March 20, 1995
The Honorable Margaret Milner Richardson
Commissioner of the Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224
Re: Proposal for Regulatory Changes Concerning Tax Aspects of Divorce and Marriage
Dear Commissioner Richardson:
The American Institute of Certified Public Accountants is pleased to present for your consideration a proposal for regulatory changes concerning tax aspects of divorce and marriage.
The AICPA's Domestic Relations Task Force, with the support of the Individual Taxation Committee, has considered a number of suggestions, and their recommendations have been approved by our Tax Executive Committee. In addition to these suggested regulatory changes, we have also prepared statutory proposals for consideration by the Congress.
Our recommendations are based on the belief that the tax law should be as unintrusive as possible in divorce and separation. Further, when individuals fail to make affirmative choices, the defaults imposed by law and regulation should be fair.
We hope you will give these proposals favorable consideration. We would be happy to meet with you or your staff to discuss these matters. If you have any questions, please call me at (202) 467-3004 or one of the following individuals: Ward M. Bukofsky, Chair, Individual Taxation Committee, at (310) 278-5850; Stephen M. Walker, Chair, Domestic Relations Task Force, at (505) 242-5271; or Eileen Sherr, Technical Manager, at (202) 434-9256.
Tax Executive Committee
cc: Willie E. Armstrong, Jr., Attorney, IRS
Nelson Crouch, IRS, Accounting Deputy Assistant (CC:DOM:CORP:1)
William A. Jackson, IRS, Branch Chief (CC:DOM:IT&A:BRANCH6)
Glen Kohl, Department of the Treasury, Office of Tax Legislative Counsel
Leslie B. Samuels, Department of the Treasury, Assistant Secretary for Tax Policy
Submitted to the Internal Revenue Service
March 20, 1995
March 20, 1995
INDEX OF PROPOSED REGULATORY CHANGES
Proposal for Additions to Regulations under I.R.C. §§121
Regarding Allocation of Sales Proceeds from Sale of Principal Residence Incident to Divorce
Proposal for Changes to Treas. Reg. §1.154-4T, Q&A 4
Regarding Revocation of Waiver of Dependency Exemption
Proposal for Changes to Temp. Treas. Reg. §1.1041-1T(c), Q&A
Regarding Stock Redemptions Incident to Divorce
Proposal for Changes to Temp. Treas. Reg. §1.1041-1T(d)
Regarding Spousal Notes Issued in a Divorce
Proposal for Changes to Temp. Treas. Reg. §1.1041-1T(d)
Regarding Tax Consequences of Transfers of Partnership Interests Pursuant to a Divorce and Resultant Debt Relief
for Changes to Treas. Reg. §1.6013-5(b)
Regarding the Criteria Applying to the Innocent Spouse Relief Provisions
Proposal for Issuance of a Published Ruling under I.R.C.
Regarding Determination of Insolvency for a Married Taxpayer
Proposal for Withdrawal of Revenue Ruling 87-112
Regarding Recognition of Income on EE Bonds Transferred Between Spouses Incident to Divorce
1. Proposal for Additions to Regulations under I.R.C. §§121 and 1034由egarding Allocation of Sales Proceeds from Sale of Principal Residence Incident to Divorce
Rev. Rul. 74-250 indicates that the gain from the sale of a jointly owned principal residence by a divorced couple will be allocated one-half to each, irrespective of how the proceeds are actually divided. Thus, taxability of proceeds will ordinarily follow legal title. The same result would occur for purposes of I.R.C. §§1034 and 121. It is thus possible for a taxpayer to unwittingly incur a significant tax or reinvestment requirement on the receipt of a small amount of proceeds.
It is recommended that the Service promulgate a regulation to make it clear that the tax consequences which follow from a divorced couple痴 sale of their principal residence will be allocated in the same manner in which the net sale proceeds are allocated. This would require tax consequences to follow the economics of a transaction; further, those parties without competent tax advice would be protected from unintended tax hardship. This can be accomplished by adding new subsections to the regulations issued under I.R.C. §§121 and 1034 as follows.
Add the following subsection to both sets of regulations issued under I.R.C. §§121 and 1034.
Allocation of sales proceeds and basis for transfers to third parties incident to a divorce. In the case of a sale or exchange of a principal residence jointly owned by spouses or former spouses and (a) the net sales proceeds are allocated between the parties by a divorce decree or separation agreement and (b) the allocation is not in proportion to record ownership of the residence, the net sales proceeds and basis shall be allocated for purposes of this section according to the divorce decree or separation agreement unless an election to allocate sales proceeds in proportion to record ownership interests is made. "Net sales proceeds" shall mean the amount realized reduced by any debt repayments and any customary adjustments (including adjustments for real estate taxes, utilities, or similar items) paid from the gross proceeds.
Debt repayments shall be a reduction only to the extent of acquisition and home equity indebtedness (as those terms are defined in I.R.C. section 163(h)(3)). For purposes of this section, the limitations in I.R.C. sections 163(h)(3)(B)(ii) and 163(h)(3)(C)(ii) will not apply. Net sales proceeds includes cash received by the parties plus cash paid to third parties on behalf of the respective spouses (or former spouses). The amount realized by each spouse or former spouse shall be an allocation of the total amount realized in the same proportions as the allocations of net sales proceeds. Basis shall be allocated between the two parties in the same percentages of total basis as the allocation percentages of the amount realized. In all cases, the divorcing spouses may elect to allocate sales proceeds in proportion to their record ownership interests. Such election shall be made on Form 2119 at any time before the expiration of the period for which an amended return may be filed.
