Divorce-Related Developments: Tax Lessons

By Larry Maples and Melanie James Earles

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Basic Alimony Requirements

Alimony and separate maintenance payments are deductible by the payor and includible in the payee’s income under IRC sections 215 and 71. If structured properly, such payments need not be taxable or deductible. Under current law [Temporary Treasury Regulations section 1.71-1T(A-3)], it makes no difference whether the payments are for support or property rights or whether they are periodic. For payments to qualify as alimony, they must meet all the requirements of IRC section 71:

• Cash must be received by or on behalf of a spouse.
• The payments must be received under a divorce or separation instrument.
• Payments must not be designated as not includible in gross income under section 71 and not allowable as a deduction under section 215.
• Where the parties are separated under a judgment of dissolution or legal separation, the spouses or former spouses cannot be members of the same household.
• Payments must cease upon the death of the payee.
• Payment may not be fixed by the instrument as support for children of the payor spouse.

IRC section 71 also provides that alimony payments cannot be front-loaded in excess of permissible amounts. Front-loading will trigger a recomputation in the third postseparation year, resulting in phantom income to the payor under IRC section 71(f).

Nonalimony Designations

In order for payments to qualify as alimony, the specific requirements of IRC section 71 must be met. The requirement that the divorce or separation instrument not designate the payment as nonalimony has been a source of conflict between taxpayers and the IRS. IRC section 71(b)(1)(B) permits nonalimony treatment if the divorce agreement designates the payments as not includible as income under section 71(a) and not allowable as a deduction under section 215. How explicit does the nonalimony designation have to be?

The Seventh Circuit in Richardson defined “designate” as “to make known directly, to point out, to name, to indicate” [125 F.3d 352 (CA 7, 1997), aff’g T.C. Memo 1995-554]. The wife in this case argued that a nonalimony designation was obvious because the divorce court arrived at the payment on the basis that it would constitute 40% of the husband’s after-tax income. The Seventh Circuit, however, said that a “clear, explicit and express” statement regarding the tax effect was required. Even a statement that the husband would be responsible for income taxes or alimony while the suit was in progress was not an explicit nonalimony designation according to the Tax Court (Jaffee, T.C. Memo 1999-196).

Normally, a property settlement is a nontaxable event under IRC section 1041. A property settlement without explicit tax language, however, may not suffice to create a nonalimony designation. In LTR 200141036, an exchange of a farm for a monthly income was ruled alimony because there was no clear and explicit language related to the tax consequences. In Baker (T.C. Memo 2000-164), the court underlined that using the term property settlement alone “does not clearly inform us that the parties considered the income tax consequences of the payments under Section 71, 215, and/or 1041.” This statement by the Tax Court might be interpreted that specific IRC references are required, but a nonalimony designation was upheld in Maloney (T.C. Memo 2000-214) without specific IRC references. The decree provided that both spouses shall be denied spousal support, and the court order said that the money transferred “shall not be considered a taxable event.” (See also LTR 9610019.)

Advisors involved in divorce negotiations where the parties agree on nonalimony tax treatment should incorporate clear, unambiguous language like “the payments are designated as excludable/nondeductible under IRC sections 71 and 215.” If, however, the language is already finalized, there may still be a reasonable basis for taking a nonalimony position in the absence of IRC references if the situation closely mirrors Maloney.

Dependency Waivers

The Tax Court continues to hear numerous cases concerning whether a divorced parent may claim dependency exemptions. Because the custodial parent can claim dependents unless he or she waives that right, the waiver has been central to many of these disputes. Two 2003 cases illustrate how the details in the waiver are scrutinized.

In Bramante (T.C. Memo 2003-228), the wife was the custodial parent and agreed to waive her right to exemptions on Form 8332. As her income increased, the value of the exemptions increased. She discovered that her Social Security number was missing on the form and that her ex-husband, the noncustodial parent, had dated the form in his handwriting. But the Tax Court would not allow her to escape the consequences of the waiver, emphasizing that the missing, but not required, details from Form 8332 should not void the waiver.

It appears that a custodial parent can take back waived exemptions only after the noncustodial parent forfeits the exemption (see IRS Chief Counsel Advice 200007031). Consequently, the custodial parent should waive the exemptions only on a year-by-year basis.

In Boltinghouse, the IRS argued that missing details defeated the waiver (T.C. Memo 2003-134). In this case, the couple had executed a separation agreement allowing the noncustodial parent to claim one of his daughters, but did not file a Form 8332. Therefore, the court had to decide whether the agreement conformed in substance to Form 8332. The IRS contended that the agreement was not in substance a Form 8332 because it did not reflect the years the exemptions were to be waived and it did not provide Social Security numbers for the parents. Although the IRS pointed to some cases in which the Tax Court had rejected waivers that were ambiguous as to the applicable years, the Tax Court said that it was clear that this agreement applied to the years the parents began filing separate returns. As in Bramante, lack of Social Security numbers was not considered a serious defect by the Tax Court.

