Divorce settlement payments that a dentist made to his ex-wife and legal fees he paid his divorce lawyer did not increase the basis in an interest in a limited liability company owned by an S corporation that he wholly owned.
The taxpayer, Steven Matzkin, was married to Georgeann Matzkin. A dentist by profession, Steven in January 2003 formed Dental Care Alliance LLC (DCA), a partnership for federal income tax purposes. DCA is a dental support organization that provides services to affiliated dentists around the country. On Jan. 1, 2008, Steven assigned his entire 70% membership interest in DCA to SRM Consulting LLC (SRM), an S corporation of which he was the sole shareholder. SRM thereafter owned a 70% membership interest in DCA.
In May 2008, after more than 20 years of marriage, Steven filed for divorce. Steven's 100% interest in SRM (and by extension his 70% indirect interest in DCA) constituted marital assets under Florida law. An appraisal performed in 2007 valued DCA at $30 million; Steven's 70% indirect interest was thus assumed to be worth about $21 million.
Not surprisingly, Georgeann wanted half of the cash and property that had been built up during the marriage. Besides the interest in DCA, the couple's assets included $4.6 million in cash and securities, $6 million in real estate, $1 million in life insurance, and artwork and furniture of an undetermined value. The couple hired a mediator to assist with the division of the assets between them.
Steven and Georgeann came to a final agreement that called for a cash down payment to Georgeann and monthly payments on a $5.4 million promissory note. It provided if DCA were sold within 18 months and Steven's share of the proceeds exceeded approximately $21 million, Georgeann would receive 50% of any excess. The sale of DCA would also accelerate the terms of the promissory note, making it payable in full 30 days after Steven received proceeds from the sale.
The agreement referred to the payments described above as "non-modifiable alimony for . . . [Georgeann's] support and maintenance." However, under its terms, Steven's payment obligations were not terminable on his or Georgeann's death or on her remarriage. It explicitly stated that Steven's payments were not intended to be taxable to Georgeann or deductible by him for income tax purposes. The agreement recited that it recorded the parties' "final, complete, and exclusive understanding regarding . . . [their] marital separation, dissolution, and property settlement and supersede[d] any prior or contemporaneous agreement, understanding, or representation, oral or written."
The agreement was adopted by the divorce court. Steven paid legal fees exceeding $160,000 in connection with the divorce and the negotiations leading up to it. During 2009, as required by the agreement, Steven paid Georgeann $3 million and discharged her $1,475,500 share of certain joint liabilities. Between 2009 and 2012, he paid her interest in excess of $1.2 million on the promissory note.
On May 24, 2012, SRM sold its interest in DCA for $93,770,600. Gains from that sale passed through to Steven as SRM's sole shareholder. In June 2012, as required by the agreement, Steven satisfied the $5,462,312 remaining balance of the promissory note.
On his federal income tax return for 2012, Steven reported net long-term capital gain of $85,735,315 on the sale of SRM's interest in DCA. The IRS selected his return for examination and adjusted the gain upward by $5,362,814. In September 2016, the IRS issued Steven a timely notice of deficiency reflecting this adjustment and determining a deficiency of $804,423. He subsequently challenged the IRS's determination in Tax Court.
The Tax Court's decision
The Tax Court held that the payments made to his ex-wife and his divorce lawyer did not increase Steven's basis in DCA. To answer the basis question, the court applied Florida law to determine the nature of his payments and then applied federal tax law to determine whether they increased Steven's basis in DCA. (As stipulated in the divorce agreement, Steven did not claim a federal tax deduction for the payments.)
Under the Florida version of the parol evidence rule, evidence outside the four corners of a contract cannot be used to interpret the meaning of the contract unless a term or terms in it are ambiguous. The Tax Court found that the settlement agreement between Steven and Georgeann was ambiguous regarding the nature of the payments to be made to Georgeann. Thus, the court looked at the negotiating history of the agreement to determine what the parties intended the payments to be.
