| But should this doctrine apply if there is no underlying asset? For example, in a transfer of rights to receive part of a monthly retirement benefit, the property transferred is simply the benefits to be paid. Does the “no gain or loss rule” in section 1041 cover this kind of transfer? The IRS has taken the position that assignment principles prevail over section 1041 when a taxpayer transfers the right to receive income, but the issue is unsettled because the IRS is facing some opposition in the courts. Two key factors in some transfers of employment benefits are whether a court-issued qualified domestic relations order (QDRO) is in effect and the timing of the order. For IRA or qualified plan transfers, a QDRO can override the assignment of income doctrine. But the IRS will continue to apply assignment principles to other types of benefits such as nonqualified plans. PERSONAL SERVICES INCOME It is a long-standing precedent that a taxpayer may not escape the tax burden on income assigned to another ( Lucas v. Earl, 2 USTC 496 (USSC, 1930); Helvering v. Eubank, 40-2 USTC 9788 (USSC, 1940)). It is possible to escape this rule only when a taxpayer also transfers the property that is the source of the income. For example, a shareholder can escape being taxed on dividends only by transferring the underlying stock. Since personal services flow from an individual’s personal capital, a “property” transfer is not possible. Under what circumstances would the IRS allow an exception to this general rule? In Kochansky (96-2 USTC 50,431 (CA-9, 1996) aff’g on this issue TC Memo 1994-160), the taxpayer made two interesting arguments in an unsuccessful attempt to avoid being taxed on part of a fee he had assigned to his former spouse. At the time of his divorce, Kochansky, an attorney, was representing a client who had filed a medical malpractice lawsuit. The divorce agreement provided that Kochansky and his wife would split (after expenses) the contingent fee from this lawsuit. When the malpractice case was settled, Kochansky and his former wife each received and paid tax on one-half of the fee. The IRS contended, however, that the entire fee was taxable to Kochansky as an assignment of income.
Kochansky made two arguments to the Ninth Circuit Court of Appeals. First, he contended that the courts have held in several cases that taxpayers may not be taxed on an assignment where the claim is “uncertain, doubtful and contingent.” (See Jones , 62-2 USTC 9629 (CA-5, 1962); Cold Metal Process Company, 57-2 USTC 9921 (CA-6, 1957); and Dodge , 78-1 USTC 9348 (D. Ct. Or., 1977)). In two of these cases, however, the Ninth Circuit saw an underlying asset transfer and not merely a transfer of the right to receive income. In Jones, the taxpayer transferred a disputed claim to a corporation to which he had earlier transferred all of his business assets. The corporation financed the remainder of the litigation to collect the claim. In Cold Metal, the taxpayer transferred a disputed patent the government was attempting to cancel. In not following these cases, the Ninth Circuit sent the message that there is a difference between when the underlying asset is of questionable value and a Kochansky situation where the only underlying asset is the taxpayer. Interestingly, one of the cases the taxpayer cited involved a transfer of contingent income from personal services. In Dodge , a decedent had entered into an oral agreement 30 years before his death whereby he promised to devote his time to managing his brother’s business affairs in exchange for the brother’s promise to leave half of his estate to the decedent’s daughter. The court did not tax the estate on an assignment of income to the daughter because of the “doubtful nature of the decedent’s claim.” However, the fact pattern in Dodge can be considered unusual. At any rate, in Kochansky , the Ninth Circuit clearly rejected any suggestion that the mere contingency of personal service income would permit the taxpayer to escape taxation by assigning it to someone else. Kochansky’s second argument was that because the couple lived in Idaho, his former wife had a community property interest in the contingent fee, making it her separate property at the time of the divorce. The appeals court would not consider this argument since it was not raised at the trial level, but this point may be relevant in some circumstances. QUALIFIED PLANS A separate property interest may cause the nonparticipant spouse in a qualified plan to be taxed on amounts he or she receives. For example, in Mess (TC Memo 2000-37, following Eatinger , TC Memo 1990-310 and others), the court held that the wife be taxed on amounts she had received from her former husband’s military pension. Under California law, she had a community property interest in her spouse’s retirement pay. The court said the result would be the same whether she received the amounts from the government (as here) or from her former spouse. A similar result should hold when other types of income rights exist at the time of a divorce. For example, the participant may have irrevocably elected a qualified joint and survivor annuity.
