With about one-half of all marriages in the U.S. ending in divorce, the unfortunate fact is that one can never be sure that one will be with one’s spouse for a lifetime. Given the high cost of divorce, it is important to be aware of the financial issues involved. This article will focus on one such issue – the income tax consequences of equitable distribution. Equitable distribution is the process by which martial assets are divided by a court in a divorce proceeding, the purpose of which is to provide a fair allocation of the property between the spouses. Typical state laws provide that an equal division is equitable, and presume that an in‑kind distribution of marital property is equitable.” However, no distribution of assets can be considered equitable without a full consideration of the tax implications to both parties.
As part of the Tax Reform Act of 1984, Congress enacted Internal Revenue Code (IRC) Section 1041 in response to the disparities and varying treatment of marital property upon divorce. Pursuant to § 1041, transfers of property between former spouses incident to a divorce are treated as a gift; therefore, the transferee spouse can exclude the property received from his or her gross income under Section 102(a). A transfer of property is incident to a divorce if it occurs (1) within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. A transfer is related to the cessation of the marriage if it is made (a) by virtue of a divorce or separation instrument, and (b) is transferred no more than six years after the cessation of the marriage. Section 1041 has broad applicability; however, the rule does not apply if the transferee is a non-resident of the United States, because the non-resident alien may not be subject to tax on a later disposition of the property.
The transferee spouse’s basis in the property received is the transferor’s adjusted basis immediately before the transfer. This basis rule provided for in § 1041 preserves any gain or loss in the property for future realization. For example, even if the transfer is a bona fide sale, the transferee does not acquire a basis in the transferred property equal to the transferee’s cost. The carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to, or greater than its fair market value at the time of the transfer, regardless of the value of any consideration provided by the transferee, and applies for purposes of determining loss as well as gain on the subsequent disposition of the property by the transferee.
Under the Tax Reform Act of 1984 and through the creation of § 1041, Congress gave taxpayers a degree of certainty as to what tax repercussions, if any, would result from property division upon their divorce. For example, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of an asset. Thus, the spouses are free to negotiate between themselves whether the “owner” spouse will first sell the asset, recognize the gain or loss, and then transfer to the transferee spouse the proceeds from that sale, or whether the owner spouse will first transfer the asset to the transferee spouse who will then recognize gain or loss upon its subsequent sale.
The Court’s Role in Considering Tax Consequences
Equitable distribution requires the court to divide the marital assets in an equitable manner, regardless of how title to the asset is held. Disregarding the tax impact of property division may result in an unjust outcome; therefore, tax consequences generally should be taken into account by the court in crafting an equitable distribution. Although it is arguable that tax consequences should always be considered for property division, courts in most states have determined that they have discretion as to whether tax ramifications should be considered upon the equitable distribution of the marital property. Some state statutes specifically list tax consequences as a factor to be considered in determining property distribution on divorce.
The timeliness and the likelihood of the actual tax consequences are determinate of whether the court is required to make such a consideration. If the tax consequences flow directly from the divorce court’s decree, courts have found that consideration of the tax liabilities is either required or at least appropriate in the overall equitableness of the distribution.
In Shaw v. Shaw, the North Carolina Court of Appeals held that the lower court erred in failing to determine the tax consequences imposed by a divorce settlement. In Shaw, the trial court ordered the husband to make a lump-sum distribution of $8,360.72 to his wife; however, the husband had no liquid assets. In order to comply with the court order, he was forced to make withdrawals from his thrift saving plan, which could only be accomplished by incurring significant tax liability and the loss of his employer’s contributions to his plan. Ultimately, the court reversed and remanded the case to the trial court to determine whether the tax ramifications imposed on the defendant through payment of the distributive award should be considered when distributing the marital property.
In De La Torre v. De La Torre, the New York Supreme Court held that the value of the husband’s pension, for purposes of equitable distribution, should be discounted by the amount of income tax he had to pay on the early withdrawal in order to make the court-ordered distributive award to his wife. In De La Torre, the husband raised the issue of tax consequences of the distribution at the trial court by providing expert testimony of a tax accountant and showing the dollar amount of the liability resulting from the withdrawal of the money from the plan. The court held that the trial court erred in failing to consider the tax consequences of the distribution order.
However, the court is not required to consider the tax consequences of property division in a divorce action where the parties fail to request the court to take the potential tax liabilities into account and do not introduce reasonably instructive evidence bearing on those issues. Similarly, a property distribution that does not award credit for tax consequences does not constitute a plain error when the parties fail to present evidence bearing on the potential tax consequences. For example, in Calhoun v. Calhoun, the Missouri Court of Appeals for the Southern District denied a wife’s appeal, which was based on the trial court’s failure to consider tax consequences when determining the equitable distribution. The court based its decision on the fact that the wife did not argue that the award resulted in an inequitable or unjust property distribution nor did she present evidence of any tax liabilities.
Courts are not required to consider theoretical or speculative tax consequences of transactions that are not necessary or probable to the equitable distribution. Thus, the court does not have to anticipate and consider the tax repercussions if the transferee spouse decides to sell the asset in the future. In fact, as a general rule, it is erroneous for the court to consider hypothetical or speculative expenses in an equitable distribution order. Tax consequences should be taken into consideration only when the sale of the property is imminent and inevitable.
In Crowder v. Crowder, the North Carolina Court of Appeals held that speculative and hypothetical tax consequences are not a factor for equitable distribution. The appellant argued that the trial court, in valuing the property division, should not have considered the tax liabilities that may result if the appellee were to sell his logging business in the future. At trial, the defendant-appellee’s accountant testified that the value of the logging business should be reduced for prospective sales commissions and wind up costs if the company were sold, for lack of marketability, and for estimated income taxes if the logging company were sold in the future. The court agreed with the appellant - the trial court erred in reducing the value of the logging company when there was no evidence that a sale was imminent. The court held that when events have neither occurred by the date of separation nor are imminent, the trial court may not estimate the expenses in its valuation of the marital property.