A fundamental
concept in taxation is that an “accession to wealth” represents taxable income,
unless the Code says otherwise.
There are
limits on this, of course, otherwise you would be immediately taxed when your
mutual fund or house went up in value. The Code will (usually) want to see a
triggering event, such as a sale, exchange or disposition by other means. You
don’t pay tax on your stock gain, for example, until you sell the stock.
But the concept
also creates problems. For example, consider the recent development of
crowdfunding. You have an idea for the next great breakfast sandwich, and you reach
out on the internet for money to get the idea going. You have accession to
wealth, but is the money taxable to you? The tax consequence can get very murky
very quickly. For example:
·
If
you provide investors with breakfast sandwiches, there is an argument that you
sold sandwiches.
·
If
investors instead receive ownership (say shares of stock), we would sidestep
that sale-of-sandwiches thing, but you might have an issue with securities laws.
·
If
investors receive nothing, one could argue that the monies were a gift. The closer
you get to detached generosity without expectation of economic gain, the better
the argument.
Let's next consider
accession to wealth in a divorce context. Here is Code Section 1041:
(a) General rule. No gain or loss shall be recognized on a
transfer of property from an individual to (or in trust for the benefit of)—
(c) Incident to divorce. For purposes of subsection (a)(2),
a transfer of property is incident to the divorce if such transfer—
Believe it
or not, the general definition of income could trigger when marital assets are divided
upon divorce. That makes little sense, of course, so Section 1041 provides an escape
clause.
Question: how much time do you have to separate the marital assets?
The first answer
provided in (c)(1) is one year. It is immediately followed by (c)(2) which
(appears to) expand the answer to any period as long as the asset transfer is
related to the cessation of marriage. That is a bit open-ended, so the tax Regulations
interpret (c)(2) as up to six years.
The Belots started
a dance school in New Jersey in 1989. The wife was the dancer and creative
force, while the husband attended to the business side. Eventually they had several
dance studios, a corporation to manage them and a partnership to own the real
estate. They did well. While owned 100% by the spouses, the husband and wife
were not necessarily 50:50 owners in each entity.
They started
divorce action in 2006,and adjusted their ownership in each entity to 50:50.
The divorce was finalized in January, 2007.
There is a
reason they got divorced. Tired of her ex-husband's participation, Ms. Belot
bought-out his share in 2008 for $1,580,000.
Mr. Belot
took the position that this was not taxable under Section 1041. The IRS took
the opposite position and billed him almost $240,000 in tax and penalties.
Off to Tax
Court they went.
The IRS
argued that each and every transaction had to come under the umbrella of
Section 1041. There was no question that the first transaction qualified, but
the second transaction – cashing-out Mr. Belot entirely – did not because it represented
an event arising after the divorce. The second settlement represented a
business contingency and was not related to the divorce decree.
The IRS was
following a hyper-technical interpretation of its Regulations.
The problem
is that the Code does not say "pursuant to the divorce decree." It
instead says "related to the cessation of marriage." The divorce
decree is arguably the most vivid expression of such cessation, but it is not
the only one. The Belots were clearly still dividing marital assets owned at
the time of divorce.
The Court
decided in favor of the Belots.
Why did the IRS
even pursue this?
The IRS was
enforcing the everything-is-taxable position, unless excluded by the Code
somewhere.
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