I. Introduction. In an action for divorce, property is subject to “equitable distribution” pursuant to Domestic Relations Law (DRL) §236. New York distinguishes between “marital” property, which is subject to equitable distribution, and “separate” property, which is not. The distinction is crucial, because the Court of Appeals has held that marital property includes items that under the common law would be considered the separate property of one spouse. A common example would be a professional license. In O’Brien v. O’Brien, 66 NY2d 576 (1985), the Court of Appeals held that a professional license or the value of a professional career constitutes marital property. The trend of the cases expands the concept of marital property and circumscribes that of separate property.
Some qualification is necessary: Even though property may begin its life during marriage as separate property, it may be transformed into marital property upon the occurrence of an event. For example, if separate property is retitled during marriage, it will become marital property. Another act that will result in the creation of marital property is the commingling of assets.
The issue of whether property is commingled is one of fact. A prenuptial agreement may clarify whether specific property is or is not separate property. If no prenuptial agreement is in place, then it is especially important for that separate property not be commingled, if an important objective of the spouse is to preserve the nature of separate property. If, for example, a spouse applied an inheritance to purchasing a marital residence, the residence would by virtue of taking title to the property jointly, become marital property.
Another important point regarding the character of separate property relates to the distinction between separate property and the appreciation in value of separate property during marriage: Although the property itself may be separate property, appreciation in the value of separate property may be marital property. In general, passive appreciation in separate property will not cause that property to transmute into marital property. However, the active participation of a spouse in connection with the business of separate property may cause the appreciation on the property to become marital property.
In Price v. Price, 69 NY2d 8 (1986), the Court of Appeals held that where separate property has increased in value because of the efforts of the titled spouse, the non-titled spouse may claim some of the appreciation through that person’s “contribution or efforts,” including being a parent and homemaker.
It is important to remember that the equitable distribution law is the default rule. As in other legal contexts, the parties are free to alter the default rule by executing a prenuptial or postnuptial agreement. However, prenuptial agreements are made to be challenged, and one entering a marriage in New York should be aware that New York courts have shown little tolerance for, and have refused to place a judicial imprimatur on, not only agreements that are unconscionable, but also on agreements which are not unconscionable per se, but are the product of one-sidedness in the negotiation process. The element of surprise is also a factor which could militate against the enforcement of an otherwise unobjectionable prenuptial agreement.
One method of fortifying the asset protection intended by a prenuptial agreements is to utilize a trust funded by a parent, or by utilizing a self-settled trust established in another jurisdiction, such as Delaware or Nevada, that recognizes the right of a settlor to establish a self-settled spendthrift trusts. New York does not recognize the validity of self-settled spendthrift trusts.
II. Income Tax Planning
Income tax planning in the context of divorce requires familiarity with IRC §§71 and 215.
Under IRC §71, alimony payments are includible in income of the recipient spouse. IRC §215 grants the paying spouse a corresponding deduction. However, designating a payment as “alimony” is not sufficient to invoke the tax treatment of Sections 71 and 215. For alimony payments to be deductible by the paying spouse for federal income tax purposes, the following requirements must be met: (i) the payment of cash must be received pursuant to a divorce or separation agreement; (ii) the payments must cease upon the death of the receiving spouse; (iii) the payments must not be for child support; and (iv) the payments may not be “front loaded.”
Still, IRC §71 provides divorcing spouses with considerable flexibility. By structuring support obligations to continue beyond what would normally be a terminating event, difficulties associated with illiquid marital estates may be resolved. Or, if parties contemplate that payments should diminish as children mature, the regulations provide a safe harbor preventing the application of IRC §71(c), which would otherwise nullify the deduction by recharacterizing the payment as one for child support. The structuring of alimony payments thus presents an opportunity to achieve a fair and tax-favored result for both parties.
The Nature of Property Transfers Between Divorcing Spouses
The Code addresses the issue of whether property transfers between divorcing spouses are subject to income tax, or are gratuitous transfers potentially subject to gift tax. In general, Congress has decided to grant divorcing spouses a tax pass. With proper planning, most transfers between divorcing spouses should not result in income tax liability, nor should they result in the transfer being subject to the gift tax.
Note that we are not speaking of alimony or child support payments, which indeed have income tax consequences. IRC §61(a), which imposes income tax on all income from whatever source, but rather the taxation of property transfers incident to the divorce, such as the transfer of a marital residence, which could conceivably result in a sale or exchange under IRC §1001(a), resulting in capital gain under IRC §1221 if the property is a capital asset, or ordinary income under IRC §61, if it is not.
IRC §1041(a) speaks to the issue of whether the property transfer between divorcing spouses results in a “sale or exchange,” which would require calculation of gain or loss under IRC §1001. Section 1041(a) provides that no gain or loss is recognized on the transfer of property between spouses, or between former spouses, provided the transfer is “incident to divorce.” We therefore know from the clear statutory language of IRC §1041(a) that no transfers made between married spouses are subject to income tax. This seems fairly intuitive.