These cases illustrate that neither taxpayers nor the IRS can assume that missing details on Form 8332 will defeat the waiver. Nevertheless, the noncustodial parent seeking the exemption should supply details on Form 8332. Note that the waiver can be executed on an annual basis, for alternate years, or for all future years. The custodial parent may prefer granting the waiver on an annual basis to retain some leverage if child support or alimony payments are delinquent. The completed Form 8332 must be attached to the noncustodial parent’s return each year.

Interest

When a note is given to equalize the division of property incident to a divorce, the interest paid can have significant ramifications. Stated interest is included in income. In Gibbs (T.C. Memo 1997-196), a property settlement required Mrs. Gibbs to convey her interest in a convenience store for a note to be paid in 10 installments with stated interest. She argued that the interest was excludible under IRC section 1041(a), which provides for nonrecognition of gain in marital settlements. She relied on Balding (98 T.C. 368), another installment note case in which no interest was required to be included in income. The Tax Court pointed out that the interest was unstated in Balding, and required Mrs. Gibbs to report her stated interest as income. This distinction points to the possibility of the parties to a divorce eliminating the interest component, particularly if some or all of the interest would not be deductible.

All interest is nondeductible personal interest except for investment interest, passive activity interest, and qualified residence interest [IRC section 163(h)(1)]. The character of the interest expense is determined by tracing the use of the related debt per the Treasury Regulations section 1.163-8T. In Seymour (109 T.C. 279), a property settlement agreement incident to a divorce required a wife to transfer some investment property, a personal residence, and some personal property to her husband. The property he was required to transfer to his wife was insufficient to equalize the division of marital assets. Therefore, the husband agreed to equalize the division by giving his wife a note. The agreement was silent on identifying the assets for which the note was given. The Tax Court said the interest should be allocated among all the assets received after the qualified residence interest was determined. Qualified resident interest is not subject to the tracing rules per Treasury Regulations section 1.163-8T(m)(3).

The Tax Court will apparently not follow this allocation approach in all situations. In Armacost (T.C. Memo 1998-150), another case in which the settlement agreement was silent on identifying assets for which a note was given, the court allowed all of the interest to be traced to investment property. The husband convinced the court that the couple’s personal property had been equally divided and that the note was solely for the wife’s interest in investment property.

This uncertainty about how interest will be traced or allocated should favor settlement agreements that expressly identify the assets for which debt is not being given. Otherwise, a significant portion of the interest expense may be allocated to personal interest.

But even an agreement identifying an asset given for a note may not have any effect if the spouse who receives the note has no preexisting property right in the asset. In FSA 200203061, the IRS held that interest on a note to a wife could not be allocated as investment interest because the company stock was 100% owned by the husband prior to the division of assets. Therefore, the intent to equally divide all jointly and separately held property may not mean that the interest can simply be allocated among all the property.

Retirement Plans

Income from a preexisting property interest will usually be taxed to the ultimate recipient regardless of the source of the payments. For example, in Mess (T.C. Memo 2000-37), a wife was held to have a 43% community interest in her husband’s military pension. She was taxed on the payments because she had a property interest in them under California law. The result would be the same whether she received payments directly from the military or from her husband.

Taxpayers have attempted to argue that a regular cash payment from an ex-spouse was a tax-free IRC section 1041 exchange for community property rights given up. Although this approach was successful in a lump sum payment situation [see Balding 98 TC 368(1992)], it was not successful for a stream of payments [see Weir T.C. Memo 2001-184].

In contrast to these community property situations, a spouse with no preexisting property interest may receive retirement benefits incident to a divorce. The taxability of these payments to the recipient may depend upon the vagaries of state law. Benefits under IRC section 401 plans are generally taxed to the “distributee” (the plan participant) unless a Qualified Domestic Relations Order (QDRO) shifts the tax burden to an alternate payee [see Hawkins, 96-1 USTC 50,136 (CA-6-1996) rev’g and remanding 102 TC 61]. It is irrelevant whether a property interest in these section 401 benefits has been transferred under state law. But state law may be crucial in determining whether a property interest in a military pension has been transferred. The Tax Court recently ruled that military pensions are not distributions from a 401(a) trust and thus not subject to the “distributee” rule.

