Tax Issues and Planning in Divorce
"[I]n this world nothing can be said to be certain, except death and taxes." Benjamin Franklin, November 13, 1879 --
To paraphrase Benjamin Franklin, in a divorce settlement, the only issues certain to be present are tax issues. If they arise at the eleventh hour, these issues can cause carefully negotiated settlements to unravel. Worse yet, if tax issues manifest themselves after the execution of a settlement that did not consider them, one or both of the parties may be deprived of the benefits of their bargains, with untoward consequences to all concerned. This article is intended to identify some basic tax issues that repeatedly arise in the context of divorce so that they can be spotted and planned for well in advance of the end of the negotiation process. Clients and matrimonial attorneys alike are advised to seek out the assistance of a qualified tax advisor whenever entering into a settlement.
TAX TREATMENT OF ALIMONY
One of the general tenets of divorce taxation is that alimony usually is deductible to the payor and taxable to the payee. See I.R.C. §215(a). This aspect of alimony can create added value in a settlement in which the payee is in a lower tax bracket or otherwise can shelter the alimony payments through the use of offsetting deductions, such as the mortgage interests deduction. However, in order to treat alimony as deductible to the payor, certain definitional criteria set forth under I.R.C. § 71 must be met. I.R.C. § 71(b) sets forth the basic definitional requirements of the term "alimony." Section 71(b) provides generally that "alimony" means any payment in cash if (1) the payment is received by or on behalf of a spouse under a divorce decree or separation instrument; (2) the instrument does not designate the payments as being includable in gross income and not allowable as a deduction; (3) the payor and recipient are not members of the same household at the time payments are made; (4) and the payments are terminable on the death of the recipient spouse without substitute payments upon that spouse's death. Other subsections of §71 also make clear that alimony will be distinguished from child support payments where the payments are designated for the benefit of the children or where changes to payments are contingent upon events in the children's lives. Finally, §71 discusses the concept of "recapture," i.e., the recompilation of front-loaded alimony paid during the first three years after separation of the parties. Set forth below, is a more detailed discussion of each of these requirements.
1. Alimony Payments Must Be Made In By Cash To Or On Behalf Of The Payee Spouse
The term "Cash" includes currency, checks, or money orders payable on demand. Temp. Treas. Reg. Sec.; 1.71-IT (b) (A-5). In addition, payments "on behalf" of the payee spouse also may qualify as alimony. For example, "Cash payments of rent, mortgage, tax or tuition liabilities of the payee spouse made under the terms of the divorce or separation instrument will qualify as alimony or separate maintenance payments." (Id. at A-6). It is important to note however, that mortgage interest and insurance payments on real property are treated as alimony only to the extent that they are on behalf of the payee spouse. (Id.) Therefore, if the dependent spouse remains in the martial residence that is jointly owned by the parties, then it is assumed that he or she has only a one half interest and, therefore, that only one-half of the payments made by the payor spouse are on behalf of the payee. Id.
2. Alimony Must be Paid Pursuant to a Divorce or Separation Instrument
Voluntary payments may not be treated as alimony. There must be an established obligation to pay, either by a decree of divorce or separate maintenance, an agreement made pursuant to such a decree, a written separation agreement, or any other decree of the court requiring the payor to make payments for the support of the other spouse. I.R.C. §71 (b)(2). Nor may payments of alimony above the amount specified in the original instrument be treated as alimony. See Ellis v. Commissioner, T.C.M. 1990-456 (oral upward modification of alimony payments did not meet requirements of I.R.C. sec. 71). Payments may be treated as alimony only after the execution of the relevant agreement or entry of the order. The Code does not permit retroactive treatment as alimony of support payments made before the execution or entry of the order or decree.
3. Alimony Payments May be Designated as Non-Deductible and Non-Taxable
I.R.C. § 71 (b)(1)(B) provides that an alimony payment may not provide that the payment is not includable under gross income and is not deductible. When read together with I.R.C. §215, which provides that alimony is deductible to the payor and taxable to the recipient, this provision permits parties to choose to state in their property settlement agreement that the payments will be neither taxable nor deductible. This will allow parties to make payments that are adjusted for taxes in what are essentially "after-tax" dollars.
