Our Federal income tax laws often build upon the presumption that seemingly adverse parties are actually adverse. Our tax laws do not always account for instances where the parties are actively working in concert to reduce the IRS’s cut.
Transfers and payments made in relation to divorce are an example. With our tax laws, it is generally presumed that divorcing parties are at odds and tax savings are secondary. This presumption may not be appropriate.
Now that alimony is generally no longer deductible and tax rates likely to increase in the near future, divorcing spouses may have a larger incentive to work together to minimize their taxes.
There are a number of tax strategies that can be used. But what about selling a partnership to a third party after divorce to satisfy a payment required by a divorce decree? Can the payments to the ex-spouse to satisfy the payment in the divorce decree be used to reduce the gain from the sale? The court addressed this in Matzkin v. Commissioner. T.C. Memo. 2020-117.
Facts & Procedural History
The taxpayer-husband is a dentist. During his marriage, he started a business that assisted other dentists. He held a 70% interest. The business was taxed as a partnership.
The taxpayers divorced in 2008. Instead of transferring a 50% interest in the business to the taxpayer-wife, the parties entered into a settlement agreement whereby the taxpayer-wife would be paid $10M.
The agreement provided for an up front payment to the taxpayer-wife and the balance was to be paid pursuant to a promissory note.
The business was sold to a third party in 2012 for $93 million. Part of the proceeds were paid to the ex-wife to satisfy the promissory note.
The IRS audited the 2012 tax return. It proposed to increase the amount of gain and tax due from the sale.
During the tax litigation, the parties agreed on the amount of gain that was to be reported. The taxpayer-husband raised an additional issue as to whether the payments to the taxpayer-wife and the attorney’s fees for the divorce attorney increased his tax basis in the business. If it did, it would reduce the gain from the sale.
Tax Basis in a Partnership
The general formula for calculating the gain on the sale of a partnership is: amount realized minus adjusted tax basis. The result is multiplied by the appropriate tax rate to compute the amount of tax.
Taxpayers typically want a high tax basis, as it reduces the amount of gain and, thereby, reduces the amount of tax.
Tax basis in a partnership starts with any contributions. It is increased by contributions. Tax basis is also increased by any partnership income. Tax basis is decreased by distributions and partnership losses.
Property Settlement Payments
In this case, the taxpayer-husband asserted that payments made to the taxpayer-wife to satisfy the payments required by the divorce settlement agreement added to his tax basis in the partnership.
The court started by analyzing whether the payments were deductible alimony (under the tax laws at the time) or a property settlement that is not deductible to the taxpayer-husband. Transfers to ex-spouses are generally not subject to tax, even if they are made after the spouses are divorced.
The court concluded that the payments were non-deductible payments pursuant to a property settlement. As a property settlement incident to divorce, the court reasoned the payments were personal expenses that do not add to the taxpayer-husband’s tax basis in the business.
The Payments From Husband to the Ex-Wife
The taxpayer-husband raised several arguments. The taxpayer-husband argued that the payments were a contribution to the business.
The court noted that the payments were not made to the business. They were made to the taxpayer-wife. Thus, there was no contribution that would increase the tax basis.
The taxpayer-husband argued that the payments were required to satisfy a cloud on title to the partnership. According to the taxpayer-husband, he had to make the payments and that they were paid in connection with the business. Thus, according to the taxpayer-husband, this entitled him to increase his tax basis in the business.
The court did not agree. The court focused on the lack of any connection between the payments to the taxpayer-wife and the business.
Tax Planning for the Sale of the Business
With advance tax planning, maybe the parties might have been able to accomplish the goal of increasing the basis in the business. This may not have increased the tax for either the taxpayer-husband or wife.
The court opinion does not provide a lot of facts, but it appears that the promissory note was not owed or guaranteed by the partnership. It might not have even been secured by the partnership interest.
It also appears that the third party buyer may have paid the taxpayer-husband and then the taxpayer-husband paid the taxpayer-wife. The proceeds may not have been paid by the third party buyer directly to the taxpayer-wife.
The third party buyer may not have secured a release of the debt from the taxpayer-wife.
These are facts that could have bolstered the taxpayer-husband’s position. If these facts were true, it would seem a closer question as to whether the costs increase the taxpayer-husband’s basis in the business.