Transfer of property incident to a divorce that is covered by IRC §1041 is a nonrecognition transaction, with each spouse getting a carryover basis, even if the transaction otherwise appears to be a sale. The taxpayer in the case of Belot v. Commissioner, TC Memo 2016-113 argued that this nonrecognition provision should apply in his case.
IRC §1041(a) provides:
(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.
The term”incident to a divorce is defined at IRC §1041(c) which provides:
(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.
Regulation §1.1041-1T(b), Q&A 7 provides more detail on the second test provided above, dealing with transaction outside the one year automatic window that are still “related to the cessation of the marriage.”
Q-7: When is a transfer of property related to the cessation of the marriage?
A-7: A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in section 71(b)(2), and the transfer occurs not more than 6 years after the date on which the marriage ceases. A divorce or separation instrument includes a modification or amendment to such decree or instrument. Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than 6 years after the cessation of the marriage is presumed to be not related to the cessation of the marriage. This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage. For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one- and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.
The issue in this case involved a transfer that was not pursuant to a divorce or separation instrument.
After the taxpayer’s marriage ended the couple agreed to continue to operate their business as equal owners. Not surprisingly it turned out that they didn’t work well as partners in business and eventually Mr. Belot’s former wife filed suit to end this arrangement, contending “had mismanaged the business” and asked the court “to remove petitioner as director and employee of Gotta Dance and to compel him to sell his shares of Gotta Dance either to the corporation or to Ms. Belot.”
The former partners in marriage did eventually enter into a settlement agreement in this matter:
On April 11, 2008, petitioner and Ms. Belot entered into a settlement agreement (2008 settlement agreement) regarding the lawsuit. Pursuant to the 2008 settlement agreement, Ms. Belot agreed to purchase from petitioner all of his interests in Gotta Dance, Boutique, and Jobee for a total of $1,580,000, paid as follows: (1) $900,000 to be paid at closing and (2) the balance of $680,000, [*6] evidenced by a promissory note, payable in equal monthly installments on the first of each month beginning June 1, 2008, over 10 years bearing interest at the fixed rate of 5% on the principal amount outstanding. The amount of each monthly payment under the promissory note was $7,212.46.
On May 22, 2008, petitioner and Ms. Belot executed a stock and membership interest purchase agreement regarding the ownership of the businesses. The stock and membership interest purchase agreement allocated the total $1,580,000 among the interests in the businesses as follows: (1) $1,080,000 for the interest in Gotta Dance; (2) $475,000 for the interest in Jobee; and (3) $25,000 for the interest in Boutique. Petitioner's basis in each business is not in dispute. Petitioner executed a stock power instrument in which he sold, assigned, and transferred his 500 shares of Gotta Dance, representing a 50% interest, to Ms. Belot. Petitioner also executed an assignment of membership interest in which he transferred his 50% interest in Jobee and 50% interest in Boutique to Ms. Belot. On July 18, 2008, the general equity court entered a consent order of dismissal in the lawsuit.
Mr. Belot contended that the transaction was a nonrecognition transaction governed by IRC §1041 since the transaction related the cessation of his marriage. But the IRS objected that this was a separate transaction not governed by any divorce document, thus it simply represented a sale by Mr. Belot of his interest in the businesses.
The Tax Court notes that while there is a presumption in the regulation that a transaction not covered by divorce instrument is not related to the cessation of the marriage, that presumption can be overcome by sufficient evidence, noting:
The third sentence of the regulation provides that there is a presumption that section 1041 does not apply to "[a]ny transfer not pursuant to a divorce or separation instrument". Consistent with section 1041, the fourth sentence makes clear that the presumption may be rebutted "by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage." See, e.g., Young v. Commissioner, 240 F.3d 369, 374 (4th Cir. 2001), aff'g 113 T.C. 152 (1999); see also Barnum v. Commissioner, 19 T.C. 401, 407 (1952). Petitioner has made that showing here.
The Court also disagrees with the IRS’s view that the presumption can only be overcome if some legal or business issue prevented the matter from being included in the divorce decree, finding that while that is offered as an example of how the presumption may be overcome, the regulation does not provide that as a specific condition to be able to overcome the presumption.
Finding this case similar to the matter decided in the case of Young v. Commissioner, 240 F.3d 369, 374 (4th Cir. 2001), aff'g 113 T.C. 152 (1999):
In both Young and here, a former spouse alleged shortcomings with implementation of the first settlement agreement by the other spouse, and as a result in both cases the parties negotiated a second settlement agreement employing different terms for disposition of their marital assets than were contained in their first settlement agreement. The transfers made pursuant to the second settlement agreements in Young and here were made (as required by the fourth sentence of the regulation) to "effect the division of property owned by the former spouses at the time of the cessation of the marriage"; and as required by section 1041 were "related to the cessation of the marriage.