Tax Consequences of Equitable Distribution
Article Date: Monday, February 28, 2011
Written By: Gregory Herman-Giddens
Equitable distribution is the process by which martial assets are divided by a court in a divorce proceeding, the purpose of which is to provide a fair allocation of the property between the spouses. North Carolina law provides that “an equal division is equitable," and the presumption is that “an in kind distribution of marital or divisible property is equitable." However, no distribution of assets can be considered equitable without a full consideration of the tax implications to both parties.
As part of the Tax Reform Act of 1984, Congress enacted Section 1041 in response to the disparities and varying treatment of marital property upon divorce. Pursuant to Section 1041, transfers of property between former spouses incident to a divorce are treated as a gift; therefore, the transferee spouse can exclude the property received from his or her gross income under Section 102(a). A transfer of property is incident to a divorce if it (a) occurs within one year after the date on which the marriage ceases, or (b) is related to the cessation of the marriage. A transfer is related to the cessation of the marriage if it (a) is made by virtue of a divorce or separation instrument, and (b) is transferred no more than six years after the cessation of the marriage. Section 1041 has broad applicability; however, the rule does not apply if the transferee is a nonresident of the United States, because the nonresident alien may not be subject to tax on a later disposition of the property.
The transferee spouse’s basis in the property received is the transferor’s adjusted basis immediately before the transfer. This basis rule provided for in Section 1041 preserves any gain or loss in the property for future realization. For example, even if the transfer is a bona fide sale, the transferee does not acquire a basis in the transferred property equal to the transferee’s cost. The carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to, or greater than its fair market value at the time of the transfer, regardless of the value of any consideration provided by the transferee, and applies for purposes of determining loss as well as gain on the subsequent disposition of the property by the transferee.
Under the Tax Reform Act of 1984 and through the creation of Section 1041, Congress gave taxpayers a degree of certainty as to what tax repercussions, if any, would result from property division upon their divorce. For example, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of an asset. Thus, the spouses are free to negotiate between themselves whether the “owner” spouse will first sell the asset, recognize the gain or loss, and then transfer to the transferee spouse the proceeds from that sale, or whether the owner spouse will first transfer the asset to the transferee spouse who will then recognize gain or loss upon its subsequent sale.
The Court’s Role in Considering Tax Consequences
Equitable distribution requires the court to divide the marital assets in an equitable manner, regardless of how title to the asset is held. Disregarding the tax impact of property division may result in an unjust outcome; therefore, tax consequences generally should be taken into account by the court in crafting an equitable distribution. Although it is arguable that tax consequences should always be considered for property division, courts in most states have determined that they have discretion whether tax ramifications will be considered upon the equitable distribution of the marital property.
Some state statutes, including North Carolina, specifically list tax consequences as a factor to be considered in determining property distribution on divorce. N.C.G.S. § 50-20(c) provides in pertinent part:
There shall be an equal division by using
net value of marital property and net
value of divisible property unless the
court determines that an equal division is
not equitable. If the court determines
that an equal division is not equitable, the
court shall divide the marital property
and divisible property equitably. The
court shall consider all of the following
factors under this subsection:
(11) The tax consequences to each party,
including those federal and State tax con-
sequences that would have been incurred
if the marital and divisible property had
been sold or liquidated on the date of val-
uation. The trial court may, however, in
its discretion, consider whether or when
such tax consequences are reasonably
likely to occur in determining the equi-
table value deemed appropriate for this
The timeliness and the likelihood of the actual tax consequences are determinate of whether the court is required to make such a consideration. If the tax consequences flow directly from the divorce court’s decree, courts have found that consideration of the tax liabilities is either required or at least appropriate in the overall equitableness of the distribution.