The negotiating history, the court stated, made it absolutely clear that the parties desired to make, through the agreement, an equitable distribution of marital assets, including real estate, cash and securities, life insurance, personal property, and Steven's indirect interest in DCA. This, along with language in the text of the agreement providing that the payments would survive Georgeann's death or remarriage, led the Tax Court to conclude they were intended to be lump-sum alimony in the nature of a final settlement payment, and the court treated them as such.
Having determined the nature of the payments to Georgeann, the Tax Court then considered how they would affect the basis in the DCA partnership under Sec. 705. The court found that upon formation SRM's basis in DCA presumably was the same as Steven's basis. Under Sec. 705(a)(1), a partner's initial basis is increased by the partner's distributive share of:
- Taxable income of the partnership as determined under Sec. 703(a);
- Income of the partnership exempt from tax; and
- The excess of the deductions for depletion over the basis of the property subject to depletion.
Steven's payments to Georgeann and his divorce lawyer did not affect SRM's distributive share of DCA's income or deductions. Accordingly, the court found that the payments did not increase or otherwise affect SRM's basis under Sec. 705(a)(1).
The court also noted the basis of a partner's interest is also increased by any subsequent "contribution of property, including money, to the partnership" and by a partner's assumption of partnership liabilities (Secs. 722 and 752(a)). However, it concluded that this rule did not help Steven because his payments to Georgeann and his divorce lawyer did not cause DCA to receive any money or other property, and SRM and Steven did not assume any of DCA's liabilities.
Steven in addition argued his payments were "acquisition costs" that generated basis under Sec. 742, which provides that "[t]he basis of an interest in a partnership acquired other than by contribution" is determined under the Code's general basis rules. The Tax Court found this argument failed because SRM owned 70% of DCA both before and after the divorce. Thus, neither Steven nor SRM "acquired" any interest in DCA (from Georgeann or anyone else) as a result of the payments.
Going in another direction, Steven further asserted that Georgeann's claim to an equitable share of marital assets constituted a "cloud hanging over" Steven's title to his partnership interest, which would cause difficulties with the sale of DCA. Therefore, the payments he made to Georgeann and his divorce lawyer were made "in order to retain clear title over the DCA membership interests which he retained." Steven argued that these payments must be capitalized under Temp. Regs. Sec. 1.263(a)-2T(e)(1) (now, Regs. Sec. 1.263(a)-2(e)(1)), which provides that "[a]mounts paid to defend or perfect title to real or personal property are amounts paid to acquire or produce property . . . and must be capitalized."
The Tax Court was not persuaded by this argument for several reasons. First, the payments to Georgeann and to the divorce lawyer were made by Steven, not by SRM, which owned the 70% partnership interest in DCA. Steven failed to explain why the payments, if capitalizable at all, should not be capitalized to his basis in SRM, rather than to SRM's basis in the partnership.
Second, even if Steven had owned a direct partnership interest in DCA, Georgeann's claim to marital assets did not cloud his title, and his payments to her were not made to "defend or perfect title to . . . personal property." The court found that this was the case because Georgeann for various reason did not want an interest in DCA and could not have compelled Steven to transfer an interest to her if she had.
Third, the court reasoned that because Georgeann never challenged Steven's title to the indirect interest he held in DCA, he was in effect arguing "that any debtor who honors his obligations is entitled to capitalize those payments on the theory that he is removing a cloud on his title to assets that might be subject to collection action if he defaulted." The court stated that this was plainly not the law and "if it were, every payment by a partner on a personal debt would increase his basis in the partnership."
Steven complained to the Tax Court that unless he was allowed a basis increase, he would have no way of recovering the costs of his divorce against his taxable income. As the Tax Court put it, "That is correct and unsurprising." It seemingly should have been unsurprising to Steven, too, given that the settlement agreement explicitly stated that it was the parties' understanding that, for income tax purposes, the payments would be neither taxable to Georgeann nor deductible by him.
Matzkin, T.C. Memo. 2020-117