John R. Bullis: Transfers ‘incident to divorce’ are not taxable

IRS Code Section 1041(a) provides that no gain or loss is recognized on a transfer of property from an individual to a spouse, or a former spouse if made “incident to a divorce.”

A recent Tax Court case found IRS was wrong to try to tax a transfer done in accordance with a second settlement agreement where ownership of business interests was transferred.

IRS Regulation 1.1041-1T(a) generally provides:

A transfer of property is treated as related to the cessation of the marriage (divorce) if it is pursuant to a divorce or separation instrument, and the transfer occurs not more than six years after the date on which the marriage ceases.

A divorce or separation instrument includes a modification or amendment.

If the transfer happens more than six years after divorce, it is presumed to be taxable.

That presumption may be rebutted (overcome) if the transfer was made to effect the division of property owned by the former spouses at the time of divorce.

That presumption may be rebutted by showing the factors that hampered the earlier transfer of property (such as legal or business problems to the transfer or disputes concerning the value of the property owned at date of divorce) and the transfer is done promptly after the problem is solved.

In the Belot case, IRS said it was a taxable transfer because the second settlement agreement was a sale so each owned 50 percent. The Court said it is OK to divide marital property through sales.

IRS then said Ms. Belot’s dissatisfaction with the first settlement agreement was a business dispute. The Court agreed the marital property was stock in three businesses operated by Mr. Belot and Ms. Belot during and after their marriage. However the Court ruled the regulations can apply to marital property that is business-related property. IRS pointed out Ms. Belot filed the 2008 lawsuit in a civil court, not a family court so the lawsuit concerned a business dispute, not a marital dispute. The Court disagreed saying it was a transfer resulting from the settlement of a lawsuit and Code Section 1041 applied.

Then IRS urged the holding in a different lawsuit “Young” be disregarded but the Court disagreed. The parties negotiated a second settlement agreement employing different terms for the disposition of their marital assets that were contained in the first settlement agreement. It held the transfers made by the second settlement were made to divide property they owned at time of divorce.

It is good our system allows for correction of the IRS “over reaching.”

Did you hear? “Challenges are what make life interesting, and overcoming them is what makes life meaningful,” by Joshua J. Marine.

John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.