In Shaw v. Shaw, 451 S.E. 2d 648 (1995), the North Carolina Court of Appeals held that the lower court erred in failing to determine the tax consequences imposed by a divorce settlement. The trial court ordered the husband to make a lump-sum distribution of $8,360.72 to his wife; however, the husband had no liquid assets. To comply with the court order, he was forced to make withdrawals from his thrift saving plan, which could only be accomplished by incurring significant tax liability and the loss of his employer’s contributions to his plan. Ultimately, the court reversed and remanded the case to the trial court to determine whether the tax ramifications imposed on the defendant through payment of the distributive award should be considered when distributing the marital property.
In De La Torre v. De La Torre, 183 A.D. 2d 744 (1992), the New York Supreme Court held that the value of the husband’s pension, for purposes of equitable distribution, should be discounted by the amount of income tax he had to pay on the early withdrawal to make the court-ordered distributive award to his wife. The husband raised the issue of tax consequences of the distribution at the trial court by providing expert testimony of a tax accountant and showing the dollar amount of the liability resulting from the withdrawal of the money from the plan. The court held that the trial court erred in failing to consider the tax consequences of the distribution order.
However, a court is not required sua sponte to consider the tax consequences of property division in a divorce action where the parties fail to request the court to take the potential tax liabilities into account and do not introduce reasonably instructive evidence bearing on those issues. Similarly, a property distribution that does not award credit for tax consequences does not constitute a plain error when the parties fail to present evidence bearing on the potential tax consequences. For example, in Calhoun v. Calhoun, 156 S.W. 3d 410 (2005), the Missouri Court of Appeals denied a wife’s appeal, which was based on the trial court’s failure to consider tax consequences when determining the equitable distribution. The court based its decision on the fact that the wife did not argue that the award resulted in an inequitable or unjust property distribution nor did she present evidence of any tax liabilities.
Courts are not required to consider theoretical or speculative tax consequences of transactions that are not necessary or probable to the equitable distribution. Thus, the court does not have to anticipate and consider the tax repercussions if the transferee spouse decides to sell the asset in the future. In fact, as a general rule, it is erroneous for the court to consider hypothetical or speculative expenses in an equitable distribution order. Tax consequences should be taken into consideration only when the sale of the property is imminent and inevitable.
In Crowder v. Crowder, 556 S.E. 2d 639 (2001), the North Carolina Court of Appeals held that speculative and hypothetical tax consequences are not a factor for equitable distribution. The appellant argued that the trial court, in valuing the property division, should not have considered the tax liabilities that may result if the appellee were to sell his logging business in the future. At trial, the defendant-appellee’s accountant testified that the value of the logging business should reduced for prospective sales commissions and wind up costs if the company were sold, for lack of marketability, and for estimated income taxes if the logging company were sold in the future. The court agreed with the appellant that the trial court erred in reducing the value of the logging company when there was no evidence that a sale was imminent. The court held that when events have neither occurred by the date of separation nor are imminent, the trial court may not estimate the expenses in its valuation of the marital property.
Division of Particular Types of Property
Regulation § 1.1041-1T(e) provides for a notice and recordkeeping requirement with respect to any transfers incident to divorce under Section 1041. At the time of the transfer, the transferor must provide the transferee spouse records that indicate the adjusted basis and holding period of the property. Similarly, if the asset has the potential for investment tax credit recapture, the transferor spouse must provide the transferee spouse with adequate records to determine the amount and period of any potential liability.
The marital residence is often the largest marital asset. With regard to determining the taxable gain upon sale of the primary residence, Section 121 provides that a single taxpayer can exclude up to $250,000 in gain, provided he or she has lived there for two out of the last five years. Married couples filing jointly may exclude up to $500,000.
There are various ways for dividing the marital home, depending on the preference of the parties, and each has its own particular tax consequences. The four most common ways to divide the martial residence are (1) equal aggregate value division, (2) equalizing payment division, (3) sale and division of the proceeds, and (4) continued co-ownership.
(1) Equal Aggregate Value Division.
