Transfers of Property Between Divorcing Spouses

John, a white man with dark brown hair, wears a pale blue shirt, lime green and blue tie, and black suit. By John G. Hodnette

Prior to the Tax Cuts and Jobs Act of 2017, transfers between spouses or former spouses incident to divorce were treated as either (a) nontaxable transfers under Section 1041 or (b) alimony or separate maintenance payments under Section 71. Under that prior regime, alimony payments under Section 71 were included in the taxable income of the recipient and resulted in an income tax deduction for the payor. The 2017 Act repealed Section 71 and its corollaries, Sections 62(a)(10) and 215, which provided the deduction for the payor of alimony. Although most states follow the current Internal Revenue Code, some do not. Accordingly, in some states, alimony is still taxable to the recipient and deductible by the payor for state income tax purposes.

Although Section 71 is repealed, Section 1041 remains intact. Section 1041(a) provides no gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) (i) a spouse, or (ii) a former spouse but only if the transfer is incident to divorce. Section 1041(b) provides “in the case of any transfer of property described in subsection (a), (1) for purposes of this subtitle, the property shall be treated as acquired by the transferee by gift, and (2) the basis of the transferee in the property shall be the adjusted basis of the transferor.” The effect of treating a transfer as a gift for income tax purposes is the application of Section 102, which excludes the value of gifted property from the gross income of the recipient. Section 1041(c) provides that “for purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer (1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.” Section 1041(d) provides subsection (a) does not apply if the spouse (or former spouse) of the individual making the transfer is a nonresident alien of the United States.

Temporary regulations under Section 1041(c)(2) clarify that a transfer of property between former spouses is deemed related to the cessation of marriage under Section 1041(c)(2) if (i) the transfer is pursuant to a divorce or separation instrument, and (ii) the transfer occurs not more than six years after the date on which the marriage ceases. Treas. Reg. § 1.1041-1T(b), Q&A-7.  Any transfer made more than six years after the cessation of the marriage and any transfer not pursuant to a divorce or separation instrument is presumed non-divorce related. However, the presumption is rebuttable where it is shown the transfer was made to effect the division of property owned by the former spouses at the time of divorce.

Any interest paid in connection with late transfers between a spouse or former spouse incident to divorce is not exempt from tax.  Gibbs v. Commissioner, T.C. Memo 1997-196. Similarly, Seymour v. Commissioner, 109 T.C. 279 (1997), establishes interest paid to a spouse or former spouse incident to divorce gives rise to a deduction to the extent it is allocable to a deductible expense.

John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.

Jack Cummings Receives Tax Notes’ Award for Excellence in Tax Commentary

By Herman Spence III

Jack Cummings, a white man with grey hair and wire-rimmed glasses, wears a pale blue shirt, red tie and black jacket.

Jack Cummings

Jack Cummings received Tax Notes’ inaugural Award for Excellence in Tax Commentary on May 3 at the ABA Tax Section’s annual meeting. Jack is counsel in Alston & Bird’s Raleigh and Washington offices.

The quality and quantity of Jack’s tax articles and other scholarly work are extraordinary. Many of us are like Salieri in “Amadeus.” Our lesser talents allow us to appreciate, but not replicate, Jack’s insightful work.

Congratulations, Jack! Below is a conversation with him:

Over the years, what percentage of your time was spent on client work, and what percentage on scholarly pursuits?

That’s a good question. Only in the last few years has it become pretty heavily weighted towards articles, scholarly or not!

How have you found time to write so many excellent and thorough articles?

Often an article grows out of a practice issue, so research can do double duty.

Read more

Claim of Right Doctrine of Section 1341

John, a white man with dark brown hair, wears a pale blue shirt, lime green and blue tie, and black suit. By John G. Hodnette

Under the claim of right doctrine, a taxpayer who receives income under a claim of right that is free of restrictions must include the amount in income in the year of receipt. That is the case even if the taxpayer may, in a future year, be required to return to the payor the amount included in income. If the amount is returned within the same tax year, the rescission doctrine can apply to prevent taxation. Where the amount included in income is repaid after the year of inclusion, a deduction may be available to reduce current year income for the amount repaid. In some cases a deduction in the year of repayment does not produce as much reduction in tax liability as the amount of tax paid in the year of inclusion (due to changes in tax rates or limits on the use of the deduction). Section 1341 addresses that potential whipsaw by allowing taxpayers to elect to reduce the tax liability in the current year by the amount of tax generated in the previous year by the inclusion of such amount in income.

Read more

Federal Income Tax Update

Keith, a white man with brown hair, wears wire-rimmed glasses, a white shirt and black jacket.By Keith A. Wood

I. No Reasonable Cause Penalty Defense where CPA did not Give Specific Advice about Erroneous Items; Johnson v. Commissioner, TC Memo 2023-116

Mr. and Mrs. Johnson hired a CPA to prepare their tax returns for 2015-2018. From 2006 to 2013, Mr. and Mrs. Johnson improperly claimed depreciation deductions on certain commercial buildings by using a seven-year depreciation life, rather than the 39-year life applicable to commercial property. As a result, the Johnsons overstated their depreciation deductions between 2006 and 2013 by $1.5 million.

The Johnsons sold their property in 2016 for $5 million. Because of the improper depreciation deductions claimed between 2006 and 2013, the IRS made a Section 481 accounting method adjustment of almost $2 million for 2015. In addition, for 2015, the Johnsons claimed a charitable contribution deduction. However, they filed an incomplete Form 8283 (Non-cash Charitable Contributions) that was fatally defective in numerous respects.

Read more

Partnership Representatives

John, a white man with dark brown hair, wears a pale blue shirt, lime green and blue tie, and black suit. By John G. Hodnette

Congress adopted new partnership audit rules as part of Bipartisan Budget Act of 2015 (“BBA”), replacing the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). As part of that change, the role referred to as the tax matters partner has been replaced by the partnership representative.