The provisions of this subsection are illustrated by the following examples:
Example (1): A and B are in the process of getting divorced. They jointly own a principal residence, with a basis of $50,000. The residence is sold for $200,000; selling expenses are $10,000; and mortgage loans totaling 90,000 are repaid from the gross sales proceeds. The parties agree that B is to receive all but $10,000 of the remaining $100,000. In this example, the net sales proceeds are $100,000. 10% is allocated to A; 90% is allocated to B. The amount realized is $190,000 which is allocated $19,000 to A and $171,000 to B. The basis will be similarly allocated: $5,000 to A and $45,000 to B.
Example (2): Assume the same facts as Example (1) except that the agreement between A and B states that $20,000 of A's legal fees and $5,000 of B's credit card debts will be repaid from the residence sales proceeds. The remaining $75,000 will be allocated 10% to A and 90% to B. The net sales proceeds are $100,000. A's share is $7,500 plus $20,000 (legal fees) or 27.5%; B's share is $67,500 plus $5,000 (credit card debts) or 72.5%. Thus, the amount realized and basis will be allocated in the ratios of 27.5% to A and 72.5% to B.
Reason for Change. Divorcing taxpayers who sell their jointly-owned principal residences often allocate net sales proceeds very differently from an equal division. Those who are wealthy enough to receive expert tax advice may be told to re-title the house in proportion to the division of the net sales proceeds. The proposed change is intended to have taxability follow economic results. Currently, a taxpayer who received more than 50% of net proceeds will use Rev. Rul. 74-250 to his or her advantage while the other spouse may take a more aggressive position and report only proceeds received. As a result, the Government is whipsawed.
In addition, a recent case not involving a principal residence illustrates the uncertainty in allocating ownership of assets divided in divorce. In that case, the Third Circuit ordered that allocation of stock sales proceeds follow "beneficial ownership" rather than record ownership. Yonadi v. Commissioner, 21 F.3d 1292 (1994); 94-1 USTC par. 50,183.
This proposal would not resolve all such conflicts, but it would significantly reduce their number.
2. Proposal for Changes to Treas. Reg. §1.152-4T, Q&A 4由egarding Revocation of Waiver of Dependency Exemption
Comments. Since the 1984 revisions to the Internal Revenue Code, §152(e)(1) provides that the parent who has custody of a child for the greater portion of the year will ordinarily be entitled to claim the dependency exemption for such child. The custodial parent, however, can relinquish the exemption to the noncustodial parent, either permanently or annually, by executing Form 8332. See I.R.C. §152(e)(2).
Reason for Change. Due to the dependency phaseout rules enacted in 1988, the exemption may provide little or no tax benefit. Under such circumstances, it is unclear whether the noncustodial parent who has been permanently assigned the exemption can relinquish that exemption back to the custodial spouse. It is recommended that the Service modify Treas. Reg. §1.152-4T to permit the noncustodial parent to agree to a revocation of the assignment at any time. Form 8332 would be modified to include such a waiver provision.
Recommendation. The following change is recommended to Treas. Reg. §1.152-4T, Q&A 4:
Q-4. For what period may a custodial parent release to the noncustodial parent a claim to the exemption for a dependent child? How and for what period may a noncustodial parent entitled to an exemption waive the exemption back to the custodial spouse?
A-4. The exemption may be released for a single year, for a number of specified years (for example, alternate years), or for all future years, as specified in the declaration. If the exemption is released for more than one year the original release must be attached to the return of the noncustodial spouse and a copy of such release must be attached to his/her return for each succeeding taxable year for which he/she claims the dependency exemption. If for any year for which the noncustodial parent is entitled to the exemption, he or she wishes to waive the exemption back to the custodial parent, he or she may do so by specifying a single year, specified years, or all future years in a new declaration. In that event, a copy of the declaration need not be attached to either former spouse痴 tax return because it is presumed in the statute that the custodial spouse is entitled to the exemption. Further, the custodial parent is not precluded from releasing the exemption again in subsequent years.
3. Proposal for Changes to Temp. Treas. Reg. §1.1041-1T(c), Q&A 9由egarding Stock Redemptions Incident to Divorce
Comments. I.R.C. §1041 was enacted in 1984 essentially to nullify United States v. Davis, 370 U.S. 65 (1962), by providing that property transfers incident to divorce shall be tax-free. Further, as the Internal Revenue Service has correctly construed the intent of I.R.C. §1041 in PLR 9046004:
Under section 1041, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of the asset. The spouses are thus 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. (PLR 9046004 (July 20, 1990), p.5).
In an attempt to provide early guidance to taxpayers and their representatives, the Service issued temporary regulations in 1984 relating to numerous topics associated with divorce. Among these is Temp. Treas. Reg. §1.1041-1T(c), Q&A 9, which provides:
Q-9. May transfers of property to third parties on behalf of a spouse (or former spouse) qualify under section 1041?
A-9. Yes. There are three situations in which a transfer of property to a third party on behalf of a spouse (or former spouse) will qualify under section 1041, provided all other requirements of the section are satisfied. The first situation is where the transfer to the third party is required by a divorce or separation instrument. The second situation is where the transfer to the third party is pursuant to the written request of the other spouse (or former spouse). The third situation is where the transferor receives from the other spouse (or former spouse) a written consent or ratification of the transfer to the third party.... In the three situations described above, the transfer of property will be treated as made directly to the nontransferring spouse (or former spouse) and the nontransferring spouse will be treated as immediately transferring the property to the third party. The deemed transfer from the nontransferring spouse (or former spouse) to the third party is not a transaction that qualifies for nonrecognition of gain under section 1041."
