Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.
• Position: TAX TRENDS

LLCs & LLPs

Divorce settlement payments do not increase LLC basis

Divorce settlement payments that a dentist made to his ex-wife and legal fees he paid his divorce lawyer did not increase the basis in an interest in a limited liability company owned by an S corporation that he wholly owned.

Background

The taxpayer, Steven Matzkin, was married to Georgeann Matzkin. A dentist by profession, Steven in January 2003 formed Dental Care Alliance LLC (DCA), a partnership for federal income tax purposes. DCA is a dental support organization that provides services to affiliated dentists around the country. On Jan. 1, 2008, Steven assigned his entire 70% membership interest in DCA to SRM Consulting LLC (SRM), an S corporation of which he was the sole shareholder. SRM thereafter owned a 70% membership interest in DCA.

In May 2008, after more than 20 years of marriage, Steven filed for divorce. Steven's 100% interest in SRM (and by extension his 70% indirect interest in DCA) constituted marital assets under Florida law. An appraisal performed in 2007 valued DCA at $30 million; Steven's 70% indirect interest was thus assumed to be worth about $21 million.

Not surprisingly, Georgeann wanted half of the cash and property that had been built up during the marriage. Besides the interest in DCA, the couple's assets included $4.6 million in cash and securities, $6 million in real estate, $1 million in life insurance, and artwork and furniture of an undetermined value. The couple hired a mediator to assist with the division of the assets between them.

Steven and Georgeann came to a final agreement that called for a cash down payment to Georgeann and monthly payments on a $5.4 million promissory note. It provided if DCA were sold within 18 months and Steven's share of the proceeds exceeded approximately $21 million, Georgeann would receive 50% of any excess. The sale of DCA would also accelerate the terms of the promissory note, making it payable in full 30 days after Steven received proceeds from the sale.

The agreement referred to the payments described above as "non-modifiable alimony for... [Georgeann's] support and maintenance." However, under its terms, Steven's payment obligations were not terminable on his or Georgeann's death or on her remarriage. It explicitly stated that Steven's payments were not intended to be taxable to Georgeann or deductible by him for income tax purposes. The agreement recited that it recorded the parties' "final, complete, and exclusive understanding regarding... [their] marital separation, dissolution, and property settlement and supersede[d] any prior or contemporaneous agreement, understanding, or representation, oral or written."

The agreement was adopted by the divorce court. Steven paid legal fees exceeding $160,000 in connection with the divorce and the negotiations leading up to it. During 2009, as required by the agreement, Steven paid Georgeann $3 million and discharged her $1,475,500 share of certain joint liabilities. Between 2009 and 2012, he paid her interest in excess of $1.2 million on the promissory note.

On May 24, 2012, SRM sold its interest in DCA for $93,770,600. Gains from that sale passed through to Steven as SRM's sole shareholder. In June 2012, as required by the agreement, Steven satisfied the $5,462,312 remaining balance of the promissory note.

On his federal income tax return for 2012, Steven reported net long-term capital gain of $85,735,315 on the sale of SRM's interest in DCA. The IRS selected his return for examination and adjusted the gain upward by $5,362,814. In September 2016, the IRS issued Steven a timely notice of deficiency reflecting this adjustment and determining a deficiency of $804,423. He subsequently challenged the IRS's determination in Tax...