4. Parties Must Be Living In Separate Households When the Payments Are Made
Temporary Treasury Regulation 1.71-IT (A-9), interpreting I.R.C. §71(b)(1)(C), states in relevant part, "Generally a payment made at the time when the payor and payee spouses are members of the same household cannot qualify as an alimony or separate maintenance payment if the spouses are legally separated under a decree of divorce or of separate maintenance. For purposes of the preceding sentence, a dwelling unit formerly shared by both spouses shall not be considered two separate households even if the spouses physically separate themselves within the dwelling unit." Therefore, a payor must cease living under the same roof as the payee not more than one month after the payment is made in order for it to be treated as alimony.
5. Payments Must be Terminable Upon the Death of the Payee
I.R.C. § (b)(1)(D) expressly provides that "there is no liability to make nay such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse." This provision is in keeping with the underlying concept that the purposes of alimony is to support the payee spouse and not otherwise to transfer assets or make payments for any other purpose. The requirement that the obligation to pay alimony must cease upon the death of the recipient has particular importance with regard to pendente lite support orders, i.e. temporary support orders entered before a final judgment. Pendente lite support orders are "instruments" under section 71(b)(2)(C). However, these orders often provide that the payor is to provide "unallocated support" and do not break the payment out between alimony and child support. Two cases arising out of New Jersey pendente lite orders address the issue of whether unallocated pendente lite support payments may be treated as alimony, with different results. The first case is Gonzales v. C.I.R., T.C. Memo. 1999-332 (U.S. Tax Ct., 1 Oct. 1, 1999), 1999 WL 778531 (U.S. Tax Ct.), 78 T.C.M. (CCH) 527, T.C.M. (RIA) 99,332, 1999 RIA TC Memo 99,332. In that case, the New Jersey court's pendente lite order called for unallocated support payments and neither provided how the payments would be treated for tax purposes nor provided that those payments would cease should the recipient spouse die. The court held that the payments were not alimony and therefore, should not have been included in the recipient wife's taxable income.
More recently, in Kean v. C.I.R. T.C. Memo.2003-163 (U.S. Tax Ct., June 4, 2003) 2003 WL 21278331 (U.S. Tax Ct.), 85 T.C.M. (CCH) 1445, T.C.M. (RIA) 2003-163, 2003 RIA TC Memo 2003-163, the court distinguished Gonzales and ruled that under the facts before it, unallocated support payment should be treated as alimony. In Kean, the court's pendente lite order, among other things, required that the payor husband: (1) Pay all household expenses, including, but not limited to, the mortgage, taxes, and utilities; (2) pay all expenses for the children, including, but not limited to, private school tuition; and (3) maintain insurance coverage and pay all unreimbursed expenses for health and medical needs of the wife and the children. Like the underlying Family Court order in Gonzales, the pendente lite order in Kean did not indicate whether the disputed payments would terminate at the wife's death.
Importantly in Kean, the Family Court ruled that the parties were to have joint legal and physical custody of the children of the marriage, and denied cross applications by the parties for sole physical custody pending a final judgment. Based upon this fact, the Kean court ruled that the holding in Gonzales did not apply. The court found that if the wife had died prior to final judgment, the divorce action would have terminated in accordance with the general rule under New Jersey law that divorce proceedings abate with the death of either party Carr v. Carr, 120 N.J. 336 (1990). The court also found that because the parties had joint legal custody, the provisions of N.J.S.A. 9:2-5 would not apply and custody would have reverted automatically to the husband. With the divorce action terminated and custody of the children firmly with the husband, his obligation to pay support would have ceased. Therefore, although not express in the pendente lite order in Kean, the husband's obligations were terminable upon the death of the payee.
The Kean court distinguished Gonzales on the ground that, in that case, the wife had been awarded temporary custody of the parties' children. In the event of her death, pursuant to N.J.S.A. 9:2-5, custody of the children would not have reverted to the husband, and the husband could have been required to continue making support payments to a successor custodian for the benefit of the children.
6. Treatment of Payments as Child Support
I.R.C. §71(c) distinguishes between alimony and child support payments and identifies the circumstances under which purported alimony payments will nevertheless be treated as non-deductible and nontaxable child support payments.
I.R.C. §71(c) (1) provides that payments to a recipient spouse will not be included in that spouse's income, to the extent that any portion of that payment is fixed as a sum payable for the support of the children of the payor spouse. Section 71(c) (2) further provides that the recipient spouse shall not include in gross income any part of a payment from the payor spouse that is to be reduced either (1) upon the happening of a contingency expressly specified in the instrument relating to a child, or (2) at any time which can clearly be associated with a contingency relating to the child. Note, however, that the presence of child related payments, or reductions upon child related contingencies, does not wholly disqualify a payment as alimony, but merely reduces the portion of that payment that is treatable as child support from the gross income of the recipient and deductible portion of the payor's payment.