A number of recent court cases, in attempting to interpret and apply Temp. Treas. Reg. §1.1041-1T(c) have arrived at conflicting conclusions. Further, Congress' intention to permit spouses to determine which of them will pay the tax on the ultimate disposition of an asset, as illustrated by the Service in PLR 9046004, has been thwarted. We believe certainty for taxpayers in stock redemptions incident to divorce can be re-established consistent with Congressional intent by modifying Temp. Treas. Reg. §1.1041-1T(c), Q&A 9 in the manner we have suggested below.
Recommendation. We recommend the addition of the following examples:
Example (1). A and B obtain a divorce in taxable year 19XX. The marriage settlement agreement divides the couple's interest in X Company, a 100-percent owned closely held corporation, equally between A and B. The agreement further provides that the parties will cause X Company to redeem B's stock subsequent to the property division by giving B a note in payment thereof. A is obligated to guarantee X Company's payment of the note. The marital settlement agreement specifies that the property division settles all claims between A and B. The division of X Company stock between A and B is a transfer of property between spouses which is subject to the rules of section 1041. The subsequent redemption of B's stock, however, is not a transaction between spouses and will be characterized as a redemption between B and X Company. Thus, the redemption from B will be governed by the provisions of sections 301 and 302.
Example (2). C and D obtain a divorce in taxable year 19XX. The marriage settlement agreement awards the couple's entire interest in Y Company, a 100-percent-owned, closely held corporation to C. The agreement further provides that D will receive from C a note in the amount of XXXX dollars to equalize the division. C causes Y Company to redeem D's interest in its stock and assume payment of the note. The award of Y Company stock to C and the receipt of the note by D is a transfer of property between spouses which is subject to the rules of section 1041. The subsequent redemption of the stock from C and assumption of the note by Y is on behalf of C and is not controlled by section 1041, since C had the primary and unconditional obligation to acquire D's stock which was fulfilled by Y Company. Thus, the redemption from C will be governed by the provisions of section 301.
Reasons for Proposed Change
(1) The conflicting conclusions discussed below will be resolved, thus providing taxpayers with certainty in redemption transactions.
(2) Congressional intent will be served by permitting spouses to determine which of them will pay the tax on the ultimate disposition of an asset.
(3) The addition of the above two examples to Temp. Treas. Reg. §1.1041-1T(c), Q&A 9 will make clear that:
(a) Taxpayers can determine which of them will pay the tax on the ultimate disposition of corporate stock, as the Service ruled in PLR 9046004.
(b) The "on behalf of" standard requires a primary and unconditional obligation on the continuing shareholder to purchase stock in order to shift the tax burden to such continuing shareholder.
(c) Taxpayers can rely on the regulations and be assured of consistent treatment.
(4) Further, the Service would escape the inevitable deluge of private ruling requests which will undoubtedly be engendered by the Arnes' cases.
Discussion. A division of closely held stock between spouses incident to a divorce will be a tax-free transaction pursuant to I.R.C. §1041. A subsequent complete redemption of one spouse's stock following the property division will ordinarily be governed by the provisions of I.R.C. §301 and where applicable, §302.
Further, Temp. Treas. Reg. §1.1041-1T(c), Q&A 9 provides that §1041 will apply to a transfer of property to a third party on behalf of a spouse (or former spouse) where the transfer is required by a divorce instrument. Based on this, the Service ruled in PLR 9046004 that the mandatory redemption from an ex-wife of stock which had been transferred to her pursuant to the divorce decree would be treated as a §1041 transfer followed by a taxable redemption from the ex-wife.
In its most recent pronouncement, PLR 9427009 (Apr. 6, 1994), the Service addressed yet another interspousal transfer of stock followed by a corporate redemption from the transferee. The marital settlement agreement involved in the ruling transferred a portion of husband's stock to wife, specified wife would seek to have the stock redeemed, indicated husband had no obligation whatsoever to acquire the stock or cause the corporation to so acquire, provided an escrow for the payment of wife's income taxes on the gain from redemption, and finally, referenced the nonapplicability of Temp. Treas. Reg. §1041-1T(c), Q&A 9's "on behalf of" standard to the husband. Even though the stock was redeemed immediately after the execution of the marital settlement agreement, the Service ruled that I.R.C. §1041 governed the stock transfer from husband to wife and that wife's redemption would be governed by I.R.C. §302(b)(3); complete termination of interest.
Prior to the enactment of I.R.C. §1041, however, many cases have held that where there exists a personal and unconditional obligation on the part of a taxpayer to purchase stock held by another in the taxpayer's corporation and such obligation is discharged in any manner by the corporation, whether by payment of a note the taxpayer has given to the other party or redemption of the shares which the taxpayer is unconditionally obligated to purchase, the taxpayer receives a dividend. See, e.g., Wall v. United States, 164 F.2d 462 (4th Cir. 1947); Louise H. Zipp, 28 T.C. 314 (1957), aff'd 259 F.2d 119 (6th Cir. 1958); Roy M. Berger, 33 T.C.M. 737 (1974); John K. Gordon, 34 T.C.M. 437 (1975).
