Marital planning is the bedrock of estate and income tax planning for individual taxpayers, but even a well-conceived plan suffers when the married couple decide to divorce. During the divorce proceedings, it is critical for each taxpayer to work with a tax adviser to understand the estate, gift, and income tax consequences of the marriage dissolution. Several provisions of the Internal Revenue Code apply commonsense rules to dividing asset ownership and implement the general rule that divorce should not be a taxable event. Other Code sections, however, can create unexpected difficulties for divorcing spouses. This item outlines considerations for managing and correctly timing a marital property settlement from a tax perspective.
The first key provision is Sec. 2516, a gift tax rule that renders nontaxable certain payments and transfers between former spouses that would otherwise be taxable. However, Sec. 2516 applies only to payments and transfers made pursuant to a written agreement that resolves the divorcing spouses' marital and property rights or provides for the support of minor children. In addition, the final decree of divorce must occur no later than two years after execution of the written agreement and no earlier than one year prior to the execution of the agreement. While the actual payments do not have to be made during the three-year period, they must be traceable to the agreement. Sec. 2516 provides that the transfers will be deemed to be made for full and adequate consideration, which negates the gift.
Sec. 2516 covers both direct transfers and transfers in trust but only to the extent of the value of the former spouse's marital and property rights and a reasonable allowance for the support of minor children. Taxpayers who have tried to argue that payments or discretionary distributions to adult children should fit within Sec. 2516 have been unsuccessful, as exemplified by Technical Advice Memorandum 200011008, in which the IRS ruled that life insurance proceeds paid to adult children were not protected by Sec. 2516.
Another gift tax rule that divorcing spouses must navigate is Sec. 2513, which governs the gift-splitting election. Because this statute mandates that the donor spouse and the nondonor spouse signify their consent to the gift-splitting election and that the spouses be married at the time of the gift (and neither may remarry during the calendar year), it is essential for divorcing spouses to incorporate the timing of the divorce into their gift planning.
So that the signed consent does not become a point of contention, it is optimal to have the nondonor spouse agree in the property settlement agreement to sign the Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, when finalized, consenting to the gift-splitting election. The consenting spouse is not required to file a separate gift tax return, but it is important that each spouse understand that with gift splitting, the entire gift tax liability is joint and several, and all gifts eligible for gift splitting in a calendar year are subject to the gift-splitting election.
Many estate plans are drafted with "kick-out" provisions, which are triggered upon divorce, once spouses are no longer cohabiting, or upon the filing of a petition for legal separation or dissolution of the marriage. The typical kick-out provision provides that the former spouse and all of his or her family members (except the divorcing couple's descendants) are deemed to have died intestate on the date of the triggering event. As such, these persons are incapable of serving as trustees or trust protectors and are also removed as beneficiaries. These provisions are common in wills and irrevocable trusts, including spousal limited access trusts (SLATs), grantor retained annuity trusts (GRATs), and intentionally defective grantor trusts (IDGTs).
Many advisers recommend these provisions to avoid forced grantor trust status. Under Sec. 672(e)(1)(A), a grantor is treated as holding any power or interest held by "any individual who was the spouse of the grantor at the time of the creation of such power or interest." If a former spouse remains a beneficiary or trustee, the grantor loses the flexibility to turn off grantor trust status. It is essential to plan for the termination of grantor trust status, especially if the trust has outstanding liabilities.
Sec. 682 is intended to override the grantor trust rules and causes trust income that is distributed to a former spouse to be included in his or her gross income. Income distributed for the support of minor children remains taxable to the grantor. The open question here is what definition of income applies for purposes of Sec. 682, as income is not defined in the Sec. 682 regulations. Since Sec. 682 is intended to override the grantor trust rules, most advisers believe that the Sec. 671 definition applies in a way that income is not limited to fiduciary accounting income but rather should be interpreted as taxable income. Given this uncertainty, it is recommended that a written settlement agreement governing distributions to a former spouse from a grantor trust that falls within Sec. 682 include a tax reimbursement provision so that the former spouses agree that if the IRS were to take a contrary interpretation on the definition of income, the aggrieved party could be reimbursed.
Sec. 1041 is the income tax counterpart to Sec. 2516 and furthers the legislative goal of preventing recognition of income, gain, or loss on transfers of property between spouses incident to a divorce. This nonrecognition treatment under Sec. 1041 and Temp. Regs. Sec. 1.1041-1T can (or must, in many cases) survive the divorce itself and applies to transfers between former spouses if the transaction occurs (1) not more than one year after the marriage ceases, or (2) not more than six years after the marriage ceases and is made pursuant to a divorce or separation instrument or a modification or amendment to such an instrument. Although the property transfers themselves do not trigger taxable income, advisers should still study the impact of the ultimate disposal of those assets. Thus, when dividing marital assets, spouses must look beyond fair market value (FMV). Consider the assets in the exhibit below, assuming for simplicity a 40% ordinary income tax rate and a 20% long-term capital gain tax rate.