This occurs if one spouse decides to remain in the principal marital residence. In this situation, the residence would be allocated to one spouse as his or her property, and marital property of equal value would be allocated to the other spouse. Under Section 1041, the sale by one spouse of his or her interest in the home to the other is a tax-free event. There are no tax consequences with an equal aggregate value division of the marital property. The selling spouse takes the proceeds without gain recognition and the purchasing spouse takes the seller’s basis, as opposed to a cost basis which normally happens for transfers that are not incident to a divorce.
(2) Equalizing Payment Division.
This takes place when one spouse buys the other spouse out of the marital residence. Under this approach, the home may be allocated to one spouse who makes an equalizing payment to the other spouse. This type of equalizing transfer is a nontaxable transaction under Section 1041. The spouse who receives the note or other equalizing payment incurs no tax consequences, because there is no sale or exchange to this spouse. Consequently, the transferee spouse receives a basis in the residence equal to the couple’s basis in the residence before the transfer. For purposes of a subsequent sale of the principal residence pursuant to Section 121, the seller spouse is deemed to have owned the property for the entire period the transferor owned the property. This rule is beneficial to the transferee spouse if he or she chooses to sell the property in the future, because it will make it easier to exclude the gain from the sale of the property from his or her gross income by making it more likely that the transferee spouse will meet the ownership and use requirements of Section 121.
(3) Sale and Division of the Proceeds.
This occurs if the spouses sell the residence to third party and divide the proceeds among themselves. In this situation, the martial residence can be sold, with the proceeds of the sale divided equally between the parties. This type of division usually triggers a gain which must be recognized by both spouses. Each spouse must recognize his and her portion of the gain realized, if any, on the sale, unless non-recognition treatment applies. The gain could be exempt from recognition if it meets the requirements of Section 121 for the sale of a principal residence. For example, if the martial residence is sold pursuant to a divorce agreement and the proceeds are divided between the parties, each spouse’s share of the gain is eligible for exclusion, so long as it does not exceed $250,000.
(4) Continued Co-Ownership.
This is when both spouses continue to own the residence as tenants-in-common. Typically, the spouse with custody of the children will be entitled to possession. The custodial spouse will often possess the residence until either death or remarriage or until the youngest child reaches the age of majority. There are no tax consequences until the home is sold because there has been no disposition. When the home is sold, the spouse in possession must recognize gain from the sale to the extent that non-recognition treatment does not apply.
The spouse who is not in possession of the marital home may be affected under the continued co-ownership approach. Because the house is no longer his or her principal residence, nonrecognition treatment cannot apply. However, if the non-possession spouse sells his or her interest in the home to the possession spouse through a divorce instrument, Section 1041 permits nonrecognition of gain.
Additionally, the non-possession spouse can use the two-out-of-five years rule of Section 121 to exclude any gain from the sale of the principal residence from his gross income. For example, if the marital home is not to be sold for several years following the divorce, the non-possession spouse’s failure to qualify for the exclusion for lack of use can be remedied by proper planning at the time of the divorce. If the decree specifies that one of the spouses may continue to reside in the home (the possession spouse), and if the home continues to be owned, or partly owned, by the non-possession spouse, that spouse is treated as meeting the two-out-of-five years use test as well.
Example: Marty and Renee have owned
Transfer of Annuities.
their house jointly for many years. Marty
moves out. The divorce decree provides
that Renee may continue to reside in their
home. She lives there for six more years
and then sells the house for a gain of
$450,000. Both Marty and Renee are
entitled to exclude $225,000 of the gain,
because the two-out-of-five rule regarding
ownership and use is satisfied.
Pursuant to Section 1041, a spouse who assigns an annuity contact to the other incident to a divorce can do so tax-free. The assignment is nontaxable for both the transferor and the transferee spouse. Additionally, the transferee spouse is able to assume the transferor’s investment in the contract. The IRS has approved the use of an annuity to equalize the division of property. This rule is beneficial to the transferee spouse because he or she can recover the transferor spouse’s investment in the contract tax-free under the usual Section 72 annuity rules as if he or she had purchased the annuity contract herself.