The partnership representative can take a number of actions on behalf of the partnership, including (i) entering into a settlement agreement; (ii) agreeing to a notice of final partnership adjustment; (iii) requesting modification of an imputed underpayment; (iv) extending the modification period; (v) waiving the modification period; (vi) agreeing to adjustments and waiving the final partnership adjustment; (vii) extending the statutory periods for making adjustments; and (viii) making a push out election.

Read more

Allocation of Income When a Partner Leaves a Partnership

John, a white man with dark brown hair, wears a pale blue shirt, lime green and blue tie, and black suit. By John G. Hodnette

The allocation of income when the ownership of an S corporation changes is discussed in my previous article Section 1377(a)(2) Elections for S Corporations. That article explains the default method for allocations of income when an ownership change occurs as to an S corporation is the proration method. However, one can make a Section 1377(a)(2) election and instead use the closing of the books method. In contrast, in the case of partnerships, the default is the opposite.

Pursuant to Reg. § 1.706-4(a)(3)(iii), “absent an agreement of the partners . . . to use the proration method, the partnership shall use the interim closing method.” Reg. § 1.706-4(f) defines “agreement of the partners” to mean either (i) an agreement of all the partners to select the method in a dated, written statement maintained with the partnership’s books and records or (ii) a selection made by a person authorized to make such selection under state law or the partnership agreement, provided that person’s selection is in a dated, written statement maintained with the partnership’s books and records. The interim closing method is similar to the S corporation closing of the books method. The interim closing method generally treats each change in partnership ownership as the time to close the books for such interim period. That means only partners who were owners in such period are allocated income and loss that occurred during the period. However, the regulations provide great flexibility in determining the length of interim periods.

Read more

Deemed Asset Sales Under Rev. Rul. 99-5

By John G. Hodnette

Revenue Ruling 99-5 discusses the tax treatment of the purchase of some but not all of the membership interests in a wholly-owned LLC. Pursuant to Reg. § 301.7701-3(b)(1)(ii), unless electing otherwise, a domestic LLC with only one owner is treated as an entity disregarded as separate from its owner for income tax purposes. However, that raises the issue of how to treat an acquisition of less than 100% of the membership interests in the LLC. This is not an unusual circumstance, particularly because the Rev. Rul. 99-5 structure is often used in S corporation F reorganization transactions.

Rev. Rul. 99-5 explains two situations involving a wholly-owned LLC that is disregarded for income tax purposes. It is assumed in both situations that the resulting partnership is not treated as an investment company, all of the assets are capital assets or Section 1231 property, and there is no indebtedness.

Read more

Tax Benefit Rule

John, a white man with brown hair and blue eyes, wears a blue jacket, white shirt, and blue tie. By John G. Hodnette

The tax benefit rule was originally established by case law but later codified as Section 111. It provides a taxpayer is not permitted to retain the tax benefit of a deduction when later events demonstrate she is not entitled to it. The rule prevents taxpayers from receiving the benefit of a deduction in one year, but upon an unexpected change of circumstances in a later year, receiving a recovery of items that were deducted as a loss in the prior year (and without treating that recovery as income).

An example of the rule is where a taxpayer takes a deduction for a bad debt in year one under Section 166(a). Without the tax benefit rule, the repayment of the bad debt in year two (which would be a nontaxable return of capital) is not a taxable event. Thus, the taxpayer would have had the benefit of the deduction while also receiving the benefit of the recovery of nontaxable cash. To prevent that double benefit, the tax benefit rule requires the taxpayer to recognize income from the receipt of the unexpected payment in year two to offset the tax benefit of the deduction in year one.

Read more

How Are Restricted Stock Units Taxed?

John, a white man with brown hair and blue eyes, wears a blue jacket, white shirt, and blue tie. By John G. Hodnette

Employers often issue incentive stock to employees to promote retention and performance. Restricted Stock Units or “RSUs” are one of many ways to do so. Unlike similarly named restricted stock, an RSU does not initially provide the recipient with any ownership in the corporation. Rather, they are a contractual obligation of the employer to issue stock to the holder of the RSU once the RSU vests. It is only upon the issuance of stock that the RSU holder is taxed. Therefore, a Section 83(b) election is not possible or necessary for RSUs, unlike restricted stock.

Once an RSU vests, the corporation issues stock to the RSU holder. That results in compensation income equal to the fair market value of the issued stock at the time of issuance. The corporation receives a corresponding deduction. Like other compensation income, the issuance of stock is subject to withholding of income and FICA taxes.

Read more

Federal Income Tax Update: Part 4

Keith, a white man with brown hair, wears wire-rimmed glasses, a white shirt and black jacket.By Keith A. Wood

I. Termination of S Corporation Status was Inadvertent where Shares were Owned by an IRA.

In PLR 202319003, the IRS again demonstrated its willingness to grant amnesty to inadvertent S corporation terminations. The IRS waived an S termination where shares were issued to an IRA.  The corporation elected to be an S corporation, but the election was invalid because one of its shareholders was an IRA. Apparently, when the S election was filed, the officers of the S corporation and the owner of the IRA did not know an IRA is not an eligible S corporation shareholder.

After the corporation learned the IRA was an ineligible shareholder, the stock was transferred from the IRA to its owner. The IRS waived the inadvertent termination and permitted the S corporation’s status as of its original incorporation date. However, as a condition of the favorable PLR, for all open years in which the S corporation had positive income, the IRA owner had to be treated as the shareholder for all purposes.  Also, for any open years in which the corporation had a net loss, the IRA had to be treated as the owner of the stock.

Read more