In Preston v. Commissioner, 208 F.3d 1281 (11th Cir. 2000) the court held that when payments are earmarked for the payment of specific expenses relating to children, the payments will be treated as child support, even if the divorce decree does not set forth a specific amount for those payments. Therefore, where pursuant to the terms of a divorce instrument, a payor is responsible for some or all of the children's unreimbursed medical expenses or tuition, those payments may not be treated as alimony for tax purposes. Similarly, payments that abate during periods when the children of the marriage are staying with the payor will also be treated as child support. See Priv. Ltr. Ruling 8746085 (Aug. 21, 1987). Under that ruling, the divorce instrument provided that alimony payments would be reduced during those periods of time in which the children of the marriage were saying with the payor. The ruling held that the portion of the payment stream that abated during those times was not alimony and could not be deducted, nor would it be included, in the recipient's gross income.
With respect to contingencies that can clearly be associated with a contingency relating to children (See I.R.C.§71 (c) (2)(B), the Internal Revenue Service will presumptively treat as child support those payments that abate within six months of such a contingency, although that presumption may be overcome. See Hill v. Commissioner, T.C. Memo 1996-179; Shepard v. Commissioner, T.C. Memo 2000-174. Child related contingencies include but are not limited to a child reaching a certain age, marrying, graduating or leaving school, dying and the like. Most often, these contingencies reflect events that relate to the emancipation of the child, or changes in the child's life that will terminate certain expenses such as private school tuition).
4. Recomputation of Front-Loaded Alimony Payments
I.R.C. §71(f) provides a formula for scrutinizing alimony payments made in the first three years after separation for the purpose of identifying "excess" alimony payments. The reason for this provision is to prevent parties from avoiding taxes by front-loading alimony to disguise property transfers that are not in fact intended as support payments. Such a situation might occur at a year-end separation and a subsequent payout of an amount that is actually the equitable distribution of property - and not support - in the following years. The front-loading is evidenced by the fact that there is a significant drop between the amounts paid in the first and/or second post-separation year, and the amounts paid in the third post separation year. §71(g) defines the "first post-separation year" as "the 1st calendar year in which the payor spouse paid to the payee spouse alimony or separate maintenance payments to which this section applies. The 2nd and 3rd post separation years shall be the 1st and 2nd succeeding calendar years, respectively." Accord Temp Treas. Reg. A-22 of §1.71-1T
Any amounts found to be "excess" payments upon the application of the formula, become included in the payor's gross income and may be deducted from the recipient's income in the tax return filed for the third post-separation year. This recapture rule applies only to the first three "post-separation years" and includes "excess payments in the income of the payor for the third post separation year." There are three exceptions that recognize that a drop in payments may be the result of something other than a disguised property transfer. They are: (1) when payments cease because of the death of either party, or the remarriage of the recipient spouse; (2) where payments are made under a pendente lite order and then are reduced at final; and (3) where payments are not set in a fixed amount, but are rather set as a percentage of income or compensation fixed by the payor.
The formula set forth in section 71(f) appears complex, but if followed step by step can be easily applied. The formula provides that an "excess alimony" payment is the sum of the excess payments made paid by the payor spouse in the first and second post separation years.
The excess paid in the first post-separation year is calculated as follows:
The total amount of alimony payments made by the payor spouse during the first post separation year over THE AVERAGE OF
The excess paid in the second post-separation year is the excess, if any, calculated as follows:
8. The Use Of Business Assets To Pay Alimony
Where a payor controls a corporation, and the corporation makes payments to the recipient spouse for his or her support, neither the payor nor the corporation may deduct the payments. First, the payor obviously cannot deduct the payments because the payor did not make them. In WSB Liquidating Company v. Commissioner, T.C. Memo 2001-9, the court held that the corporation could not deduct them either. There, the husband controlled a closely held corporation. In consideration of the wife's waiver of alimony, the parties agreed that the husband's corporation would provide the wife with certain benefits and that the corporation would also provide automobiles to the wife. The wife ceased providing any services to the corporation. The Company issued W-2 forms to the wife reporting the payments as income to her and deducting the payments from the corporation's income for tax purposes. The IRS denied the deductions for the corporation and the tax court agreed. The court found that the payments were not actual compensation to the wife for any services rendered by her, and that the payments were in fact non-deductible payments of the personal expenses of the husband, unrelated to the business. The corporation was penalized for filing an inaccurate return under I.R.C. §6662(a).
