Tax planning in the context of divorce requires familiarity with IRC §§ 71 and 1041, the first of which governs the taxation of alimony (support) payments and the second of which sets forth the general rule of nonrecognition with respect to property transfers incident to divorce. Careful tax planning can result in a lower overall tax burden between divorcing spouses, especially if a significant tax rate differential exists.
IRC § 71 gives divorcing spouses considerable flexibility. For example, by structuring support obligations to continue beyond what would normally be a terminating event, difficulties associated with illiquid marital estates may be surmounted. Or, if parties contemplate that payments should diminish as children mature, the regulations provide a safe harbor for preventing the application of IRC § 71(c), which would otherwise operate to preclude those amounts from being treated as alimony for federal tax purposes. The structuring of alimony payments thus presents an opportunity to achieve a fair and tax-favored result for both parties.
Under IRC § 1041, no gain or loss is recognized on the transfer of property from an individual to a spouse or former spouse incident to divorce, whether or not consideration is present. Since no gain or loss is recognized, the transferee spouse must take a carryover basis in the property. If marital assets consist of properties with varying degrees of appreciation, equity would suggest that each party receive a mix of property with the same relative degree of built-in gain. If this is not possible (e.g., one spouse retains the personal residence with a higher basis), the parties may wish to compensate the spouse who takes the lower basis property since the sale of that property will generate future capital gains tax.
IRC § 1041 overrides some familiar tax principles. For example, a recent ruling, Rev. Rul. 2002-22 held that the assignment of income doctrine is inapplicable with respect to transfers of nonstatutory stock options or rights to deferred compensation between divorcing spouses. Instead, IRC § 1041 dictates the counterintuitive tax result that the recipient spouse will be taxed when the options are exercised or the deferred compensation is received, even though she did not earn that income. Rev. Rul. 2002-22 provides, however, that until November 9, 2002, parties to a new or existing agreement may elect to tax the transferor under familiar assignment of income principles, even many years later when the realization event occurs, provided certain technical requirements are met.
After November 9, 2002, assignment of income principles may no longer be “elected”. Thereafter, the transfer of nonstatutory stock options and deferred compensation will result in income to the transferee when the options are exercised or the income is actually or constructively received. To make matters worse, the transferee will also be treated as the employee for FICA and FUTA employment tax purposes. Since the transferee spouse may not have expected to pay income or employment taxes upon the exercise of stock options or receipt of deferred compensation, the tax implications of the transfer could affect the terms of the overall agreement.
¶ Divorcing spouses should also not overlook a planning opportunity involving the sale of a personal residence: The $250,000 exclusion provided for by IRC § 121 has been increased to $500,000 for married couples filing a joint return. To preserve the full $500,000 exclusion, the couple is required to file a joint return. Therefore, it may be prudent for the sale to occur in a taxable year in which the parties are married and can still file a joint return.