The IRS has addressed the issue of whether payments made pursuant to an annuity agreement qualify for non-recognition of gain under Section 1041 when they may not occur within six years from the date of the cessation of the marriage. The private letter ruling dealt with an annuity agreement that provided for annual payments during A’s life by B to an irrevocable trust created for the benefit of A. Only the first annual payment was likely to occur within one year of the separation; therefore, for the remaining payments to qualify for non-recognition under Section 1041, they had to relate to the cessation of the marriage.
There is a presumption that transfers during the first six years following the cessation of the marriage are related to the cessation of the marriage if the transfer is made pursuant to a divorce or separation agreement. The issue in this ruling hinged on the fact that the annual payments were supposed to continue for the remainder of A’s life, which would likely be greater than six years from the cessation of the marriage. Although the presumption applies to transfers occurring six years from the date of the divorce, transfers which occur beyond six years from the date of divorce can be excluded so long as they are intended to effectuate the division of the martial property. Consequently, the IRS ruled that although the payments extended beyond six years after A and B’s divorce, they were all related to the cessation of the marriage under Section 1041(c)(2). Thus, A’s gain on the annuity contract qualified for nonrecognition.
Life Insurance Proceeds.
Sometimes divorce or separation agreements provide for the continuation of alimony payments after the death of the payor spouse. Alimony obligations are often secured by insurance on the life of the payor spouse, with the intention that the policy proceeds replace the alimony payments. Pursuant to Section 1041, no gain or loss is recognized by the parties on the transfer of an insurance policy incident to a divorce, and a transferee spouse can exclude life insurance proceeds received from the policy during the marriage or incident to a divorce.
To determine the value of the life insurance, the court will first determine whether the policy has a cash surrender value. If the policy has a cash surrender value, proof of the value must be clearly shown through the policy itself or through testimony and descriptions of its value. If the life insurance policy does not have a cash surrender value, the court will take the following factors into account in determining the policy’s worth: its replacement value, the sum of the contributions, the face value of the policy, the amount of the premium, the life expectancy of the insured, whether the policy is convertible to whole life insurance, and when, if ever, the policy is deemed fully paid.
Term Interest in Property.
Examples of a term interest in property include a life interest, an interest in property for a term of years, and an income interest in a trust. Section 1001(e)(1) provides that a donee’s carryover basis is disregarded in the determination of gain or loss from the disposition of a term interest in property that was acquired by gift. Therefore, if the donee subsequently sells the term interest, he or she is taxed on the entire amount realized because he or she has a zero basis in the interest received by gift. Consequently, a transferee spouse who receives a term interest in property and subsequently sells the term interest will be taxed on the entire amount realized because he or she would have a zero basis.
U.S. Savings Bonds.
Typically, interest on Series E, Series EE, and Series I United States savings bonds is not subject to current taxation because the interest is subject to tax when the bonds are redeemed. However, under Rev. Rul. 87 112, the transferor must recognize the accrued interest on the bonds in the year in which the bonds are transferred. This rule affects the transferee spouse because the interest that accrues after the date of the transfer is includible in the transferee spouse’s gross income. After the transfer, the transferee spouse’s basis in the bonds is equal to the transferor spouse’s basis in the bonds and is increased by any interest income taxable to the transferor that occurs as a result of the transfer.