TAX TREATMENT OF DIVORCE-RELATED PROPERTY TRANSFERS
A. Section 1041 - "Non-Taxable" Transfers Incident to Divorce
1. Non-Recognition of Gain or Loss on Transfer
The starting point of any discussion of the tax treatment of property transfers incident to a divorce is a discussion of I.R.C. § 1041. That section provides that the transfer of property from an individual to, or for, the benefit of a spouse or former spouse (under certain conditions) is not a taxable event, i.e., neither party will recognize any gain or loss at the time of the transfer. (I.R.C. § 1041(a)). Importantly, the property received by the transferee will be treated as having been acquired by way of gift and the basis of the transferee in the property will be the adjusted basis of the transferor. I.R.C. §1041(b)(2); Temp. Treas. Reg. Q&A 11 of §1-1041-1T. The "adjusted basis" of property is the original cost of the property as adjusted pursuant to the provisions of IR.C. § 1016. Such adjustments may include increases in basis as the result of capital expenditures or decreased in basis as the result of depreciation. Notably, the basis in a home may be reduced by any gain on a previous principal residence, which was rolled over into the present principal residence of the parities when former I.R.C. §1034 was in effect.
2. The Meaning of "Incident to a Divorce" under §1041
Under §1041(a) (2) the non-recognition rule always applies to spouses in an intact marriage. Therefore, transfers prior to the entry of a judgment of divorce should always involve non-recognition. The non-recognition rule applies to a former spouse only if the transfer is "incident to a divorce." §1041(c) provides that a transfer is incident to a divorce if the transfer occurs within one year of the date upon which the marriage ceases, or is "related to the cessation of the marriage." If the transfer is made less than one year of the cessation of the marriage, it will receive non-recognition treatment under § 1041 even if it is not pursuant to a divorce decree or separation instrument. If the transfer takes place more than one year after the marriage ceases, it will receive non-recognition treatment if it is related to the cessation of the marriage. The Internal Revenue Service will treat a transfer as being related to the cessation of the marriage if (1) the transfer is pursuant to a divorce instrument and (2) if the transfer takes place less than six years after the cessation of the marriage. There exists a rebuttable presumption that transfers taking place more than six years after the cessation of the marriage are not incident to divorce and therefore, that gain or loss may be recognized on such transactions. Temp Treas. Reg. A-7 of §1-104-1T (emphasis added) states:
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. . . and the transfer occurs not more than 6 years after the date on which the marriage ceases. A divorce or separation agreement includes a modification or amendment to such a decree or instrument. 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. This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by both spouses at the time of the cessation of the marriage. 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.
In Young v. Commissioner, 240 F.3d 369 (4th Cir. 2001), the United States Court of Appeals for the Fourth Circuit affirmed the ruling of the tax court that a specific transfer of property was incident to a divorce and therefore, that the provisions of §1041 applied to preclude gain or loss. In so doing, the Fourth Circuit found that the taxpayer had overcome the presumption that, where a transfer of property to a former spouse is not pursuant to a divorce decree or separation instrument (as those terms are commonly understood), it is not a transfer incident to a divorce. In so doing, the Fourth Circuit articulated principles that have application beyond the limited scope of the facts there before it.