A number of recent cases have addressed the transfer-redemption transaction. Chief among these are the two Arnes decisions: Joann C. Arnes v. United States, 981 F.2d 456 (9th Cir. 1992) (Arnes I) aff'g 91-1 USTC par. 50,207 (W.D. Wash. 1991), and John Arnes, 102 T.C. 522 (1994) (Arnes II). Based upon the same facts, the Ninth Circuit in Arnes I and the Tax Court in Arnes II reached diametrically opposite conclusions.
The key issue in the Arnes' cases was whether John Arnes had a primary and unconditional obligation to purchase Joann's stock in their closely held corporation. The marital settlement agreement provided that the parties would cause the corporation (emphasis added) to redeem Joann's stock.
In attempting to apply Temp. Treas. Reg. §1.1041-1T(c), Q&A 9, the District Court held that the stock redemption from Joann was "on behalf of" John, since he received a benefit from the transfer -- the settlement of all future community claims Joann could have asserted. Consequently, Joann was found to have a tax-free §1041 transfer.
The Tax Court, on the other hand, in a reviewed decision held that John did not have a primary and unconditional obligation to acquire Joann's stock. In refusing to express an opinion as to whether the standard of "on behalf of" the spouse set forth in Temp. Treas. Reg. §1.1041-1T(c), Q&A 9, is the same as the primary and unconditional obligation rule, the Court found John did not have a constructive dividend. The large number of concurring opinions and five dissenters, coupled with the above language relating to Q&A 9, make it quite evident that the "on behalf of" standard requires clarification.
In Gloria Blatt, 102 T.C. 77 (1994) (appealed to 6th Cir. in June 1994), the Tax Court on facts similar to Arnes, found that a redemption satisfied no obligation of the continuing shareholder. Further relief from possible claims under marital distribution laws does not mean a redemption was "on behalf of" the continuing shareholder. A concurring opinion went so far as to indicate that a proper interpretation of the regulations under I.R.C. §1041 requires that no redemption should be considered "on behalf of" the remaining spouse unless such spouses's primary and conditional obligation to purchase the stock is discharged.
In the final recent case, Jimmy Hayes, 101 T.C. 593 (1993), Jimmy was obligated to purchase his ex-wife Ruth's stock in their corporation. Finding that an attempted nunc pro tunc order to reform the transaction as a corporate obligation was invalid under applicable state law, the Court found Jimmy had a constructive dividend since he had the obligation to purchase Ruth's stock. In Hayes, the Court did say the redemption was on behalf of Jimmy.
We urge the adoption of the proposed examples to Temp. Treas. Reg. §1.1041-1T(c), Q&A 9.
4. Proposal for Changes to Temp. Treas. Reg. §1.1041-1T(d)由egarding Spousal Notes Issued in a Divorce
Comments. Under Temp. Treas. Reg. §1.1041-1T(d), there is uncertainty regarding the basis of a note, given by a maker spouse, in the hands of the holder spouse who has received the maker spouse's note as part of a property settlement in a divorce. If the note is sold by the holder, it is unclear whether gain or loss will result. Also, once the note has been issued by an individual to his or her spouse or former spouse, the tax consequences of full or partial discharge of the indebtedness are not clear.
Additions to the existing regulation, making use of the existing question and answer format, could resolve the uncertainty.
Recommendation. We recommend the following addition to Temp. Treas. Reg. §1.1041-1T(d):
Q-x1. What is the basis of a note issued by one spouse to the other spouse under section 1041(a)(2)?
A-x1. The transferee spouse (hereinafter referred to as the holder spouse) has a basis in the note of the transferor spouse (hereinafter referred to as the maker spouse), pursuant to section 1041(b)(2), equal to the face of the note. Consequently, the sale or other disposition of the note by the holder spouse to a third party may result in gain or loss to that spouse. The realized gain or loss is computed by comparing the sale proceeds to the basis of the note in the hands of the holder spouse. A realized gain or loss would be a capital gain or loss subject to the applicable holding period.
Q-x2. Once a spouse (the maker spouse) has made or issued a note to his or her spouse or former spouse (the holder spouse) in a transfer to which section 1041(a)(2) applies, what are the tax consequences if the debt is discharged in full or in part, or if the debt becomes worthless in the hands of the holder spouse?
A-x2. The full or partial discharge of a note between spouses or former spouses, subject to section 1041(a), is treated as a transfer of property from the holder of the note back to the maker of the note. Accordingly, if the requirements of sections 1041(a)(1) or (c) are met, such discharge itself shall be treated as a section 1041(a) transfer and shall not result in discharge of indebtedness income to the maker under section 61(a)(12) or a bad debt deduction for the holder spouse under section 166(d). For purposes of determining whether section 1041(c) applies to such discharge, the guidance set forth above in Temp. Treas. Reg. section 1.1041-1T(b) shall apply. The foregoing is also applicable to notes which become worthless in the hands of the holder spouse.
Reason for Proposed Changes. When a note is issued by a maker spouse to a holder spouse incident to a divorce, it is generally to create an equal or desired division of the property between the spouses. Because property is not always subject to an equal division, the issuance of a personal promissory note is a common means of achieving the desired property division.
