Reforming the Tax Treatment of Divorce: Splitting the Benefits of a Split

• Publication year: 1984
• Citation: Vol. 7 No. 03

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 7, No. 3SPRING 1984

Reforming the Tax Treatment of Divorce: Splitting the Benefits of a Split

C. Garrison Lepow(fn*)

I. Introduction

Dear Sammy,

Our life together was a financial success, but an artistic failure.(fn1) Our marriage is over.

Regards, Becky cc: my lawyer

Whether Becky has grounds for divorce is hardly at issue under the typical no-fault divorce statute.(fn2) Becky's terse epistolary farewell omits reference to the subjects of dispute that will soon dominate their new relationship as a divorced couple: the family business; the home; the furniture; and other investments, most of which are not easily divisible. The last thing they are thinking of is the implications of their financial arrangements or their present and future tax liability. As they travel along the path of divorce, the problems that will assail them include the laws governing the taxation of the divorce settlement. The question for Becky, Sammy, and their respective advisors is how to unscramble the assets of the marriage in a way that will lead to a fair division after the tax burdens are imposed. The basic problem in achieving this end is that the price tag of the split-up is uncertain because the incidence of income tax on the division of the marital assets under current law is unpredictable.(fn3) The inevitable result is that many separation agreements, which the parties think will settle the financial responsibilities fairly, have unwanted tax consequences.

The purpose of this article is to consider the tax consequences of divorce, particularly those problems relating to property settlements. The tax consequences of alimony and child support are also considered. These problems have a long history that must be reviewed in order to understand both the present law and the current proposals(fn4) which were considered by the House Ways and Means Committee during the last session of Congress. Unfortunately, the narrowness of the legislative proposals permits many of the problems to continue; the proposals change only the timing of the problem.

II. Property Division

A. No Direct Election Under Current Law

The act of "splitting the sheets," under current law, may have any one of three disparate results: nontaxable division of assets,(fn5) recognition of gain or loss,(fn6) or includible(fn7)/deductible(fn8) alimony. Becky and Sammy may come to learn that determining the holder of legal title to property, by either contract wording or presumptions of state law, has more importance in establishing respective tax burdens than either their agreement or the divorce court decree. Will there be a cost at all? If so, to whom? Ultimately, geography governs in determining whether a divorcing couple's tax liabilities remain unchanged in the wake of divorce or whether they have each made money, lost it, or received a deduction.(fn9)

Under current law, divisions of co-owned property are nontaxable.(fn10) Divisions of separate property are taxable.(fn11) State law often provides a presumption of either separate property or co-ownership of property, but that presumption can be varied by contract.(fn12) Hence, residents of community property states can elect separate property status resulting in taxable transfers in connection with divorce, and residents of common-law states can elect joint ownership resulting in nontaxable divorce settlements. Thus, if a couple wants a taxable or nontaxable division of property to occur upon divorce, fulfillment of their dream merely requires early planning. For most married taxpayers, tax planning is not done until the divorce; at that time, the tax consequences of property divisions are obscure but final. The need for certainty as to the tax cost of the division is acute. Without this figure, one cannot calculate the value of a property settlement. Yet, the tax law prohibits a direct election of tax consequences by the divorcing couple. To have the chosen tax consequences, the election must not be connected to the divorce.(fn13)

Although antithetic to true romance, the best divorce for tax purposes is the one that is premeditated and, preferably, one that is is planned from the first date. However, even the divorce that is planned on the courthouse steps can afford the participants some options for tax consequences. One example is the selection of taxable (alimony) or nontaxable (child support) support payments. Despite whatever current law allows the parties to plan by agreement, tax consequences cannot be specifically elected as such. Such consequences are effects of other unrelated substantive transactions. The choice offered is not between taxable and nontaxable payments, but between alimony(fn14) and child support,(fn15) or alimony and property settlement.(fn16) Becky, who wants a payment to be nontaxable, cannot say so directly. She must style the agreement as child support.(fn17) On a government challenge to the agreement, the court may find the desired child support payment was, in fact, alimony.(fn18) The court's decision will produce tax consequences exactly contrary to the careful plans of the divorced couple, by changing a nontaxable and nondeductible payment into a taxable and deductible one. This is so because the question is not whether the payment was intended to be taxable or nontaxable, but whether it is properly termed child support or alimony in law.(fn19)

B. No Safe Harbor

How do you split the pie, if no child is involved? Sammy and Becky will soon learn that property transfers do not provide a safe harbor.(fn20) Assume their only property is 100 shares of stock with a basis of $100 and a fair market value of $1,000, which were held for investment for more than a year.(fn21) The stock has a potential gain of $900. Sammy and Becky desire a 50-50 split of property owned at the time of divorce. Becky does not want alimony. Sammy has title to the stock which was acquired during the marriage.

Sammy and Becky have two options: either sell the property and divide the cash proceeds, or divide the property itself. Selling the stock avoids untoward division of the tax burden, but at the cost of immediate recognition of gain. If the stock is community property and it is sold,(fn22) the divorced couple share equally the tax burden ($90 each) and the net proceeds ($410 each).(fn23) If it is separate property, Sammy's tax burden is technically increased to $180, but the after-tax distribution still nets each party $410. Therefore, title affects the tax burden but not the amount of ultimate proceeds to be divided. Can the obvious defect, the immediate recognition of tax consequences, be deferred without compromising equal division?

The answer is yes if Sammy's stock is community property. Sammy and Becky can each take 50 shares with a basis of $50. One-half the community basis is allocated to each party.(fn24) Assuming for the purpose of comparison that he and she both immediately sell their shares for $500, the tax burden and the proceeds are unchanged from the cash division above. Each pays $90 in tax and nets $410.(fn25) However, if Sammy's stock is separate property, there is a substantial difference in the amount of net proceeds shared by each party: with the entire tax burden of $180 paid by Sammy, he nets only $320, while Becky nets $500.(fn26) In sum, in a common-law jurisdiction, an equal division of separate property cannot both divide the tax burden fairly and avoid the immediate recognition of gain.

Treatment of the transfer as alimony(fn27) is a possible unintended tax consequence in either a community property(fn28) or

TABLE 1
A		B		C		D
	H	W	H	W	H	W	H	W
A. Fair Market Value	$500	$500	$1,000	$	$1,000(fn2)	$500(fn2)	$1,000(fn3)	$500(fn3)
B. Less Basis	50	50	100		100	500	100	50
C. Gain	450	450	900		900	0	900	0
D. Capital Gain Deduction	(270)	(270)	(540)		(540)	0	(540)	0
E. Includible in Gross Income	180	180	360

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