In Rev. Rul. 87 112, the IRS considered whether a taxpayer who transfers a United States savings bond to a former spouse pursuant to Section 1041 must include the deferred, accrued interest on the bonds in his or her gross income in the year of the transfer. In the ruling, A held Series E and EE bonds in her name and purchased entirely with her funds, with a maturity date after 1985. A had not included any interest that accrued on the bonds in her gross income pursuant to Section 454. Then, as part of a divorce decree in 1985, she transferred the bonds to her former spouse, B, who redeemed the bonds the following year. Under Section 454(c) and Regulation 1.454-1(a), the increase in redemption value must be included in gross income for the taxable year the date in which the bond matures, is redeemed, or is disposed of, unless the taxpayer reports the interest income each year. The IRS noted that the income at issue was accrued but unrecognized interest rather than gain; therefore, Section 1041 does not shield the income from recognition. B was deemed to have received the bonds as a gift, and his newly acquired basis in the bonds was equal to A’s basis in the bonds immediately prior to the transfer plus any income recognized by A under § 1.454-1(a) as a result of the transfer of the bonds.
The IRS further stated that B must include in income only the deferred, accrued interest in the bonds from the date of the transfer to the date of the redemption of the bonds.
Transfer of S Corporation Stock.
As a general rule, an S corporation shareholder may only deduct S corporation losses and deductions to the extent the losses and debt do not exceed his or her adjusted basis. Pursuant to Section 1366(d)(1), the aggregate amount of losses and deductions taken into account by a shareholder for any taxable year may not exceed the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation, and (B) the shareholder’s adjusted basis in any indebtedness of the S corporation to the shareholder. Any loss or deduction that is disallowed by this rule is treated as being incurred by the corporation in the succeeding taxable year.
Although such suspended losses and deductions are generally non-transferable, there are exceptions depending upon the date of the transfer. For example, if S corporation stock is transferred before Dec. 31, 2004, the losses are nontransferrable and the transferee spouse cannot claim a deduction for the loss because the transferor spouse’s losses were suspended and carried forward. However, if the transfer took place after Dec. 31, 2004 and was incident to a divorce, the suspended loss or deduction with respect to the stock transferred is treated under Section 1366(d)(2)(B) as incurred by the corporation in the later year with respect to the transferee spouse.
Compensatory Stock Options.
In Rev. Rul. 2002-22, The IRS has concluded that when a spouse transfers his or her vested non-statutory stock options incident to a divorce, he or she is not required to recognize income on either the transfer or the subsequent exercise of the options or the payment of the deferred compensation. For example, the IRS addressed the following situation:
A and B were divorced in 2002. A is
employed by X Corporation. Before the
divorce, X issued non-statutory stock
options to A that did not have a readily
ascertainable fair market value at the time
granted. Thus, no amount was included
in A’s gross income with respect to those
options at the time of grant. Under the
law of the state in which A and B were liv-
ing, stock options earned by a spouse dur-
ing the period of marriage are marital
property subject to equitable division
between the spouses in the event of
divorce. Under the property settlement
at their divorce, A transferred to B one-
third of the non-statutory stock options
issued to A by X. In 2006, B exercised all
of the stock options and received X stock
with a fair market value in excess of the
exercise price of the options.
The IRS held that the interests A transferred to B constitute property that can be transferred between spouses incident to divorce, without gain recognition. The IRS also concluded that the assignment of income doctrine does not apply to A’s transfer to B. Consequently, A did not recognize any income resulting from B’s exercise of the stock options in 2006. However, when B exercised the stock options in 2006, he or she must recognize income as if he or she were the person who performed the services.
Qualified Retirement Plans.
A qualified domestic relations order ("QDRO") may be used to avoid the tax problems associated with ordering immediate distribution of funds from an employer-sponsored retirement account incident to a divorce. Interests in qualified pension and profit sharing plans can be transferred by a QDRO to shift the tax liability from the transferor spouse to the transferee spouse. A QDRO creates the existence of an alternate payee’s right to receive all or a portion of the benefits that otherwise would have gone to the owner.
QDROs can be used for any retirement plan covered by the Employment Retirement Income Security Act of 1974. Traditional pension and profit-sharing plans as well as 401(k), 403(b) and 457 plans are included. The QDRO provides specific instructions for a retirement plan administrator to distribute the benefits of a retirement plan according to the percentages agreed upon by the parties and approved by the court. The QDRO also describes how the assets of a pension plan are disbursed after a party dies.