Questions with respect to the taxation of the holder spouse arise if the note received in a divorce is transferred to a third- party. Upon the sale or disposition of the note, the holder spouse would have to recognize gain to the extent that the sales proceeds exceed the selling spouse's basis in the note. Because the note was received by the selling spouse in a transaction to which §1041 applied, the holder spouse's basis in the note should be the same as the maker spouse's adjusted basis in the note. I.R.C. §1041(b)(2). Since the note was not acquired from a third-party, little authority exists with respect to the maker spouse's basis. The Internal Revenue Service has ruled that principal payments, with respect to an installment note transferred from one spouse to the other spouse, incident to a divorce, are excluded from income as a transfer of "property" under §1041. PLR 9235026 (May 29, 1992) and PLR 9123053 (Mar. 13, 1991). These private letter rulings would suggest that the maker's basis in his own note could be an amount less than face. Only under these circumstances would §1041(a) have to take effect to exclude the gain. This logic, however, is faulty. The application of §1041 should not be necessary if the face of the note and the basis in the note are the same, as no gain or loss should result. The maker of a note should have a basis in his own note equivalent to the face of the note.
As an example, assume that a husband and wife entered into a divorce decree which provided that their only asset, a fully paid for $100,000 residence, was to be transferred to the husband as his property and the wife was to receive one-half of the equity, or $50,000 in cash from the husband. The regulations would allow the husband to place a mortgage on the home to obtain the funds needed to satisfy the $50,000 obligation to his wife. In this case, the wife has received the cash without triggering a taxable event. I.R.C. §1041(a); Temp. Treas. Reg. §1.1041-1T(c), Q&A 12.
Consider, however, the situation where, following the receipt of the cash, the wife loaned the $50,000 back to the husband in exchange for his $50,000 promissory note. The husband then repaid the original third-party lender. In this case, the wife would hold the husband's note with a full $50,000 basis. The same result should logically be achieved if the husband initially gave his personal note to the wife in exchange for the wife's interest in the residence. The basis of the note, in wife's hands, would be determined under §1041(b)(2).
Thus, a personal note of one spouse, given by that spouse to the other spouse, in a property settlement incident to a divorce, should have a basis equivalent to its face. The holder spouse will not have a gain (unless the note is disposed of at a premium) on the sale or other disposition of said note, but the holder spouse could incur a loss if the note were disposed of at less than face. To treat the question of basis otherwise would allow form to control over substance. The note in the hands of the holder spouse would be a capital asset. Thus, any gain or loss on disposition of the note would be a gain or loss subject to the capital gain provisions.
Once a personal note of a spouse has been issued by one spouse to the other spouse incident to a divorce, the maker spouse will incur §61(a)(12) debt discharge income and the holder spouse will have a §166(d) non-business bad debt deduction, if the debt is discharged in full or in part. First, all transfers that occur within one year following the date of the cessation of the marriage are automatically incident to divorce. Thus, the discharge of the indebtedness within the one year time frame should come within the scope of §1041(a). See I.R.C. §1041(c). The transfer is of property since the spouse holding the note is actually transferring all or a portion of the maker-spouse's note back to that spouse. Thus, the discharge of indebtedness within one year of the cessation of the marriage is controlled by §1041(a). This code section would not only exclude the §61(a)(12) discharge of indebtedness income for the debtor spouse but would also deny a loss for the holder of the debt which might otherwise occur under §166(d).
If the transfer occurred more than one year after the cessation of the marriage, subject to §1041(c)(2), then §§61(a)(12) and 166(d) would apply unless it were shown that the deemed transfer of the note, or part of the note, back to the maker-spouse was related to the cessation of the marriage. The logic of this approach is that the maker of the note has been enriched beyond the intent of the parties or the court. The regulations would allow the parties to avoid the recognition of income by obtaining a modification or amendment to a divorce decree to extinguish all or part of the debt within six (6) years after the date of the cessation of the marriage. Temp. Treas. Reg. §1.1041-1T(b), Q&A 7. This would bring the entire reformation of the note within the terms of I.R.C. §1041(a) and, thus, not only would the debt discharge income, under §61(a)(12), be excluded, but the correlative deduction for the holder of the note under §166(d) would also be denied by §1041(a). The discharge of indebtedness with respect to a note which had been issued by one spouse to the other spouse, incident to a divorce, should be treated as a transfer of property between the spouses subject to §1041(a) if the terms of §1041(c) and Temp. Treas. Reg. §1.1041-1T(b), Q&A 7 can be met. In all other situations, there exists an enhancement in the wealth of one party and a correlative decrease in the wealth of the other party. Furthermore the transaction cannot be shown, or presumed, to be incident to the divorce. In these cases, income should be realized pursuant to §61(a)(12) and a deduction allowed under §166(d). The foregoing principles should also apply if the note becomes uncollectible and fully or partially worthless.
5. Proposal for Changes in Temp. Treas. Reg. §1.1041-1T(d)由egarding Tax Consequences of Transfers of Partnership Interests Pursuant to a Divorce and Resultant Debt Relief
Comments. The AICPA has identified the following as a potential problem and offers the following regulatory addition to Temp. Treas. Reg. §1041-1T(d). The following, as is the existing regulation, is in question and answer format. It is proposed that this addition be identified as Q&A 13 and the existing Q&A 13 be renumbered as Q&A 14.
Presently there exists ambiguity with respect to the interaction of I.R.C. §§752(b), 752(d) and 1041. This interplay takes place when a partnership interest is transferred from one spouse to the other in a transaction governed by I.R.C. §1041(a). The unresolved question is whether a taxpayer transferring a partnership interest in this situation can incur taxable income as the result of a deemed distribution of cash, due to debt relief. The application of I.R.C. §752(b), and the resultant gain, does not require the transfer of the partnership interest. Thus, the gain is the result of a transaction between the partner and the partnership, not between the partner and the partner's spouse. However, when the partnership interest is transferred in a divorce, the decrease in liabilities occurs only because of the transfer to which I.R.C. §1041 applies.