If there is no preexisting income right, a qualified plan distribution will usually be taxed to the plan participant. In Darby (97 TC 51 (1991)), the Tax Court held that a lump sum distribution to a nonparticipant spouse, who had no right to the money until the court assigned it to her in the divorce, was taxable to the participant spouse. Despite the fact a lump sum was involved, section 1041 was not discussed in the case presumably because the nonparticipant spouse was not exchanging any preexisting rights for the lump sum. But a lump sum payment where the nonparticipant spouse has preexisting rights may trigger nonrecognition under section 1041. In Balding (98 TC 368 (1992)), the court said section 1041 prevailed over assignment of income principles where the wife relinquished her community interest in her husband’s military retirement benefits in exchange for cash. The IRS argued the wife should be taxed immediately on an anticipatory assignment of income, but the court said section 1041 shielded the payment from current income. It did not answer the question of whether she would have to report income when her former husband began to collect his pension. When that question arises, the IRS will likely respond that her share of the future payments is an assignment by the wife to the husband, which will be taxable to her. The ultimate disposition of this issue in the courts may depend on whether they view the situation as a single transaction under section 1041 or bifurcate it into a nontaxable lump sum under section 1041 followed by a taxable assignment of income when the pension payments begin. THE ROLE OF QDROs Under IRC section 401(a)(13)(B), a QDRO will override the assignment of income doctrine for qualified plans. Thus an alternate payee who is a spouse or former spouse will generally be taxed as the “distributee” under IRC section 402. But CPAs should note that this shift of tax burden applies only to spouses and former spouses. The employee-participant will remain the taxable distributee on amounts paid to others such as children. The timing of the QDRO may have major tax and nontax ramifications. For example, if an employee dies before the court enters a QDRO, the spouse loses any right to a survivor annuity. Or if the employee remarries before a QDRO is entered, the new spouse’s rights to a survivor annuity supersede those of the divorced spouse ( Hopkins v. AT&T Global Information Solutions Company, 105 F.3rd 153 (CA-4, 1997)). CPAs should closely examine when benefits start to the nonemployee spouse under a QDRO. Under ERISA, the alternate payee may begin receiving benefits when the employee attains the earliest retirement age under the plan, making it unnecessary to delay benefits until the employee’s retirement. Transferring qualified plan benefits before a QDRO may not only disqualify the plan but also cause negative tax consequences. The employee will be taxed on a premature distri-bution, plus a 10% penalty. The nonemployee will be treated as having received a tax-free transfer under section 1041. However, if the distribution exceeds $2,000, rolling over the entire amount to an IRA will trigger a penalty for excess contributions. Trying to escape this penalty by rolling money into an ineligible plan such as a tax-sheltered annuity will cause the entire distribution to be taxable under section 402(c)(8)9B. HANDLING NON QUALIFIED PLANS
Nonqualified plans lack some of the tax incentives qualified plans offer. For example, the employer may not qualify for an immediate deduction and distributions are not subject to special tax breaks. But the plans are common because they are not subject to discrimination rules, making them useful in rewarding key employees. Nonqualified plan distributions are taxable to the distributee, but section 402(b)(2) does not define distributee to include spouses and former spouses. Thus the IRS will usually tax the employee under assignment principles. For example, a professional baseball player transferred part of his unfunded deferred compensation plan to his wife in a divorce settlement. The IRS refused to apply section 1041 as per the Tax Court’s Balding decision. Instead, it applied assignment principles and taxed the ballplayer (LTR 9340032). This IRS attempt to narrow the focus of Balding will likely result in additional litigation. STOCK OPTION OPTIONS CEOs of 180 of the nation’s largest public companies held an average of $28.7 million in options on their company’s stock at the end of 1997, according to the compensation firm Pearl Meyer & Partners. Until the 1980s stock options were not even considered property to be distributed in a divorce. But now, virtually every state considers vested options to be marital property. Courts are also going after unvested options granted during the marriage but not yet exercisable at the time of the divorce. There are two classifications of options: statutory or qualified options—those granted under and governed by specific code sections—and nonstatutory or nonqualified options—those governed by the more general code principles of compensation and income recognition. The employer determines the type when making the option grant; tax treatment differs for the two types of options. There are two kinds of statutory (qualified) options: incentive stock options (ISOs) under IRC section 422 and options granted in employee stock purchase plans (IRC section 423). Certain rules apply to all statutory stock options that do not apply to nonstatutory options. Only the individual to whom they are granted may exercise statutory options unless the right passes by will or law at the grantee’s death. IRC section 424(c) allows transfers of these types of options pursuant to divorce only after the options have been exercised. If someone disposes of an option before exercise, the tax treatment depends on whether the disposition is at arm’s length. If it is, the transferor recognizes compensation income equal to the amount realized over the amount paid to acquire the option. If the disposition is not at arm’s length, the tax treatment is the same except the transferor will also recognize additional income when the transferee exercises