Tax considerations for divorcing spouses.

• Author: Passini, Nick

Marital planning is the bedrock of estate and income tax planning for individual taxpayers, but even a well-conceived plan suffers when the married couple decide to divorce. During the divorce proceedings, it is critical for each taxpayer to work with a tax adviser to understand the estate, gift, and income tax consequences of the marriage dissolution. Several provisions of the Internal Revenue Code apply commonsense rules to dividing asset ownership and implement the general rule that divorce should not be a taxable event. Other Code sections, however, can create unexpected difficulties for divorcing spouses. This item outlines considerations for managing and correctly timing a marital property settlement from a tax perspective.

The first key provision is Sec. 2516, a gift tax rule that renders nontaxable certain payments and transfers between former spouses that would otherwise be taxable. However, Sec. 2516 applies only to payments and transfers made pursuant to a written agreement that resolves the divorcing spouses' marital and property rights or provides for the support of minor children. In addition, the final decree of divorce must occur no later than two years after execution of the written agreement and no earlier than one year prior to the execution of the agreement. While the actual payments do not have to be made during the three-year period, they must be traceable to the agreement. Sec. 2516 provides that the transfers will be deemed to be made for fall and adequate consideration, which negates the gift.

Sec. 2516 covers both direct transfers and transfers in trust but only to the extent of the value of the former spouse's marital and property rights and a reasonable allowance for the support of minor children. Taxpayers who have tried to argue that payments or discretionary distributions to adult children should fit within Sec. 2516 have been unsuccessful, as exemplified by Technical Advice Memorandum 200011008, in which the IRS ruled that life insurance proceeds paid to adult children were not protected by Sec. 2516.

Another gift tax rule that divorcing spouses must navigate is Sec. 2513, which governs the gift-splitting election. Because this statute mandates that the donor spouse and the nondonor spouse signify their consent to the gift-splitting election and that the spouses be married at the time of the gift (and neither may remarry during the calendar year), it is essential for divorcing spouses to incorporate the timing of the divorce into their gift planning.

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