In Newell (T.C. Summary Opinion 2003-1), a military spouse in a divorce settlement was granted a $1,017 monthly award to be satisfied by payments directly from the government. The Tax Court said she would be taxed on the payments if an ownership interest had been transferred to her. Under Virginia law, however, the state court had no power to order a transfer of an ownership interest. The Uniformed Service Former Spouse’s Protection Act allows state courts to “treat” pensions as jointly or separately held property, but the federal law does not permit a court to direct a transfer of an ownership interest.

Although a state court cannot cause a transfer of a property interest, it can approve a transfer. In Pfister (T.C. Memo 2002-198), the parties agreed on the division of a military pension that was then incorporated in the decree. The wife argued that she should not be taxed on her portion because Virginia law prohibited a court from ordering a property transfer. But the Tax Court said she should be taxed because Virginia law prohibits a property transfer only in the absence of an agreement between the parties.

IRA Issues

IRC section 408(d)(1) requires a taxpayer to include amounts paid or distributed from an IRA in gross income. Under the section 408(d)(6) exception, however, the transfer of an individual’s interest in an IRA to a former spouse under a divorce decree is not taxable to the individual. The interest is treated as the former spouse’s IRA. Nonetheless, taxpayers must meet two requirements: There must be a transfer of the IRA participant’s interest in the IRA to the spouse or former spouse, and this transfer must be made under an IRC section 71(b)(2) divorce or separation agreement. Case law contains many examples of taxpayers that withdraw funds from IRAs and then write checks to ex-spouses in order to comply with divorce judgments. These taxpayers must include the amount of the distribution in gross income and sometimes pay the 10% early-distributions penalty.

The 10% penalty on early distributions from qualified retirement plans does not apply to distributions made to an alternate payee pursuant to a QDRO within the meaning of IRC section 414(p)(1). A “domestic relations order” is defined as any judgment involving the provision of marital property rights to a spouse, or former spouse, of a participant that is made pursuant to a state domestic relations law. A QDRO is a specific type of domestic relations order that creates an alternate payee’s right to receive all or part of the benefits payable with respect to a participant under a plan, clearly specifies certain facts, and does not alter the amount of the benefits under the plan.

To qualify for this IRC section 72(t)(2)(C) exception, the distribution must be made by the plan administrator to an alternate payee in response to a QDRO. IRC section 414(p) provides certain procedural rules for domestic relations orders to provide guidance to plan administrators. Implicit in these rules is the requirement that a domestic relations order be presented to the plan administrator and adjudged “qualified” before any distribution by the plan to the spouse or former spouse [Rodoni v. Commissioner, 105 T.C. 29, 36 (1995)]. This was the crux of the dispute in Bougas v. Commissioner (T.C. Memo 2003-194). The divorce judgment ordered Bougas to pay a lump sum of $150,000 tax free to his ex-wife, $47,000 to various credit card companies, and $10,000 to her attorney. The divorce judgment also contained a provision that Bougas’ 401(k) and IRA accounts were his sole and exclusive property, free and clear of any claims by his spouse. The divorce judgment did not provide for a specific source of funds from which Bougas was to pay his divorce obligations. There was no mention of a QDRO, nor any reference to making the wife an alternate payee on Bougas’ IRA.

After depositing a $250,000 distribution from his IRA into his personal checking account, Bougas wrote checks to satisfy the terms of the divorce judgment. He reported the $250,000 as income on his tax return, but did not report the 10% penalty for early withdrawal. The Tax Court said the divorce judgment was a domestic relations order under section 414(p)(1)(B), but that it did not qualify as a QDRO under section 414(p). It did not qualify as a QDRO because the divorce judgment did not create or recognize the wife’s right to receive any portion of her husband’s IRA as an alternate payee, nor did it award her any interest in the IRA. In addition, Bougas never submitted a copy of the divorce judgment to the plan administrator prior to requesting and receiving the distribution from his IRA.

The taxpayer tried to make the argument that he was only following the directions of the New Jersey court, which required him to make the IRA distributions to pay his divorce obligations. The court rejected the same argument in Czepiel [2001-1 USTC para. 50,134 (CA-1, 2000), aff’g T.C. Memo 1999-289]: The taxpayer was not required to pay his divorce obligations from his IRA; he chose to use the IRA because he had no other source of funds.

Stock Options

Nonstatutory stock options (NSO) and nonqualified deferred compensation are governed by the more general principles of compensation and income recognition. The first question is whether the transfer of NSOs and nonqualified deferred compensation pursuant to a divorce will trigger the unpaid tax under IRC section 83. If not, does the assignment of income doctrine require the spouse who earned the compensation to pay the tax when the other spouse exercises the option or receives the distribution?

