Developments: Tax Lessons
Larry Maples and Melanie James Earles
and the IRS have been very active recently in the divorce
arena. Developments in the areas of nonalimony designations,
dependency waivers, interest, retirement plans, IRAs, stock
options, and stock redemptions significantly affect the negotiation
of divorces and the taking of tax return positions after a
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
Cash must be received by or on behalf of a spouse.
The payments must be received under a divorce or separation
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.
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
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?
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).
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.”
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.)
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.
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.
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.
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.
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.
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.
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.
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
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
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.
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.
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.
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].
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.
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.
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.
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.
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.
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.
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.
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.
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 (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
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.
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.
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.
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.
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
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.
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.
Maples, DBA, CPA, is the COBAF Professor of Accounting,
and Melanie James Earles, DBA, CPA, is an
associate professor of accounting, both at Tennessee Technological