Avoiding third-party transfers in a divorce.

Author:Quinn, Tina Steward
 
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The tax controversy continues.

Divorce is never easy for any of the parties involved. The divorcing spouses must consider how the split will affect themselves, their children, the disposition of their marital property and other financial arrangements. CPAs need to be able to ease the transition by advising clients on the tax consequences of property settlements that take place as a result of the divorce. Under IRC section 1041, the transfer of property between spouses "incident to a divorce" is generally tax-free. However, when the transfer involves a third party such as a closely held corporation, the tax consequences may be less predictable.

For example, Tom and Mary jointly own the Widget Corp. Under their divorce agreement, Mary agrees to accept $100,000 for her stock, which has a basis of $10,000. Instead of Tom buying the stock directly from Mary, they agree that Widget Corp. will redeem her stock for cash, leaving Tom as the sole shareholder. With a third-party redeeming the stock, which spouse should pay the tax on the appreciation of the stock's value? In cases involving spouses and their closely held corporations, the courts have held conflicting opinions on the answer to this question. A recent case, Read v. Commissioner, 114 TC No. 2 (2000), adds to the controversy--and confusion for CPAs--surrounding third-party transfers.

SOME ESSENTIAL BACKGROUND

Congress enacted section 1041 to negate the effects of the U.S. Supreme Court ruling in U.S. v. Davis, 370 U.S. 65 (1962), where the Court held that a spouse transferring appreciated property in a divorce must recognize gain on the appreciation for tax purposes, thereby allowing the nontransferring spouse to receive a basis in the property equal to its fair market value (FMV). If the transferring spouse failed to report the gain on the transfer, the government might be "whipsawed" (the appreciation in value could escape taxation; see box on page 27) since the recipient spouse took an FMV basis.

Section 1041 provides that taxpayers will recognize no gain or loss on transfers of property between spouses in a divorce. The transferring spouse's basis in the transferred property carries over to the recipient spouse. Section 1041, whose intent is to treat the husband and wife as a single economic unit, does not eliminate tax on any appreciated property; it merely defers the tax until the property is transferred outside the economic unit to a third party.

DIRECT TRANSFERS TO A THIRD PARTY

Temporary regulations section 1.1014-1T(c), Q&A 9 provides three situations in which a property transfer to a third party on behalf of a spouse qualifies for nonrecognition of gain under section 1041, provided all the section's other requirements are met.

* The divorce or separation agreement requires the transfer to the third party.

* The transfer to the third party is done according to the other spouse's written request.

* The other spouse gives the transferor written consent for the transfer to the third party. In those situations, the property transfer will be treated as made directly to the nontransferring spouse. He or she will then be considered to have immediately transferred the property to the third party. In Tom and Mary's case, the deemed transfer from wife to husband is one that qualifies for nonrecognition of gain under section 1041; the deemed transfer from Tom to the Widget Corp. is not a transfer that qualifies for non-recogniton of gain.

Example. Assume a husband owes a note at the bank and his wife transfers appreciated stock to the bank to settle the debt. Under Q&A 9, she is treated as transferring the stock to her husband, who then transfers it to the...

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