In Young, the parties had divorced in 1989, pursuant to a property settlement agreement. In or about 1990, the wife brought a collection action on the divorce judgment seeking satisfaction of approximately $2.2 million in obligations under the property settlement agreement as to which the husband had defaulted. In 1992, the parties settled the collection action pursuant to another separate settlement agreement. The second settlement required the husband to transfer to the wife a parcel of land worth in excess of $1.5 million for which he had paid approximately $130,000. Although not express in the Fourth Circuit's opinion, it is apparent that the property settlement agreement entered into at the time of the divorce did not require the husband to transfer the property to the wife. The wife subsequently sold the property. The issue before the court was whether the husband was required to recognize the gain as of the time of the transfer to the wife, or the wife was required to recognize the gain at the time of sale, using the husband's basis. Both the tax court and the Fourth Circuit ruled that the settlement of the collection action and the transfer of the property were "incident to a divorce" and therefore that the husband's transfer to the wife was not a taxable event. Importantly, the court noted that section 1041 "looks to the character of and reason for the transfer, not to the status of the transferee. . . .." Id. at 374. The court also found that the transfer of the property was intended to effect the division of the property owned by the former spouses at the time of the cessation of their marriage. Id. In Priv. Ltr. Rul. 9235926, (May 29, 1992), the I.R.S. found that the taxpayer had overcome the six-year "safe harbor" provision of §1041, where the transfer of real property owned by the parties at the time of the cessation of their marriage was delayed beyond the six-year boundary because of a dispute between the parties as to the purchase price and payment terms relating to the property. The issue of whether §1041 applies to bar recognition of gain or loss does not appear to have been directly addressed in the context of a fairly typical fact pattern involving the situation in which parties to a divorce agree that the children will remain in the marital residence with the primary custodial parent. Such agreements often provide that the marital residence will remain in the parties' joint names until the youngest child graduates from high school, at which time the custodial parent will buy out the non custodial parent's interest in the house, or sell the house to a third party. When the youngest child is scheduled to graduate more than six years after the date of the divorce judgment, a strict reading of Temp Treas. Reg. A-7 of §1-1041-1T would suggest that there is a presumption that the subsequent transfer of the non-custodial parent's interest in the home is outside the scope of §1041. Indeed, the examples of situations overcoming the presumption given in A-7 and the facts of Priv. Ltr. Rul. 9235926 both deal with transfers that were scheduled to take place within the six year period, but were delayed as the result of disputes between the parties. By contrast, the situation involving delay of the sale of the transfer of title to the marital residence between former spouses deals with a situation in which the parties contemplated that the transfer between former spouses would not take place until after six years had passed. Under the principle enunciated in Young, that the nature of the transfer controls the applicability of §1041, it would appear that the presumption should be overcome. By specifically identifying the property in the property settlement agreement entered into at the time of the divorce, and articulating the reasons for the delay in transfer, the non-custodial spouse could well argue that the transfer was made to effect the division of property owned by both spouses at the time of the cessation of the marriage, and therefore, that the transfer was incident to the divorce, notwithstanding the passage of time. The absence of any discussion or decisional precedent under this fact pattern may indeed suggest that the IRS simply assumes that such transfers are incident to divorce. Nevertheless, reliance upon common sense in both the areas of divorce and taxation may present risks that the practitioner may wish to take into account. Such a practitioner may wish respond to those risks those risks, either by structuring settlements to avoid them or by including language in property settlement agreements to minimize them.
Section 1041 also will protect transfers to third parties on behalf of a spouse or former spouse from recognition of gain or loss under appropriate circumstances. As set forth in Temp. Treas. Reg. Q&A-9 of §1-1041-T1, there are three circumstances in which, all other conditions being met, §1-41 will apply to transfers to third parties: (1) where the transfer to a third party is required by the divorce or separation instrument; (2) where the transfer to the third party is requested in writing by the non-transferor spouse or former spouse; and (3) where the transferor receives a written consent or ratification of the transfer to the third party. Such a consent or ratification must also state that the parties intend to treat the transfer as being subject to §1041 and that the consent is received by the non-transferor spouse prior to the date of filing of the first tax return following the year in which the transfer was made. In all three case, the transfer of property will be treated as having been made by the non-transferring spouse, or former spouse, and the non-transferring spouse will be required to recognize any gain or loss generated by the transaction with the third party.
B. Tax Treatment of Specific Types of Property or Transfers
1. Tax Issues Affecting the Sale Marital Residence
Section 1041 bars recognition of gain or loss upon the transfer of title to the marital residence from one spouse to the other at the time of their separation or divorce. However, eventually, the house will be sold to a third party, either at the time of the separation or divorce or at a later date, either while both parties own the house jointly or while it is held in the name of only one of the parties. The primary issue involved in the sale of the marital residence to a third party deals with the recognition (or avoidance of recognition) of gain at the time of sale to a third party.
2.Tax Issues Concerning United States Savings Bonds
Section 1041 applies only to bar recognition of gain or loss. It does not apply to recognition of income received by a taxpayer. The Tax code treats accrued interest as income, not gain. Therefore, if savings bonds are transferred from one spouse to another in connection with a divorce, the spouse receiving the bonds must report the accrued interest as income in the year in which the bonds are transferred, even if they are not "cashed in" after the transfer. This result however, may not be obtained if the spouse who had originally owned the bonds had reported the incremental increase of the maturity value of the bonds as income in the years in which he or she owned the bonds in his of her name. See I.R.C. §451.