Recommendation. We recommend the following change to Temp. Treas. Reg. §1.1041-1T(d).
Q-13. Will a transfer of a partnership interest under section 1041 result in income to the transferor spouse as a deemed cash distribution due to debt relief pursuant to sections 752(b) and 731(a)(1)?
A-13. When a partnership interest is transferred by one spouse to the other spouse in a transaction governed by section 1041, the transferor spouse will not be treated as receiving a distribution of money pursuant to section 752(b) and section 731(a)(1) of the Internal Revenue Code. Transfers of partnership interests to which section 1041 and section 752 apply will be treated as a transfer to which section 752(d) applies. In this case, no gain or loss will be recognized upon the transfer of a partnership interest between spouses.
A-14. (Present section 1.1041-1T(d) A-13)
Q-14. (Present section 1.1041-1T(d) Q-13)
Reasons for Proposed Change. It is well established that liabilities assumed, or taken subject to, in connection with a sale or exchange of property are to be included in the purchaser's basis and the seller's "amount realized." Crane v. Commissioner 331 U.S.1 (1947). This principle is extended to the partnership area through I.R.C. §752. The general principle, that debt relief or a reduction of indebtedness constitutes the receipt of cash for the computation of gain or loss, is set forth in I.R.C. §§752(b), 752(d) and 731.
Section 752(b) provides that any decrease in a partner's share of partnership liabilities will be considered a distribution of cash by the partnership to the partner. This section, when applied with §731(a)(1), provides that, to the extent that a distribution of cash exceeds the partner's adjusted basis in his partnership interest, gain will be recognized. This transaction does not require a third-party transferee and thus, is a transaction between a partnership and its partner. Because no sale or exchange is required with a third-party, the application of these two Code sections to a gratuitous transfer of a partnership interest can result in gain to the transferor partner. As an example, where an individual has transferred a partnership interest by gift to a third-party, the transferor may experience gain if the liabilities transferred exceed the basis of the transferred property. See Treas. Reg. §§1.1001-2(a)(1), 1.1001-2(a)(4)(i), 1.1001-2(a)(4)(iii). Yet, it is strongly suggested that the overall structure of §752 indicates that Congress did not intend §752(b) to be applicable to partner-level transfers of partnership interests. See McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, 2nd Ed., Vol 2, Section 15.05(1)(c), (Warren Gorham & LaMont, Inc., 1990).
Section 752(d) provides that in the case of a "sale or exchange of a partnership interest," liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with the partnership. Regulation §1.1001-2 provides that the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. This includes liabilities from which a transferor is discharged as the result of a sale or disposition of a partnership interest, to the extent of the transferor's share of the partnership liabilities. See Treas. Reg. §1.1001-2(a)(4)(v). I.R.C. §1041 provides that no gain or loss will be recognized in those cases where the transfer of property is between an individual and that individual's spouse. This will also apply to a former spouse but only if the transfer is incident to a divorce and occurs within one year after the date on which the marriage ceases, or is "related to the cessation of the marriage." I.R.C. §§1041(a) and (c). Transfers between spouses which are subject to §1041 are to be treated as gifts between the spouses. The transferee spouse's basis in the property will be the adjusted basis of the property in the hands of the transferor. I.R.C. §1041(b).
Because §1041 treats the transfer between spouses as a transfer by gift, rather than a "sale or exchange," §752(d) by its own terms may not be applicable. A more logical approach to §752(d), and the approach preferred by the Internal Revenue Service, is a broad interpretation of §752(d) as being applicable to all transfers. McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, 2nd Ed., Vol 2, section 15.05(1)(a) (Warren Gorham & LaMont, Inc., 1990). Under this approach any transfer in which there is the presence of liabilities is a "sale or exchange." If liabilities are treated as realized under §752(d) in this context, then the transaction is bifurcated into a sale or exchange, to the extent of the debt relief or decrease in liabilities, and a gift transaction with respect to the net equity. Id.
The legislative history relating to §1041 of the Internal Revenue Code states that "this non-recognition rule applies whether the transfer is for the relinquishment of marital rights, for cash or other property, for the assumption of liabilities in excess of basis, or for other consideration and is intended to apply to any indebtedness which is discharged. Thus, uniform Federal income tax consequences will apply to these transfers not withstanding that the property may be subject to differing state property laws." H.R. Rep. No. 432, 98th Cong., 2d Sess. 1492 (1984). This language indicates legislative intent that when liabilities associated with transferred property exceed the basis of said property, no gain or loss is to be recognized due to the application of I.R.C. §1041.
It is also well-established that the non-recognition rule applies when the transfer is for the relinquishment of marital rights in exchange for cash. This should also include deemed distributions of cash. I.R.C. §752(b) treats the decrease in liabilities as a "deemed distribution of cash" to the partner by the partnership resulting from the transfer. Section 731(a) provides that in the case of a distribution by the partnership to a partner, gain is recognized by the partner to the extent that the cash distributed exceeds the partner's adjusted basis in his partnership interest. Any gain recognized is to be considered gain from the "sale or exchange" of the partnership interest belonging to the distributee partner. Because the deemed distribution of cash by the partnership to the partner is the result of a transfer incident to a divorce, §1041 should apply. In reality the gain is solely attributable to the fact that there is a transfer of the partnership interest from one spouse to the other spouse. The partnership interest is not being transferred to the partnership but to the transferor's spouse. Therefore, §1041 is applicable.
