC) Section 1041.
Before we get into the specifics of the case, we have to remember that the general rule under IRC 1041 is that “no gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse or a former spouse, but only if the transfer is incident to the divorce”. Sounds pretty simple. If you have an asset which has appreciated and you give it to your spouse or former spouse in divorce, you don’t have to tax the appreciation/gain. So, you have to ask yourself, i.e. if this is such a simple concept/rule, then why is there a Tax Court case? Well, IRC 1041 explains that a “transfer incident to divorce” is one where the transfer occurs within one-year after the date that the marriage ceases or is related to the cessation of the marriage.
Now to the case. During the marriage, the taxpayer and his ex-wife jointly owned three businesses. Their divorce was finalized in January 2007. The Marital Settlement Agreement (MSA) equalized their interests in these businesses, whose interests during the marriage were not equal. In September 2007 (only 9 months after the MSA was signed) the ex-wife filed a complaint where she claimed he mismanaged the businesses, and further asking for his removal as a director and employee of one of the businesses and to sell her shares in the business. To settle that lawsuit, he sold his ex-wife his shares in 2008 for $1.58 million. Remembering that the sale occurred more than a year after cessation of the marriage, the IRS wanted him to recognize taxable gain on that sale.
The IRS argued many different items, which were all rejected by the Tax Court.
- The IRS argued that the transfer under the second settlement agreement did not qualify because that settlement did not relate to the divorce agreement. This argument was not upheld because the regulations under IRC 1041 says “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”.
- The IRS also argued that the MSA resolved all the property issues between the taxpayer and his ex-wife. The Tax Court pointed out that neither IRC 1041 nor its regulations limit the application of the section to one, or the first, division of marital property.
- The IRS argued that in form and in substance, the division of the marital businesses made the second settlement agreement a sale of the property. Tax Court said no.
- The IRS also argued that the second settlement characterized the ex-wife’s dissatisfaction with the first settlement, and thus became a business dispute. The Tax Court said that though this may be true, the Code and Regulations can apply to marital property that consists of business-related property.
So, what does this tell us. First, it tells us that just because the IRS says something is so, it is not always so. Next, it tells us that whenever there is a transfer of an asset from one spouse or ex-spouse to the other, we should be mindful of properly documenting the issue in the Marital Settlement Agreement. We want to make sure that the Agreement deals with all the known and potentially unknown tax ramifications. And lastly, it tells us that we must keep the Internal Revenue Code and its Regulations in mind as we are entering into an agreement that may have a tax effect. To ignore them will only create problems down the road.