or otherwise disposes of the option. When a taxpayer transfers a nonqualified stock option to a former spouse pursuant to a divorce decree, under IRC section 83 the transferor is taxed at the time of the transfer. Generally, transactions between related parties are not considered to be at arm’s length. However, in Davis, the U.S. Supreme Court held that stock transfers between spouses pursuant to divorce were at arm’s length, causing recognition of gain to the transferor spouse. Even though section 1041 nullified Davis on the recognition of gain requirement, the fact that transfers pursuant to a divorce are arm’s-length transactions still stands. Thus, when section 1041 does not apply to a transfer, taxable income can result. In FSA 200005006, the IRS found section 1041 (nonrecognition of gain or loss) should not apply to stock option transfers pursuant to a divorce, because the options’ value is considered compensation, not gain. In this case the IRS ruled the husband had to recognize compensation income when he transferred both incentive and nonqualified stock options to his ex-wife. Because of the ISO rules (only transferable upon the optionee’s death), options that were ISOs in the husband’s hands became nonqualified in the hands of his ex-wife. She received a carryover basis equal to the compensation her husband recognized. Since the transfer was at arm’s length, there were no additional tax consequences to the husband when his ex-wife later exercised the options. Another factor for CPAs to consider in the transfer of stock options pursuant to a divorce is the community property laws in the taxpayers’ state of residence. There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In letter rulings 8751029 and 9433010, the IRS ruled that the proposed division of options under the divorce decree was a nontaxable event because under the community property laws, the nonemployee spouse had always owned half the options. Presumably, the taxpayers in FSA 200005006 did not live in a community property state. Divorce-related stock option transfers must be valued for income tax purposes before exercise . This is especially difficult considering the compensation the employee spouse receives in exchange for the options may not be ascertainable. Parties to a divorce agreement might want to consider transferring assets other than options or agree to transfer the aftertax proceeds once an option is exercised. IRA ISSUES IRC section 408(d)(1) requires a taxpayer to include in gross income an amount paid or distributed from an IRA. However, under the section 408(d)(6) exception, the transfer of an individual’s interest in an IRA to a former spouse under a divorce decree is not taxable to the individual. The interest is treated as the former spouse’s IRA. However, taxpayers must meet two requirements: There must be a transfer of the IRA participant’s interest in the IRA to the spouse or former spouse, and such a transfer must have been made under an IRC section 71(b)(2) divorce or separation instrument. Two cases illustrate taxpayer failures to meet the first requirement. In Bunney (114 TC 259 (April 10, 2000)), the court ordered Michael Bunney’s IRA divided equally between the parties. Michael withdrew money from his IRA, deposited it in a money market account and then transferred funds to his former wife to buy out her interest in the family home. The Tax Court agreed with the IRS that Michael was the sole recipient of the distributions and held that the entire amount was includable in his gross income. The transfer did not meet the exclusion requirements because Bunney did not transfer his interest in the IRA. Rather, he cashed it out and gave his former wife the proceeds. In a 1995 divorce judgment, the court ordered Richard Czepiel to pay his ex-wife $29,000. To satisfy the judgment, Czepiel liquidated his IRAs (his only assets). In Czepiel (2001-1 USTC 50,134, (CA-1, 2000) aff’g TC Memo 1999-289), he argued the divorce judgment was a QDRO because the court had in effect ordered him to make the withdrawal, since his only funds were in his IRAs. The court agreed with the IRS that the divorce judgment was not a QDRO. If a legitimate QDRO is involved, the timing of the transfer can be crucial. The Tax Court would not permit tax-free treatment of a rollover from an employee’s IRA deposited in the spouse’s IRA before the court entered a QDRO ( Rodoni, 105 TC 29 (1995)). An interest in an IRA must be transferred subject to the divorce or separation agreement. IRS Publication 590 describes two methods of transferring an IRA interest: Change the name on the account to that of the nonparticipant spouse, or direct the trustee to transfer the IRA assets to the trustee of an IRA the nonparticipant spouse owned. If a client has mistakenly taken a distribution, he or she has 60 days to roll the proceeds into another IRA. AVOIDING SURPRISES The taxation of employee benefits in a divorce has been the subject of much recent litigation. The entry of a QDRO, the timing of transfers, community property laws and the harmful tax consequences of transferring some types of employment benefits are all factors CPAs should consider when advising clients involved in a divorce. Given the changing landscape, CPAs should carefully review all recent court cases and other developments as they help clients negotiate divorce settlements to avoid unpleasant surprises. 
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FOR MANY COUPLES, THE MONEY THEY HAVE in employee benefit plans represents the most valuable asset accumulated during their marriage. Dividing these funds in the event of a divorce is a complex process fraught with serious tax implications CPAs need to be aware of to counsel divorcing clients. 
aby boomers have trillions of dollars invested in employee benefit plans. For many couples, these benefits represent the most valuable asset they have accumulated during their marriage. Dividing the spoils in a divorce is fraught with serious tax implications that CPAs should examine carefully. 
Your Pension Rights at Divorce: What Every Woman Needs to Know, the Pension Rights Center, 1140 Nineteenth Street, NW, Washington, D.C. 20036 
