Transfers Incident to a Divorce

Divorce can be a very complex matter, both emotionally and financially. The financial complexity is illustrated by the many tax implications of divorce. People going through divorces often find themselves in disputes with the IRS. The Tax Court recently decided one such matter.

John and Louise Young were married in 1969 and divorced in 1988. (Note: The court combined two cases into one because they concerned the same transaction. This discussion follows the case from Louise’s perspective.) In October 1989 they entered into a property settlement whereby Louise received a promissory note for $1,500,000, previously held by John. The note was secured by property John received as part of the settlement. He was to pay the note to Louise in five annual installments, which included interest. The settlement also provided that John would pay legal and collection fees if he defaulted.

John defaulted on the note in 1990, and Louise filed suit to collect the amount he owed her. A judgment was entered in her favor. In 1991, John paid Louise only $160,000. Louise properly recognized this amount as interest income on her 1991 income tax return.

In 1992, Louise again filed suit to execute the rest of the 1991 judgment. In December 1992, John and Louise entered into another settlement whereby he transferred the land that secured the note to Louise in exchange for surrender and cancellation of the note. John’s basis in the land was $130,794. This settlement discharged all of his debts to Louise, which totaled $2,153,844 including the $1,500,000 principal amount, accrued interest of $344,938, legal expenses of $300,606 and collection expenses of $8,300. The settlement also gave John the option to repurchase the land for $2,265,000. John assigned this option to a third party, who exercised it and acquired the land from Louise in 1993. Louise’s attorneys collected $300,000 directly from the sale proceeds in settlement of Louise’s legal fees. Louise received the remainder.

The case does not give details about how Louise wanted to treat the transaction. Presumably, she wanted receipt of the land to be considered a settlement of the $1,500,000 promissory note from John. If that had been the case, she would have a capital gain equal to the excess of the value of the land she received over the face value of the promissory note. This treatment would have given Louise a $2,265,000 fair-market-value basis in the land when she sold it to the third party in 1993 instead of John’s $130,794 carryover basis. Such treatment would obviously have created for her an advantageous tax result.

The IRS claimed the transfer of the land to Louise fell under section 1041, which says that, in transfers of property from an individual to a former spouse, the transferor recognizes no gain or loss and the transferee’s basis is the same as the transferor’s adjusted basis if the transfer is “incident to the divorce”—that is, the transfer occurs within one year of the divorce or is “related to the cessation of the marriage.” Further, temporary regulations provide that certain transactions occurring within six years of a divorce may still be considered incident to divorce (temporary regulations section 1.1041-1T(b), Q&A-7).

Result. For the IRS. All parties agreed the 1989 settlement was incident to the divorce because its purpose was to divide marital property. Since the 1992 settlement was the result of legal action regarding the 1989 settlement, the Tax Court found this settlement was also incident to the divorce. Even if the regulations did not apply here, the transfer was related to the cessation of the marriage. Therefore, section 1041 applied.

The IRS also claimed that the money Louise received to pay her legal fees should be included in her gross income. Louise contended that, since John was obligated to pay the legal expenses under the 1989 settlement, the amount he paid should not be included in her income. The Tax Court found that the obligation to pay the legal fees was Louise’s and, thus, she should include the amount paid on her behalf in her gross income. The Tax Court cited Glenshaw Glass Co. (348 US no. 426 (1955)) and O’Malley (91 TC no. 352, 358 (1988)), in support of its position that taxpayers are treated as receiving taxable income when a third party pays an obligation on their behalf.

CPAs and their clients should be aware of section 1041 implications when transfers of property result from a divorce, including those that occur some time after, but are incident to, the divorce. Ignoring the provisions of this section could be disastrous for both the client and the practitioner.

John B. Young, et ux. et al. v. Commissioner, 113 TC no. 152 (1999).

—Prepared by Eddie Metrejean, CPA, instructor, University of Mississippi,
E. H. Patterson School of Accountancy, University, Mississippi.
His e-mail address is emetreje@olemiss.edu .