Tax planning issues to consider when assisting clients in a divorce

Editor: Carolyn Quill, CPA, J.D., LL.M.

Co-editors: Richard Mather, E.A., MSA, CAA; Jonathan McGuire, CPA; and Kathleen Moran, CPA, MBA, MT

Navigating a divorce can be an emotional experience for clients, and assisting them can likewise be poignant for their tax advisers, particularly when the adviser has a long-established relationship with both spouses. Once a client notifies you they are contemplating a divorce and any potential conflict-of-interest matters are resolved, it is important to swiftly meet and address tax planning issues. It is imperative to collaborate with the divorce attorneys and investment advisers so that the time frame to plan and structure optimal tax outcomes for the parties is addressed and deadlines are met.

Parties should discuss the timing of the divorce. They can file an income tax return jointly if married on the last day of the tax year, resulting in significant tax savings, if they agree the return is accurate. Signing a joint return makes each party jointly and severally liable for the tax.

Evaluate income tax impact of asset transfers

Communicating with legal counsel early will avoid surprise tax liabilities and allow for thoughtful tax planning, including maximization of tax savings for both parties.

Sec. 1041(a) provides that no gain or loss is recognized on a transfer of property from an individual to, or in trust for the benefit of, a spouse or a former spouse, but only if the transfer is incident to a divorce. Sec. 1041(c) defines a transfer of property as incident to a divorce if it occurs within one year after the date the marriage ends or is related to the cessation of the marriage.

Temp. Regs. Sec. 1.1041-1T(b), Q&A-7, defines a property transfer as related to the cessation of a marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than six years after the date the marriage ends. Transfers not pursuant to a divorce or separation instrument and transfers occurring more than six years after the end of the marriage are presumed not to be related to the cessation of the marriage. Taxpayers can rebut this presumption by showing that the transfer was made to effect the division of property owned by the former spouses at the cessation of the marriage.

It is not always possible or practical to transfer assets when the divorce is finalized. Sec. 1041 provides taxpayers additional time to plan for assets that are difficult to transfer, including closely held business interests, real estate, and notes receivable assignments.

High-net-worth couples and those owning family businesses often have extended and complicated divorce proceedings. Additional disputes can arise after the original divorce instrument is executed, resulting in transfers of property that would otherwise be taxable if they did not qualify under Sec. 1041. Courts do not focus solely on the original divorce instrument or timing of the transfer but carefully consider whether the transfer was made to divide property between the former spouses when the marriage ended.

In Belot, T.C. Memo. 2016-113, the husband was entitled to nonrecognition of gain from the sale of his business interests held jointly with his former wife based on a second settlement agreement. The taxpayers agreed in the initial divorce decree to equal ownership interests in family businesses. Within a year, the taxpayers realized they could not act as equal business partners. Pursuant to a second settlement agreement, the husband sold his business interests to his former wife.

The court rejected the IRS’s argument that the transfer did not qualify for nonrecognition of gain because it was not included as part of the original divorce decree. The taxpayers had agreed that their first agreement contained shortcomings related to division of the family businesses and executed a second agreement with terms agreeable to both parties. The court found the transfer was made to effect a division of property at the time of, and was related to, the cessation of the marriage.

The court in Belot held that Sec. 1041 applies to multiple divisions of marital property. The court also found that Sec. 1041 can apply to marital property that is sold between former spouses and that jointly held business interests qualify as marital property.

Temp. Regs. Sec. 1.1041-1T(d), Q&A-11, provides that the transferee will have a carryover basis in the transferred property. Carryover basis will apply even if there is a bona fide sale of the property. The carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to, or greater than the fair market value at the time of transfer and applies for calculating gain or loss when the transferee later disposes of the property. It is important to note that the rules in Sec. 1041 differ from those in Sec. 1015(a) for determining the basis of property acquired by gift.

Sec. 414(p) defines a qualified domestic relations order (QDRO) as an order that assigns the payee’s rights to receive benefits payable under a retirement plan to an alternate payee. Sec. 414(p)(1)(B)(i) provides for the tax-free transfer of retirement assets, including stock options and deferred compensation plan assets, pursuant to a divorce.

Often, the downside of a QDRO is that this is not a shift of currently income-generating assets that the transferee spouse needs to support his or her lifestyle. If the transferee spouse is under age 59½, a 10% penalty on early withdrawal of retirement assets is assessed.

Another strategy for transferring income-generating assets is to shift low-cost-basis securities to the spouse under Sec. 1041. If the securities were held more than one year, they can be sold and taxed at long-term capital gains tax rates to generate cash. The transferee spouse is typically in a lower tax bracket and will benefit from a long-term capital gains tax rate that is lower than the transferor spouse would have paid had he or she retained and sold the securities.

When determining an equitable split of assets between parties, advisers should calculate the future income tax liability associated with assets such as retirement funds and highly appreciated stock and consider it in the overall plan of equitable asset transfers between spouses.