The legislative intent of §1041 was to avoid taxable gain on the transfer of property between spouses incident to a divorce. Thus, if gain is triggered by the transfer of property between spouses incident to a divorce, the gain should not be recognized at the time of the transfer. It may be argued that a resultant gain was triggered by the deemed distribution of cash from the partnership to the partner; however, any deemed distribution of cash under I.R.C. §752(b) or §752(d) is the result of the transfer between spouses. The clear intent of Congress was to allow the tax free division or transfer of assets in a divorce. To argue that the gain was the result of a transaction between a partner and the partnership circumvents Congressional intent. Consequently, §1041 should control, and §752 deemed distributions of cash should be the result of the transfer.
The Internal Revenue Service has previously ruled that when one spouse transfers a partnership interest with a negative capital account to the other spouse, §752(b) and §731 will not be applied. See Private Letter Rulings 7938092 and 9250031. In PLR 7938092, the transfer of a partnership interest to one spouse was part of an equal division of community property in a divorce. This ruling was prior to the effective date of §1041 and the Internal Revenue Service, without extensive explanation, ruled that the transfer did not result in a decrease in a partner's share of partnership liabilities under §752(b) or a distribution under §731(a). Legislative history also indicates that the intent in enacting §1041 was to obtain uniform tax results between community property and non-community property states.
In PLR 9250031 (Sep. 14, 1992), the Internal Revenue Service reached the same conclusion. In this ruling, the transfer of a partnership interest between spouses did not cause the transferor spouse to recognize gain. However, this ruling relies upon I.R.C. §1041 and Temp. Treas. Reg. §1.1041-1T. In example A-12 of this regulation, the Service found what it termed to be a situation similar to the transfer of a partnership interest which otherwise would have resulted in a Section 752 deemed distribution of cash. In the example, the taxpayer owned property having a fair market value of $10,000 and an adjusted basis of $1,000. In contemplation of transferring the property, the taxpayer borrowed $5,000 from the bank, using the property as security for the borrowed money. The taxpayer transferred to the taxpayer's spouse the property subject to the liability. This transfer was subject to §1041 of the Code. Under §1041, the taxpayer recognized no gain or loss upon the transfer of the property even though the liability attached to the property exceeded the taxpayer's adjusted basis in the property. In drawing its conclusion, the Service appears to have looked through the partnership and treated the partner as the partial owner of each piece of partnership property and the partial debtor with respect to each partnership liability. In reaching its conclusion, and application of §1041 to determine that no gain or loss would be recognized, the Service did not refer to §752.
In summary, §752(d) should apply to all transfers of partnership interests, whether the transfer is, or is not, literally a "sale or exchange." Section 752(b) should not be applied to lateral transfers of partnership interests. Legislative intent is clear that direct transfers to a spouse are to be non-taxable events. The application of §752(b) to transfers, described in §1041, will circumvent the clear legislative intent.
6. Proposal for Changes to Treasury Regulation §1.6013-5(b)由egarding the Criteria Applying to the Innocent Spouse Relief Provisions
Comments. Regulations have not been revised since enactment of the Tax Reform Act of 1984, which changed many aspects of the innocent spouse relief provisions. Current regulations, which were last revised in 1974, do not give clear guidance to taxpayers, tax professionals or the Courts for criteria to apply in evaluation of innocent spouse claims, particularly under the 1984 provisions.
Reason for Proposed Change. The IRS does not have a regulation project pending to revise the innocent spouse regulations to bring them current with the 1984 law. As a result of the lack of regulatory guidance, there is a wide disparity of rulings from various courts, which have used varying interpretations of the 1984 law and old regulations in determining if innocent spouse relief provisions apply. Because of this disparity in the various courts, the application of the innocent spouse provisions vary widely-- some court decisions are very narrow in the application of the provisions, while other courts use broad interpretations of the provisions. More specific guidance needs to be given in the regulations, based on the 1984 tax law changes.
Recommendation. Treasury Regulation §1.6013-5(b) should be revised as follows (changed language is underlined):
(b) Inequitable defined. In general. Whether it is inequitable to hold a person liable for the deficiency in tax, within the meaning of paragraph (a) (4) of this section, is to be determined on the basis of all the facts and circumstances.
(1) Benefit factors. In making such a determination a factor to be considered is whether the person seeking relief significantly benefited, directly or indirectly, from the [items omitted from gross income] grossly erroneous items within the meaning of I.R.C. 6013 (e) (2). However, normal support is not a significant "benefit" for purposes of this determination. Evidence of direct or indirect benefit may consist of transfers of property, including transfers which may be received several years after the year in which the [omitted item of income should have been included in gross income] grossly erroneous items occurred. Thus, for example, if a person seeking relief receives from his spouse an inheritance of property or life insurance proceeds which are traceable to items omitted from gross income by his spouse, that person will be considered to have benefited from those items.] a person claiming innocent spouse status will not be deemed to have significantly benefited from the grossly erroneous items of the other spouse if the other spouse used the income to gamble or pay gambling debts, support an extramarital affair, benefit third parties, maintain separate bank accounts to support a lifestyle not enjoyed by the claiming spouse, or purchase assets not in joint name or not for joint benefit. Other factors which may also be taken into account, if the situation warrants, include the fact that the person seeking relief has been deserted by his spouse or the fact that he has been divorced or separated from such spouse.