But Section 1041(a)(2) adds that the same benign rule applies to “former spouses,” provided the transfer is incident to divorce. For a transfer to be “incident to divorce,” IRC §1041(c) requires that the transfer must occur “within 1 year after the date on which the marriage ceases,” or “[be] related to the cessation of the marriage.”
What about the language in IRC §1041(b) that pushes transfers not subject to income tax into a basket of transfers potentially subject to gift tax? Of primary importance is the realization that the donee spouse will take a transferred basis in the property, courtesy of IRC §1015. This is fair; there is no reason why Congress would grant a step up in basis to assets received by a divorcing spouse.
What about the status of the transfer as a taxable gift? If the divorcing spouses are still married in the taxable year of the transfer, the gift will qualify for the unlimited marital deduction under IRC §2523. The Code makes no distinction between divorcing spouses who have not yet been granted a divorce decree and spouses who are happily married.
If the spouses are already divorced, the marital deduction will be unavailable, yet IRC §1041(b) in this case is mostly a paper tiger, since properly structured transfers between even divorced spouses will find sanctuary either in IRC §2516 or from some element of consideration. As we know from contract law, consideration exists in many forms. We will return to the gift tax issue later. Turning back to the income tax, recall that transfers made within one year of the date on which the marriage ceases are protected by the statutory safe harbor found in IRC §1041(c)(1). However, the one year safe harbor rule may be difficult to meet.
The take-away from this is that for income tax purposes, transfers between spouses not getting divorced, or who are not yet divorced, or who are divorced but have been divorced for no more than a year, or who have been divorced for more than a year but with respect to which the transfer “is related to the cessation of the marriage,” will not be subject to the income tax by reason of IRC §1041. To determine whether this somewhat vague statutory requirement is satisfied, reference must made to the Treasury Regulations.
Treas. Reg. §1.1041-1T, Q &A 7 provides that a transfer of property “is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation agreement . . . and the transfer occurs not more than 6 years after the date on which the marriage ceases.” The regulation adds that “any transfer not pursuant to a divorce or separation agreement 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.”
The presumption may be rebutted by proof showing that the transfer was not made within the prescribed time period because of factors which “hampered an earlier transfer . . . such as a legal or business impediment,” and that transfer was “effected promptly after the impediment to transfer [was] removed.”Interestingly, the IRC §1041(c)(1) clearly states that a transfer is incident to divorce if it occurs within one year after the cessation of the marriage. The statute imposes no further requirement. The regulation takes a different view: It provides that “any transfer not pursuant to a divorce or separation agreement . . . is presumed not to be related to the cessation of the marriage.
This inconsistency could be reconciled if one assumed that the Regulation is only referring to transfers not made within the one-year period of the divorce. However, if Treasury had intended this meaning, it would have been to accomplish in so many words. Therefore, the conflict between the statute and the regulation is not insignificant.
Since IRC §1041 does not expressly direct Treasury to implement regulations in furtherance of the statute, the regulations under Section 1041 are “administrative regulations.” Administrative regulations are less authoritative than “legislative regulations,” which are drafted by Treasury pursuant to a directive contained within the statute itself. In addition, it might be argued that regulations which appear as “questions and answers,” as does Treas. Reg. §1.1041-1T, might be less authoritative than regulations not drafted in question and answer form.
In any event, the safest route for divorcing spouses would be not to rely on the language of Section 1041(c)(1) which blesses transfers between divorced spouses within one year as being “incident to divorce,” but to memorialize the transfer in a divorce or separation agreement in order to satisfy the stricter requirement found in the regulations.
Retirement benefits, like most other property acquired during marriage, may be subject to equitable distribution. Qualified retirement plans themselves are subject to a plethora of requirements imposed by the Internal Revenue Code, and the simple act of dividing a retirement account between divorcing spouses would violate sundry qualified plan rules established in Code Sections 401 through 409 since qualified pension plans are required to contain anti-alienation provisions. The loss of qualified status for a retirement plan would be devastating for tax purposes. For this reason, Congress has carved out an exception to the qualified plan rules that would otherwise preclude divorcing spouses from transferring interests in retirement plans.
In accordance with federal law, a New York court may issue a “qualified domestic relations order” or QDRO, which will permit the severance of a qualified plan. If the Order meets federal tax requirements, the result will be that the retirement will be that the severance will be deemed not to violate Code provisions that would otherwise result in loss of qualified plan status. If property passes to a spouse without a QDRO, the distribution will be taxable to the account holder, and premature withdrawal penalties will apply if the account owner is under age 59½.