3. Business Related Assets - Redemption of Closely Held Stock
Where married persons both own shares in a closely held corporation, it is a typical outcome in a divorce settlement that one spouse divests himself or herself of the corporate stock and receives value in exchange. Where the transferor spouse simply transfers stock to the other spouse in exchange for other assets from the marital estate, §1041 clearly applies to make that transaction a "non-taxable" event. However, the question has been less clear when the corporation itself redeems the stock, in effect purchasing it from the transferor spouse. When this occurs, two questions arise. First, does the transferor spouse included in his or her gross income the proceeds, or does §1041 apply to this situation as well. Second, if §1041 does apply, will the monies spent by the corporation to redeem those shares be treated as a "constructive dividend" to the non-transferor spouse, which should be included in his or her gross income?
In recent years, the courts have struggled with the issue of whether the transferor spouse should report the proceeds from the redemption. The courts looked to Temp. Treas. Reg. Q&A-9 of §1-1041-T1 (discussed above) and asked if the redemption was a transfer "on behalf of" the non-transferor spouse, with mixed results. Compare Arnes v. United States, 981 F.2d 456 (9th Cir. 1992) (redemption of transferor's shares by corporation was made on behalf of the non-transferor spouse, §1041 applied), with Blatt v. Commissioner, 102 T.C. 77 (1994). In the year 2000, the tax court flipped its analysis and found that §1041 applied not because the corporation was making a payment on behalf of the non transferring spouse, but because, the transferor spouse was making the transfer on behalf of the non-transferring spouse, in as much as the transferor was agreeing to redemption of his or her shares at the request of, and for the benefit of, the non-transferor spouse in order to facilitate the division of the marital estate. See Read v. Commissioner, 114 T.C. No. 2 (2000); accord, Craven v. United States, 215, F.3d 1201 (11th Cir. 2000).
The recent enactment of I.R.C. Reg., §1.1041-2 now controls this issue in substantial part. The regulation provides that, when a divorce instrument provides that the shares of a corporation organized under Subchapter "C" or Subchapter "S" held by one spouse are to be redeemed by the corporation, the parties may elect which spouse will be required to report the proceeds of the redemption in his or her gross income. The property settlement agreement setting forth the election must meet the following criteria: (1) it must be expressly and specifically set forth whether the proceeds will be taxable to the transferring spouse as proceeds of a sale, or to the non-transferring spouse as a dividend; (2) it must recite that both spouses agree on the tax treatment of the proceeds; (3) it must be executed prior to the date on which the party paying the tax filed a timely tax return for the year in which the redemption occurred.
Gift Tax Consequences
Although section 1041 specifically excludes gains or losses on transfers between spouses, it also states that the transaction shall be treated as a gift. Therefore, there is At least the theoretical possibility of the potential for Gift Tax consequences. In most common cases, the issue of gift tax will not be significant, for two reasons. First, in most average cases, the transferor probably will not have exhausted the unified credit within which no Gift Taxes are incurred. In the year 2004, the unified Credit is $950,000. In 2005 and thereafter the unified credit will be one million dollars. Note however, that the Tax code requires that Gift Tax returns be filed for any gift in excess of $10,000.
Under I.R.C. 2523(a), interposal transfers (i.e. those made while the parties are still married), are also subject to an unlimited martial deduction equal to the fair market value of the property transferred. Second, there are several aspects of the Gift Tax laws that avoid taxation of transfers between spouses or former spouses. Further, I.R.C. § 2516 provides that transfers of property made pursuant to written agreement within two years of a divorce are not treated as gifts if the transfers are made in settlement of marital obligations. See also, Harris v. Commissioner, 370 U.S. 65 (1962). Under Rev. Rul. 68-379, transfers between former spouses made more than two years after a divorce may nevertheless be treated as not being subject to Gift tax if made under an agreement for spousal support. Thus, unless a divorce settlement involves the post divorce transfer of property for reasons other than spousal support and the transferor has exceeded the unified credit of $950,000, Gift Tax liabilities on divorce are not probable.
By being aware of the tax issues that attach themselves to every phase of the economic aspects of divorce, parties and practitioners alike can use the tax code to maximize the economic value of the assets and income stream of a family undergoing restructuring through divorce or separation. In so doing, proper tax planning can increase family resources, assist both in the management of conflict and the promotion of amicable settlement and can make the transition process a bit less painful.
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