Delayed Sale to Former Spouse Not Taxable

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Asset Sale Did Not Trigger Transferee Liability For Buyers Taxes
Asset Sale Did Not Trigger Transferee Liability For Buyers Taxes

You didn’t realize it at the time, but growing up, you didn’t take full advantage of opportunities. With time, you realize that you not only failed to take advantage of opportunities, but the actions you took actually made life even more difficult. It’s more than failure by neglect. It’s also failure by action.

That is just the tip of the iceberg, as they say. Career, family, and, in particular, your marriage. It doesn’t work out like a feel-good movie. The death of parents, and sometimes children, are in there. But so too is divorce. This is the blur of life, from not knowing, to knowing, to, maybe, maybe, acceptance.

Amidst all of this, can divorcing spouses work together to reduce their tax liabilities? Is this even a topic one can work into their thought process as they are experiencing life? For those who work together, they can do just that. The answer is yes. The recent Belot v. Commissioner, T.C. Memo. 2016-113, provides an example that explains how this can be. It addresses the tax free transfer of property following a divorce.

Facts & Procedural History

Mr. and Ms. Belot were married in 1989. They divorced in 2007. 

The taxpayers were in the business of providing dance instruction and training to others.  During this time, they created and operated three dance and dance-related businesses. 

The taxpayers’ divorce agreement provided that they would each own 50 percent of each business.  Nine months after the divorce, Ms. Belot brought suit against Mr. Belot to oust him from the businesses. 

A little over a year after their divorce was final, Mr. and Ms. Belot settled the lawsuit. The settlement required the businesses to be transferred to Ms. Belot in exchange for cash payments and installment payments that were to be made pursuant to a promissory note.

Mr. Belot did not report the sales proceeds as taxable income on his 2008 Federal income tax return, which the IRS challenged. The dispute ended up in the U.S. Tax Court. The issue for the court was whether the sales proceeds were tax exempt as transfers under Section 1041.

Tax Free Transfers Under Section 1041

Section 1041 provides that gain or loss is not recognized on transfers from a spouse or former spouse if the transfer is incident to the divorce. 

For a transfer to be considered incident to divorce, it must meet one of the following criteria:

  1. Timing Criterion: The transfer occurs within one year after the date on which the marriage ceases. This means that any property transferred between spouses or former spouses within one year of the divorce or separation will not trigger a recognition of gain or loss.
  2. Cessation of Marriage Criterion: The transfer is related to the cessation of the marriage. This includes any transfer of property that is made pursuant to a divorce or separation instrument and occurs within six years after the marriage ends. To qualify under this criterion, the transfer must be made because of the cessation of the marriage, which typically involves transfers mandated by a divorce decree, separation agreement, or other related legal documentation.

Even given these rules, the transfer has to be related to the divorce. That was the issue in this case.

Related to the Divorce

The question in this case was whether a transfer, after the divorce, could be pulled back into the divorce for tax purposes. How long after the divorce can one wait and still have a transfer qualify as a tax-free transfer?

In this case, the IRS argued that the transfer did not qualify for nonrecognition under Section 1041 because the transfer did not even relate to the divorce instrument. To the IRS, the lawsuit was simply a business dispute that was not related to the divorce. The IRS even noted that the lawsuit was not even brought in the family court, which hears divorce cases. So, according to the IRS, the ensuing settlement was simply a business sale and one that triggered a tax liability.

The court did not agree with the IRS. It held that the transfer did qualify for nonrecognition under Section 1041. The court reasoned that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage. Thus, the court concluded that the sales proceeds were not taxable income to Mr. Belot.

The Takeaway

The IRS often takes a position that results in the highest amount of tax due. Tax provisions that exempt transfers from tax are often scrutinized by the IRS. This is especially true for provisions that allow the parties to collude to cut the IRS out, which taxpayers can do with Section 1041. This case shows how taxpayers can plan for Section 1041 to structure their affairs to avoid paying tax. This is the case even if the transaction occurred more than a year after the parties were divorced.

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