The procedural requirements for a QDRO must be meticulously followed. Pursuant to Section 414(p)(2)(A)-(D), to be “qualified," a QDRO must clearly specify (1) the name of each participant and his or her mailing address, (2) the name and address of each alternate payee, (3) the amount or percentages to be received by each payee or the manner in which the percentage is calculated, (4) the duration of the order, including the number of payments, and (5) each plan to which the order applies. Section 414(p)(6)(A) provides the general procedure for the recognition of a QDRO. After the court issues the order, it must be reviewed and accepted by the appropriate pension plan administrator. If the administrator honors the order, it will be deemed “qualified” and thereby entitled to QDRO treatment.
When a spouse transfers an interest in a qualified retirement plan through a QDRO in exchange for cash or other property, the transfer is tax-free under Section 1041. The transferee spouse assumes the transferor spouse’s basis in the acquired asset. The non-employee transferee spouse is a distributee under the Code and is taxed when he or she ultimately receives the benefits from the plan. The employee former spouse is not taxed. If the retirement benefits are allocated to another person, such as a child, the employee is taxed on the payments. Thus, the employee pays the taxes on the payments to the child, not the child. The QDRO should be drafted early in the divorce process at the same time the parties negotiate the other terms of their settlement. If the employee spouse dies or retires before the QDRO is entered, the alternate payee may have problems collecting.
Individual Retirement Accounts.
The QDRO rules do not apply to the transfer of an interest in an individual retirement account ("IRA"). Under Section 408(d)(6), the transfer of an individual’s interest in an IRA to a spouse or former spouse pursuant to a divorce or separation instrument is not taxable. The IRA is treated as the IRA of the recipient spouse; thus, it is simpler to transfer the interest in an IRA than to transfer interests in other qualified pension or profit sharing plans.
If the IRA owner withdraws cash from the IRA and transfers the cash to his or her spouse as part of a divorce settlement, the distribution is taxable. Also, if the IRA owner is younger than fifty-nine and a half years old, the distribution will likely be subject to a 10% early withdrawal penalty under Section 72(t). Thus, rather than withdrawing cash, an IRA interest should be transferred pursuant to a divorce or separation instrument for the transfer to be tax-free.
There are two basic ways to divide IRA assets: (1) a direct trustee-to-trustee transfer or (2) a change of the owner’s name. Under the direct trustee-to-trustee method, the IRA owner directs the IRA trustee to transfer the assets directly to the trustee of a new or existing IRA in the name of the transferee spouse. This first method is beneficial where less than the entire balance of the IRA has been awarded to the recipient spouse because the transferor can simply transfer the portion of the funds that must be transferred and can maintain his or her IRA without having to go through the process of closing and reopening another account. The second method for transferring IRA assets is to change the IRA owner’s name. This method is simplest when all of the assets in the IRA account are to be transferred to the recipient spouse. After the name change, the IRA is treated as belonging to the recipient spouse in all respects, and only the recipient spouse can contribute to the IRA thereafter.
Tax consequences have a major impact in the equity and treatment of the division of marital assets upon divorce. If tax issues are not considered and assets not transferred with regard to tax rules, one or both parties may receive less than he or she bargained for during the divorce settlement. The goal of equitable distribution is to provide an equitable division of marital property, but if tax consequences of the division are not taken into account, the result of the distribution can be inequitable. Because courts are not always required to consider the tax consequences of a division of martial assets, practitioners should be aware of the applicable tax issues during negotiation and settlement and present evidence of such at trial.
Herman-Giddens practices with TrustCounsel, an estate planning, probate and tax law firm in Chapel Hill. He thanks J. Leeanne Burge for her assistance in the preparation of this article.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.