The parties should decide whether the primary residence will be retained or sold prior to finalizing the divorce. Sec. 121(b)(2)(A) provides for a $500,000 capital gain exclusion from the sale of a primary residence if the taxpayers resided in the home for two of the past five years. Sec. 121(b)(1) provides for a $250,000 capital gain exclusion on the sale of a primary residence on a tax return with single or head-of-household status. However, careful drafting of the divorce decree will allow each taxpayer to exclude up to $250,000 of capital gain from the home sale in a post-divorce year. Sec. 121(d)(3)(B) provides that an individual moving out of the marital home is treated as using the property as his or her principal residence during any period of ownership that such individual’s former spouse is granted use of the property under a divorce or separation agreement and will qualify for a $250,000 exclusion of gain upon the sale of the residence.

If the spouse who continued living in the marital home remarries, sells the home, and files a joint return, the couple can exclude up to $500,000 of capital gain on the sale of the property because Sec. 121(b)(2)(B) requires only one taxpayer to meet the ownership test. In this scenario, the taxpayers can collectively exclude up to $750,000 of gain on the sale of the home because the former spouse also qualifies for a $250,000 exclusion of gain on the home sale, assuming the divorce decree was properly drafted.

Gift tax issues related to property transfers

There can also be gift tax issues related to property transfers in a divorce. Proper planning eliminates the need to use the taxpayer’s lifetime exclusion to transfer assets upon a divorce.

Sec. 2516 provides that if a married couple enter into an agreement regarding their marital and property rights and a divorce occurs within the three-year period beginning on the date one year before the agreement is entered into, any transfers of property or interests in property in settlement of marital or property rights or to provide reasonable support for minor children are considered to be transfers made for full and adequate consideration and are not considered taxable gifts. If the requirements are not met, the transfers are subject to gift tax, and the spouse making the transfers must file a gift tax return.

Income tax attribute carryforwards

Tax advisers should analyze the final joint tax return and determine how taxpayers will report carryforwards in years subsequent to the divorce. Income tax carryforwards used in future years have current value and should be considered in calculating an equitable allocation of assets.

Capital loss carryforwards

Regs. Sec. 1.1212-1(c)(1)(iii) provides that if a capital loss is reported on a joint return, the carryforward is allocated between spouses on separate returns, based on which spouse incurred the capital loss.

Assume the taxpayers had the capital gains and losses as shown in the table, “2020 Joint Tax Return,” below.

Assume that in 2021 the taxpayers finalized their divorce. Spouse 1 is entitled to the entire capital loss carryforward of $4,000 on his or her 2021 tax return because the capital loss carryforward was a result of Spouse 1’s $15,000 short-term capital loss.

NOL carryforward or carryback

When taxpayers change their filing status pursuant to a divorce, Regs. Sec. 1.172-7(d)(1) provides that carryforward and carryback net operating losses (NOLs) generated by both spouses are allocated by the joint NOL that is attributable to the income and deductions of the spouses as if each had separately computed their income and deductions. If the NOL was generated by one spouse, the carryover is only available to the spouse who generated the loss. Rev. Rul. 80-7 provides guidance on allocation of estimated tax payments and overpayments on a joint return that are used when an NOL from separate returns is carried back to a prior joint return.

Suspended passive activity losses

If investments reported as passive activities are transferred to a spouse pursuant to a divorce settlement, Sec. 1041(b) provides that the taxpayers will treat the passive activities as acquired by gift, and the transferee’s basis in the property will be the carryover basis of the transferor. Sec. 469(j)(6) provides that the basis of the passive activity will be increased by any suspended passive losses, and losses will not be realized until the activity is sold. If representing the transferee, the tax adviser should request all relevant data related to the passive investments transferred, including the date of the original purchase and the adjusted basis at the time of the transfer.

Charitable contribution carryforward

Regs. Sec. 1.170A-10(d)(4)(i)(b) provides that a charitable contribution carryforward is allocated between spouses based on how the contribution would have been allocated if the taxpayers had originally filed as married filing separately. Rev. Rul. 76-267 provides that the taxpayers must follow rules set out in Regs. Sec. 1.170A-10 to determine the allocation of the charitable contributions and are not permitted to make their own allocation agreement.

S corporation losses

Transfers of S corporation stock incident to a divorce are tax-free under Sec. 1041(a). S corporation suspended basis losses are carried over to the transferee. Sec. 1366(d)(2)(B) provides that the transferee will treat disallowed S corporation losses as incurred by the S corporation in the succeeding tax year.

Ensuring an equitable division of assets

Tax advisers play an important role assisting clients in determining the tax consequences of asset transfers prior to the finalization of a divorce settlement and in making tax filing decisions for post-divorce tax years. Tax advisers have historical knowledge that is crucial to identifying tax issues that need to be addressed to provide for an equitable division of the couple’s assets. Coordinating early and frequent communication with the client and trusted advisers will ensure a fair and equitable asset division for both parties.

For more on this topic, see “Dividing Up Assets When a Marriage Ends: Tax Implications,” also in this issue.

Editor Notes

Carolyn Quill, CPA, J.D., LL.M., is the lead tax principal at Thompson Greenspon in Fairfax, Va. Richard Mather, E.A., MSA, CAA, is a director at EFPR Group in Rochester, N.Y.; Jonathan McGuire, CPA, is senior tax manager at Aldrich Group in Salem, Ore.; and Kathleen Moran, CPA, MBA, MT, is a director at Pease Bell CPAs in Cleveland. Unless otherwise noted, contributors are members of or associated with CPAmerica Inc. For additional information about these items, contact Carolyn Quill at taxclinic@cpamerica.org.