To be valid, a QDRO (i) must specify the amount or percent of benefits to be paid to the alternate payee and (ii) must not change the form of benefit or provide for increased benefits. The QDRO should state that the order is being established under New York Domestic Relations Law, and in accordance with IRC §414(p). Thus, the spouse may become a co-beneficiary of the retirement account.
IRAs & SEPs
The rules for transferring interests in IRAs and Simplified Employee Pension Accounts (SEPs) upon divorce are more lenient: No QDRO is necessary. IRC §408(d) expressly provides for transfers of IRAs between spouses, or between former spouses if made pursuant to a divorce or separation agreement. However, the divorce agreement must expressly state that “[a]ny division of property accomplished or facilitated by any transfer of IRA or SEP account funds from one spouse or ex-spouse to the other is deemed to be made pursuant to this divorce settlement and is intended to be tax-free under Section 408(d)(6) of the Internal Revenue Code.” If IRA funds are transferred to a spouse without proper memorialization in the divorce agreement, the funds will be immediately taxable to the IRA account holder and may again be subject to an early withdrawal penalty if the IRA account holder is under age 59½.
The transfer by a divorcing spouse of an interest in a residence will result in no income tax consequences under IRC §1041, provided the requirements discussed earlier are met. Nevertheless, the transfer may incur local transfer tax liability. See N.Y.C.R.R. §575.11(a) and In the Matter of Tobjy, NYC Tax Appeals Tribunal 93-2128 (1995). If the transfer is structured as a sale with interest payments, and the note is secured by the residence, the IRS has stated that the interest on the note may be deductible. PLR 8928010.
Divorcing spouses should also keep in mind IRC §121, which provides for a “rolling” two-year capital gain exclusion allowance of $250,000 per taxpayer resulting from the sale of a primary residence. If a highly appreciated primary spousal residence is sold during the tax year in which the parties are still married, a $500,000 exclusion will be available. However, once a divorce decree has been issued, the horse will already have left the barn, and only a single $250,000 of gain exclusion will be available under IRC §121. The loss of a $250,000 capital gains deduction by reason of the issuance of a divorce decree which does not taken into account the contemplated sale of a primary marital residence can be avoided by simply being aware of the requirements imposed by IRC §121.
The potential problem arising under IRC §121 illustrates the importance of timing in divorce planning. For example, planning is necessary to ensure that adverse tax consequences do not arise by reason of the inability to file a joint income tax return. No joint income tax return may be filed if the spouses are not married on December 31 of the taxable year.
Appreciated Marital Assets
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. That compensation would not be gratuitous, and would therefore not be subject to gift tax. If the requirements of IRC §1041 were met, that compensation would also not be subject to income tax.
Other Income Tax Issues
It should be noted that IRC §1041 is narrowly defined to apply only to transfers between spouses themselves. Thus, the transfer by one spouse of shares of a closely held family entity would not be within IRC §1041 and would result in a sale and exchange with the normal attendant requirement of reporting capital gain or ordinary income on the exchange, depending upon the nature of the property transaction.
IRC § 1041 also overrides some familiar tax principles. For example, 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.
III. Gift Tax Planning
In property law, a completed gift requires three elements: First, the donor must intend to make a gift. Second, the donor must deliver the gift to the donee. Third, the donee must accept the gift. Whether these elements have been met is a question of local law.
Congress (and the IRS) has dispensed with the requirement of donative intent. Thus, although divorcing spouses are not generally altruistically inclined with respect to their spousal counterpart, transfers made pursuant to settlement agreements may nevertheless spawn gift tax issues. If spouses are still married, then transfers that would otherwise constitute taxable gifts will be neutralized by the full marital deduction available under IRC §2523.
A transfer between divorced spouses could cause one to be concerned that the gratuitous transfer could be subject to gift tax, since IRC §1041(b)(1) defines as a gift any transfer that is not a sale or exchange. No protection would be accorded by the marital deduction available to married spouses, since the spouses would no longer be married.
IRC §2516 provides a good measure of protection from adverse gift tax consequences by stipulating that where spouses enter into a written agreement relative to their marital and property rights and divorce occurs within the 3-year period beginning on the date 1 year before such agreement is entered into (whether or not such agreement is approved by the divorce decree), any transfers of property or interests in property made pursuant to such agreement . . . to either spouse in settlement of his or her marital or property rights or to provide a reasonable allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money’s worth.
If IRC §2516 is inapplicable, the spouse may be able to argue that consideration existed for the transfer. Specifically, the spouse may be able to argue that no gift occurred because the spouse relinquished enforceable rights arising upon the dissolution of the marriage. Alternatively, if minor children are involved, the spouse could argue that the release of support obligations for the minor children supply the consideration necessary to eliminate the gift. Finally, it should be noted that the lifetime gift tax exclusion for federal gift tax purposes is now $5.25 million dollars, and that New York has no gift tax. Therefore, the issue of whether the transfer constitutes a gift is less important today than previously.