Chapter 14 and divorce issues.

• Author: Natoli, Susan L.

In many divorce cases, agreements are drafted between the parties without regard to all tax consequences. The income tax consequences--alimony being taxable to the payee spouse and deductible by the payor spouse and child support being neither deductible by the payor nor taxable to the recipient--are fairly well known. Property transfers between spouses incident to divorce are nonrecognition events for income tax purposes. In the gift tax arena, however, what appears to be an all-encompassing exclusion under Sec. 2516 from the gift tax may not always be so.

Sec. 2516 provides that in divorce situations a transfer of property or an interest in property made pursuant to a written settlement agreement to either spouse in settlement of marital or property rights or a transfer to provide support for children during their minority will be deemed to be a transfer for full and adequate consideration, i.e., the transfer will not be treated as a gift. For this exclusion to apply, divorce must occur within the three-year period beginning on the date one year before the agreement is entered into-whether or not such agreement is ratified by the divorce decree. Such transfers may be outright or in trust. However, a transfer in trust or as a split interest may cause unexpected gift tax consequences for those not versed in the Chapter 14 valuation rules,, namely Sec. 2702 and related regulations.

In structuring divorce settlements, the transferor spouse's attorney is usually trying to find a way to satisfy the settlemen desires of the parties without putting the property in the hands or the discretion of the ex-spouse. often this is done either through a split-interest transfer or, typically, through the use of a trust. A common structure would be one in which payments are to be made to an ex-spouse for a period of years with the remainder going to the children. Often an independent trustee is used so that the spouse receiving the payments is not subject to the whim of the payor spouse and there is less opportunity for continuing friction between the parties. The independent trustee also provides some comfort to the transferor spouse that the property placed in trust will eventually be received by the children. However, when a transfer is made in trust and a remainder interest goes to an applicable family member, the valuation rules of Chapter 14 come into play. According to Regs. Sec. 25.2702-1(c)(7), the complete exclusion from gift tax under Sec. 2516...