In Revenue Ruling 2002-22, the IRS decided that nonrecognition treatment under IRC section 1041 at the time of transfer prevails and the assignment of income doctrine does not apply to these transfers. Thus, the tax burden will pass to the receiving spouse, who must include the appropriate amount in income under IRC section 83(a) when NSOs are exercised or when distributions are received from the deferred compensation plan. This conclusion applies regardless of whether the divorcing spouses live in a community property state. The IRS will apply its holding in Revenue Ruling 2002-22 retroactively, as well as prospectively, to all situations except when the following holds:

• The transfer between spouses pursuant to a divorce was required by a provision of an agreement or court order before November 9, 2002; and
• The agreement or court order specifically provided that the transferor must report gross income attributable to the transferred interest, or it can be established to the satisfaction of the IRS that the transferor has reported gross income for federal income tax purposes.

Example. In Year 1, Corporation XYZ grants Mr. Smith a nonstatutory option to buy 2,000 shares of XYZ stock for a strike price of $30 per share at any time during the next eight years. In Year 5, Mr. Smith transfers the option to Mrs. Smith pursuant to a divorce. The transfer of the option does not result in a payment of wages for FICA and FUTA tax purposes, nor are there income tax consequences in Year 5. In Year 8, XYZ stock is selling for $50 per share, and Mrs. Smith exercises the option. Mrs. Smith must recognize $40,000 ($100,000 – $60,000) as ordinary income in Year 8. Mrs. Smith’s tax basis in the shares is $100,000. When Mrs. Smith sells the shares, she will have a capital gain or loss.

IRS Notice 2002-31 considers the same facts as Revenue Ruling 2002-22 and addresses the employment tax issue. When the nonemployee spouse exercises the nonqualified stock option, the nonemployee spouse gets the credit for the income tax that was withheld, but is also subject to the FICA tax due on exercise, and the employer is subject to its half of the FICA tax. IRC section 1041, which provides an exclusion from income tax, doesn’t apply for FICA tax purposes. The transferred property is still treated as wages in the hands of the nonemployee spouse.

In June 2003, for the first time in nearly 20 years, the IRS issued proposed regulations addressing statutory stock options. The new regulations expand the definitions of option, corporation, and stock. Option now includes warrants. Statutory option means an incentive stock option or an option granted under an employee stock purchase plan (ESPP). An incentive stock option (ISO) is a stock option granted, typically, to key employees. The grantee has the right to purchase stock without realizing income either when the option is granted or when it is exercised. The grantee is first taxed when she sells or disposes of the stock and has a capital gain or loss. Generally, ISOs cannot be transferred by the grantee to another party while keeping their special tax treatment. If a statutory stock option is transferred incident to divorce (IRC section 1041) or pursuant to a QDRO [IRC section 414(p)], the option does not qualify as a statutory option as of the day of such transfer, and is treated like nonstatutory stock options. IRC section 424(c)(4), however, provides that a section 1041(a) transfer of stock acquired on the exercise of a statutory stock option is not a disqualifying disposition. Thus, the transfer of stock acquired by exercising an ISO incident to divorce is tax free; the tax consequences are postponed until the stock is sold.

Redemption of Stock

What if a divorce settlement obligated a husband to purchase his wife’s stock in their jointly held corporation and he directed the corporation to redeem her stock? Has the husband realized a constructive dividend because the corporation’s redemption satisfied his obligation to buy out his wife’s holdings? If not, did the wife have to recognize capital gain on the transfer of her stock back to the corporation? The IRS has sometimes asserted deficiencies against both spouses. In the two Arnes decisions [93-1 USTC para. 50,016 (1992, CA-9) and 102 T.C. 522 (1994)], neither the husband nor the wife had to pay income tax on this redemption.

IRC section 1041 does not address third parties involved in property transfers incident to divorce. Treasury Regulations section 1.1041-2, issued January 13, 2003, addresses stock redemptions during marriage or incident to a divorce. The new regulations are limited to stock redemptions, while other third-party transfers continue to fall under Treasury Regulations section 1.1041-1T(c)(QA-9). Under the new regulations, stock redemptions not resulting in a constructive dividend to the nontransferor spouse (under applicable tax law) will be treated as redemptions by the transferor spouse, who will be liable for any tax consequences. Stock redemptions that do result in a constructive dividend to the nontransferor spouse will be treated as such, and that spouse will be liable for any tax consequences.

A special rule in Treasury Regulations section 1.1041-2(c) gives taxpayers the option to choose which spouse will be responsible for the tax consequences. A divorce, separation, or other written agreement must state how both spouses intend for the IRS to treat the redemption. Both spouses must execute the agreement before the date on which the spouse responsible for the tax files his or her tax return for the year of redemption. The new regulation applies to stock redemptions on or after January 13, 2003, under agreements in effect after that date. It also applies to redemptions before that date if the spouses had executed a written agreement on or after August 3, 2001.