A Divorce Decree And Past Taxes

Let’s say that a couple divorces. The divorce decree stipulates that liability for previous federal taxes will be split 50:50. They had always filed jointly The IRS audits one or more of those earlier years and assesses additional taxes.

Question: what is each spouse’s liability?

Your first thought might be 50:50, as that is what the divorce decree says.

Our protagonists this time would find out.

Mae Asad and Sam Akel filed joint returns for 2008 and 2009. The IRS audited those years, looking at rental losses. They disallowed the losses and assessed over $30,000 in taxes and penalties.

Mae filed for innocent spouse.

Later Sam filed for innocent spouse.

NOTE: Filing for innocent spouse status means that a spouse (probably an ex-spouse, but I had a client who was still married) has been assessed taxes for which he/she does not believe he/she is responsible. The classic case is the stay-at-home spouse, the other self-employed spouse, and the stay-at-home has no participation in or knowledge of the other’s business. Think Carmela Soprano.

The IRS bounced both requests for innocent spouse.

Both ex-spouses filed with the Tax Court.

Before the hearing, the IRS conceded that Mae was responsible for 28% of the 2008 tax and 41% of the 2009 tax. Sam of course was responsible for the balance.

Seems to me that Sam might not like this deal.

I do not know how, but Mae agreed to a 50:50 split. She did not have to, mind you.

The courts have been consistent that a divorce decree is not binding on the IRS, as the IRS is not party to the divorce.  A joint return means that both spouses are liable, and the IRS can go after one … or both, to the extent the IRS desires. The decree may provide for a former spouse to seek restitution against the other, but it has no impact on the IRS.

The Court accepted the IRS previous concession to Mae of 28% and 41%. It did not have to observe the divorce decree and it did not.

Then the Court reviewed the penalties of over $5,000.

But there had been a fatal flaw,

You see, Mae and Sam had filed pro se with the Tax Court. Pro se means one is going in without professional representation (not exactly correct, but close enough). It happens with small tax cases. The paperwork to get to Court and the procedural rules once there are more lenient for small cases.

Sam and Mae had not included the penalty in their petition to the Court.

The Court did not have authority to review the penalties.

But it did provide us a clear example of the downside to representing oneself pro se.

Spouses Owning Businesses, Divorce And Taxes

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)—

(1) a spouse, or

(2) a former spouse, but only if the transfer is incident to the divorce.

(c) Incident to divorce. For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer— 

(1) occurs within 1 year after the date on which the marriage ceases, or

(2) is related to the cessation of the marriage.

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. 

Losing An Alimony Tax Deduction

There are certain tax topics that repeat – weekly, monthly, ceaselessly and without end. One such is the tax issues surrounding divorce. I have often wondered why this happens, as divorce is surely one of the most lawyered life events an average person can experience. I will often skip divorce tax cases, as I am just tired of the topic.

But a recent one caught my eye.

The spouses were trying to work something out between them. It was clear to me that they solicited no tax advice, as they plunged off the bridge without checking the depth of the water below.

John and Beatrix were married. They legally separated in 2008 and divorced in 2013. In the interim John agreed to make 48 monthly maintenance payments of $2,289. There was a clause stipulating that payments were to be taxable to her and deductible by him, and the payments were to cease upon her remarriage or death.

John found himself unemployed. His payments were to begin in 2010. Presumably concerned about his financial situation, he and Beatrix agreed in 2009 to transfer his IRA worth $38,913.

John did not deduct the IRA as an alimony payment on his 2009 tax return.

Why not? Because Beatrix was to start withdrawing $2,289 monthly from the IRA the following year, presumably until the $38,913 was exhausted. It made more sense to John that those monthly payments would trigger the alimony.

There is some rhyme or reason to his thinking.

It appears his finances improved, as in 2010 he was able to directly pay Beatrix $6,920.  

In 2010 he deducted $27,468 ($2,289 times 12) as alimony.

The IRS disallowed all but $6,920.

Off to Tax Court they went.

There are four key statutory requirements before any payment can be deductible as alimony:

(1)  The payment must be required under a divorce or separation decree.

(2) The decree cannot say that the payments are not deductible/taxable.

(3)  The two individuals cannot be members of the same household.

(4) There cannot be any requirement to continue the payments after the death of the payee spouse.

It is amazing how often someone will fail one of these. A common story is one spouse beginning payments before the court issues the order, or a spouse paying more than the court order. Do that and the payment is not “required.” Another story is presuming that the payment is deductible because the decree says that it is. The IRS does not consider itself bound because one included such language in the decree.

Then there are the softer, non-key requirements.

For example, only cash payments will qualify as alimony.

If you think about this one for a moment, it makes sense. The Code already allows spouses to transfer property in a divorce without triggering tax (Code section 1041). This allows spouses to transfer the house, for example, as well as retirement benefits under a QDRO order. The Code views these transactions as property settlements – meaning the ex-spouses are simply dividing into separate ownership what they previously owned together.

COMMENT: It is highly debatable whether John’s IRA is “cash.”  Granted, there may be cash in the IRA, but that not is not the same as saying the IRA is cash or a cash equivalent. It would make more sense to say that it is the equivalent of stocks or mutual funds. This would make it property, not cash.

Let’s next go back to rule (4) above. A way to rephrase that rule is that the payee spouse cannot be enriched after death. Obviously, if maintenance payments were to continue after death, then the payee-spouse’s estate would be enriched. That is not allowed.

In our situation, Beatrix now owned an IRA. Granted, the expectation may have been that she would outlive any balance in the IRA, but that expectation is not controlling. If she passed away, the balance in the IRA would be hers to transfer pursuant to her beneficiary designation.

She was enriched. She had something that continued past her (albeit hypothetical) death.

Another issue was whether John should get credit for IRA withdrawals by Beatrix in 2010. Why?  John transferred the IRA to her in 2009. The account was no longer his. It was hers, and he could no longer piggyback on anything the IRA did. If he was going to deduct anything, he would have had to deduct it in 2009.

Which, by the way, he could not because of rule (1): it was not required under the decree. The decree called for payments beginning in 2010, not in 2009.

The Tax Court decided that John had a 2010 alimony deduction for $6,920, the amount he paid Beatrix directly.

Why did John do it this way? 

If John was less than 59 1/2, so he could not get into his IRA without penalty.  He could QDRO, but that is just a property settlement. John wanted an alimony deduction. If he kept the IRA, he would have income on the withdrawal and a deduction for the alimony. That is a push - except for the 10% penalty on the early withdrawal. John was in a tough spot.

Then again, maybe he didn't think of tax matters at all.