However, this type of analysis may oversimplify the matter. It is likely that $100 in a Roth IRA is worth more than $100 in cash, due to the possibility of future tax-free growth. In addition, limits on recognition of capital losses may limit their utilization and, thus, their value. Divorcing spouses may also wish to cooperatively plan to minimize their overall future tax impact, as certain assets may be more valuable in one individual's hands than in the other's, depending on the individuals' tax attributes, life expectancies, effective tax rates, or ability to use losses. Tax sharing agreements may be included as part of the divorce decree and aid in truing up the economic effects when assets cannot be otherwise easily divided, but these agreements can be complex and difficult to manage.
Special care must be taken in structuring the property transfer, as Sec. 1041 generally covers only transfers between spouses or transfers to a third party on a spouse's behalf (such as the payment of attorneys' fees). Structuring considerations may be as simple as the choice between splitting shares of publicly traded stock (which would not trigger gain) or selling the stock and splitting or transferring cash (which would trigger gain). However, these types of analyses become more complex in closely held businesses or other situations where divorcing spouses hold assets inside partnerships or other legal entities.
Example 1:A and B are divorcing spouses. They intend to divide their marital assets pursuant to a divorce decree and expect that all assets will be transferred and divided within six months of the dissolution of the marriage. A owns a 50% interest in XYZ LLC, which is taxed as a partnership. The FMV of her interest is $200,000, and her tax basis in the asset is $100,000.
If XYZ were to redeem a portion of A's interest in exchange for $100,000 cash, no gain would be recognized since A would have sufficient tax basis to absorb the distribution. A could then transfer the $100,000 to B in a nontaxable Sec. 1041 transaction. However, A would be left holding an interest in XYZ worth $100,000, with a zero tax basis.
If A were to instead transfer 50% of her interest in XYZ to B and XYZ were to redeem his interest, the result could be different. Immediately after the transfer, B and A would each hold an interest in XYZ worth $100,000 and with a tax basis of $50,000. As B's redemption would not be a transfer between spouses (or a payment on a spouse's behalf to a third party), it likely would not be protected under Sec. 1041. Thus, the redemption would be a taxable event to B, who would recognize $50,000 of income. However, this recognition would be a potential benefit to the remaining partners of XYZ (including A), who might be able to increase the tax basis of XYZ's assets under Sec. 734.
Generally, an LLC or other similar entity that is solely owned by a single spouse will be treated as a disregarded entity. This disregarded-entity treatment can also apply when spouses share ownership as a result of their residence in a community property state. However, disregarded-entity treatment does not apply to LLC interests held by spouses in separate property states—those entities must generally be treated as partnerships for tax purposes. Therefore, one can imagine many scenarios where transactions taking place as part of a divorce can create, or dissolve, a partnership for tax purposes.
Example 2: Prior to the divorce, AB LLC was held solely by A (or by both spouses as community property). If the divorce results in ownership of AB LLC by both A and B, the entity is no longer disregarded and is now subject to rules and regulations of Subchapter K, including the requirement to file a partnership return. Conversely, if AB LLC had been held 50/50 in a separate property state and the divorce left A as the sole owner, the entity would cease to exist for income tax purposes.
Often, the marital home is one of a couple's most significant assets. While Sec. 1041 prevents the recognition of gain on the transfer of this asset from one spouse to another, the implications of a later sale of the home should be analyzed. Sec. 121 allows a married couple to shelter $500,000 of gain related to the sale of a primary residence in which they have lived for two of the past five years. In addition, for purposes of the "two of the past five years" test, an owner may treat periods when his or her former spouse inhabited the home pursuant to a divorce decree as if the owner were still living in the home. However, if the property is not held jointly after divorce (and the selling spouse is not remarried), the selling spouse is able to shelter only $250,000 of gain upon sale of the residence. Thus, if the intent is to sell the home shortly after the divorce, it may be beneficial to enter into an agreement to sell the home jointly and split the proceeds.
Lastly, it is critical that taxpayers receive a qualified domestic relations order (QDRO) if retirement accounts are transferred under the divorce decree. The QDRO must include the name and mailing addresses of both the plan participant and the alternate payee.
In conclusion, taxpayers should work with their accountants and attorneys to ensure that a divorce is a nonrecognition event and that property rights are dissolved in the most tax-advantaged, or at least tax-neutral, manner.
Mindy Tyson Weber is a senior director, Washington National Tax, for RSM US LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or email@example.com.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.