Post-divorce settlement sale of businesses between ex-spouses was incident to divorce
Belot, TC Memo 2016-113TC Memo 2016-113
The Tax Court has held that where a couple provided in their divorce agreement that they would each own 50% of their businesses, but decided over a year later that this arrangement wasn’t working, the ex-husband’s sale of his 50% interest to the ex-wife was nontaxable because it was incident to the divorce.
Background. Code Sec. 1041(a) provides that no gain or loss is recognized on a transfer of property from an individual to a spouse, or to a former spouse if made incident to a divorce. A transfer of property is “incident to the divorce” if the transfer occurs not more than one year after the date on which the marriage ceases or the transfer is related to the cessation of marriage. (Code Sec. 1041(c))
Reg. § 1.1041-1T(a), Q&A-7, provides the following (we have numbered the sentences to facilitate our references to the reg in the discussion below):
- A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, and the transfer occurs not more than six years after the date on which the marriage ceases.
- A divorce or separation instrument includes a modification or amendment to such decree or instrument.
- Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than six years after the cessation of the marriage is presumed to be not related to the cessation of the marriage.
- This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage.
- For example, the presumption may be rebutted by showing that
- The transfer was not made within the one- and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and
- The transfer is effected promptly after the impediment to transfer is removed.
In Young, (1999) 113 TC 152113 TC 152, affd (2001, CA4) 87 AFTR 2d 2001-88987 AFTR 2d 2001-889, a transfer of a tract of land by husband (H) to wife (W) was incident to their divorce where the transfer settled H’s obligation to W on a promissory note that was part of their property settlement. H and W were divorced in ’88. In ’89, they entered into a property settlement under which H gave W a promissory note for $1.5 million. H defaulted on the note, and W sued and won a judgment against H. In ’92, H and W entered into a settlement agreement under which H agreed to transfer a tract of land to W in exchange for cancellation of the judgment and surrender of the note. The Tax Court said that the land transfer was related to the cessation of the marriage because it resolved a dispute arising under the property settlement and completed the division of marital property. It made no difference that W had the status of a judgment creditor when she entered into the ’92 agreement since the character of and reason for the transfer is what matters.
Facts. Mr. and Ms. Belot, a married couple, owned three businesses together, but their ownership in some of the businesses was not 50/50. Their divorce was finalized on Jan. 8, 2007. The judgment of divorce incorporated a March 2006 settlement agreement in which the couples transferred stock, etc. between them, so that each owned 50% of each of the three businesses.
In September 2007, Ms. Belot brought a suit in the New Jersey Superior Court, Civil Part, in which she contended that Mr. Belot had mismanaged the businesses and sought to compel him to sell his shares of the businesses to Ms. Belot. The ex-spouses entered into a settlement agreement in 2008 (second settlement agreement) under which Mr. Belot sold his shares to Ms. Belot.
The sale qualified for nonrecognition treatment. The Court held that Mr. Belot’s sale to Ms. Belot of his interests in the marital businesses pursuant to the second settlement agreement qualified for nonrecognition treatment under Code Sec. 1041.
The Court first noted that the policy behind Code Sec. 1041 is clear. Congress has chosen to treat a husband and wife, and a former husband and wife acting incident to divorce, as one economic unit, and to defer, but not eliminate, the recognition of any gain or loss on interspousal property transfers until the property is conveyed to a third party outside the economic unit.
It then went on to reject all of IRS’s arguments.
First, while IRS did not contend that the division of property under the second settlement agreement was not “made to effect the division of property owned by the former spouses at the time of the cessation of the marriage”, it did argue that the transfer under the second settlement agreement did not qualify under the regs because the transfer did not relate to the divorce instrument.
The Court disagreed. IRS’s contention that the division of marital property must relate to the divorce instrument was based on the first, second, and third sentences of the reg (which refer to the divorce instrument) but overlooked the fourth sentence. The third sentence of the reg provides that there is a presumption that Code Sec. 1041 does not apply to “any transfer not pursuant to a divorce or separation instrument”. Consistent with Code Sec. 1041, the fourth sentence makes clear that the presumption may be rebutted “by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage”. Mr. Belot made that showing here.
IRS then contended that Mr. Belot did not rebut the presumption as provided in the fourth sentence of the reg because Mr. Belot’s transfer of his interests in the businesses to Ms. Belot under the second settlement agreement was not due to “legal or business impediments that prevented a transfer called for by the divorce decree”. IRS based that argument on the fifth sentence of the reg.
The Court disagreed with this argument as well because the fifth sentence provides examples and does not create a requirement that Mr. Belot must satisfy to rebut the presumption.
Next, IRS pointed out that the judgment of divorce resolved all of the property issues between Mr. Belot and Ms. Belot. However, the Court said, neither Code Sec. 1041 nor the regs limits application of Code Sec. 1041 to one, or the first, division of marital property. IRS pointed out that in form and in substance the division of the marital businesses made by the second settlement agreement was a sale. However, the Court said, as noted in Young, neither Code Sec. 1041 nor the regs bars application of Code Sec. 1041 to divisions of marital property accomplished through sales.
IRS then characterized Ms. Belot’s dissatisfaction with the first settlement agreement as a business dispute. The Court acknowledged that the marital property at issue consisted of stock in businesses operated by Mr. Belot and Ms. Belot during and after their marriage. However, it said, Code Sec. 1041 and the regs can apply to marital property which consists of business-related property. IRS contended that the fact Ms. Belot filed the 2008 lawsuit in the Superior Court, Civil Part, rather than the family court (which had jurisdiction over Mr. Belot’s divorce), showed that the lawsuit concerned a business dispute, not a marital dispute. The Court disagreed. The application of Code Sec. 1041 to a transfer resulting from the settlement of a lawsuit is not determined by the forum in which the lawsuit is filed.
Finally, IRS urged the Court to disregard the holding in Young on the basis of alleged factual distinctions between Young and this case, i.e., that, in Young, the second settlement agreement resolved a dispute concerning the terms and obligations of the first settlement agreement (relating to the dissolution of their marriage), but here, the second settlement agreement did not resolve a dispute concerning the terms and obligations of the 2006 settlement agreement.
The Court disagreed that the cases are distinguishable on that basis. In both Young and here, a former spouse alleged shortcomings with implementation of the first settlement agreement by the other spouse, and, as a result, in both cases, the parties negotiated a second settlement agreement employing different terms for disposition of their marital assets than were contained in their first settlement agreement.
The transfers made pursuant to the second settlement agreements in Young and here were made (as required by the fourth sentence of the reg) to “effect the division of property owned by the former spouses at the time of the cessation of the marriage”; and as required by Code Sec. 1041 were “related to the cessation of the marriage”.
If you have a client that recently went through a divorce..this might be a great planning opportunity for them.