(2) Knowledge factors. Other factors to be considered in determining whether the innocent spouse had sufficient knowledge of the facts and circumstances underlying the understatement contested by the Internal Revenue Service include, but are not limited to:
(a) The general business/financial knowledge and/or experience of the person claiming innocent spouse status;
(b) The person claiming innocent spouse status' involvement in the family's business and financial affairs;
(c) lavish or unusual expenditures compared to the family's reported level of income;
(d) the other spouse's evasiveness concerning the couple's finances.
7. Proposal for Issuance of a Published Ruling Under I.R.C. §108(d)(3)由egarding Determination of Insolvency for a Married Taxpayer
Comments. I.R.C. §108(a)(1)(B) provides that discharge of indebtedness income is excluded from gross income if the discharge occurs when the taxpayer is insolvent. Section 108(a)(3) provides that the excludable amount under §108(a)(1)(B) cannot exceed the amount by which the taxpayer is insolvent.
Section 108(d)(3) defines "insolvent" as the excess of liabilities over fair market value of assets determined immediately prior to the discharge. This section, however, does not specify which assets or liabilities are taken into consideration for determining insolvency; likewise, the Bankruptcy Tax Act committee reports do not clarify the issue.
Several cases provide some guidance. In C. L. Hunt, T.C. Memo. 1989-335, the Tax Court held that assets exempted from the reach of creditors under state law are disregarded for purpose of a §108 determination. See also B. Marcus Estate, T.C. Memo. 1975-9; PLR 9130005 (Mar. 29, 1991); and PLR 9125010 (Mar. 19, 1991); all to the same effect. The rationale supporting this conclusion is that exempt assets have not been "freed up" by discharge and hence no increase in net worth results.
Based on the foregoing analysis, the Service ruled in PLR 8920019 (Feb. 14, 1989) that insolvency is determined for a married taxpayer based upon all assets reachable by that individual taxpayer's creditors. Assets belonging to the insolvent taxpayer's spouse which are not subject to the claims of the taxpayer's creditors are excluded. The Service concluded that this result is not changed by the filing of a joint income tax return by the taxpayer and spouse for the year of the discharge.
Recommendation. The Service, we believe, has correctly analyzed these issues in its previously issued PLR 8920019, 9130005 and 9125010. We recommend the Service issue a published ruling combining and restating the facts and holdings of these private letter rulings to provide a higher level of precedential value.
Reasons for Proposed Change. The Service and Tax Court have properly construed and applied I.R.C. §108 relating to the insolvency of a married taxpayer. The policy underlying the insolvency exception to discharge of indebtedness is based upon taxing economic gains; exempt assets do not enhance an insolvent taxpayer's financial position after discharge.
Issues of asset ownership, liability for debt, and exemption classification are all resolved based upon applicable state law. Thus, the filing status of an insolvent taxpayer and spouse is not relevant to income determination under I.R.C. §108.
We believe this issue is of sufficient importance that all affected taxpayers should have definitive guidance upon which they can safely rely. Thus, we urge the Service to issue a published ruling as described above.
8. Proposal for Withdrawal and Replacement of Revenue Ruling 87-112由egarding Recognition of Income on EE Bonds Transferred Between Spouses Incident to Divorce
Recommendation. Revenue Ruling 87-112 should be withdrawn and replaced.
Reasons for Proposed Change. In Revenue Ruling 87-112, the Service ruled that a divorce-related transfer of U.S. EE Bonds to a former spouse triggered recognition of the accrued interest on the bonds despite §1041(a) which provides that no gain or loss will be recognized on a transfer of property to a spouse or former spouse (if the transfer to a former spouse is incident to a divorce). But the ruling went beyond EE Bonds. In this ruling, the Service stated,
Although section 1041(a) of the Code shields from recognition gain that would ordinarily be recognized on a sale or exchange of property, it does not shield from recognition income that is ordinarily recognized upon the assignment of that income to another taxpayer.
The ruling should be withdrawn because it is contrary to one of the fundamental precepts underlying the addition of §1041 to the Code-- that a husband and wife are a single economic unit. It is generally inappropriate to tax transfers between spouses and the tax laws should be as unintrusive as possible with respect to relations between spouses.
In addition, the ruling ignores the nature of spousal rights in a marital dissolution proceeding under state laws. Virtually every state, whether by community property laws or by equitable distribution statutes, vests each spouse with a species of ownership in the divisible property upon the filing of a marital dissolution action. There are well-settled principles that state law creates legal interests and rights. In determining ownership of property, state law controls [U.S. v. Mitchell, 403 U.S. 190, 197 (1971)]. Federal law determines what transactions involving interests or rights created by state law are taxed [Morgan v. Commissioner, 309 U.S. 78, 80 (1940)].
The facts in Rev. Rul. 87-112 specified the bonds were registered in the transferor's name and were purchased entirely with the transferor's funds, thus implying the transferee had no ownership interest in the bonds under state law. Would the holding be different if, under state law, the bonds were purchased with "marital property"? Such a situation brings us right back to Davis (370 U.S. 65 (1962)] and its progeny, Collins "IV" [412 F.2d 211 (10th Cir. 1969)], Imel [623 F.2d 853 (10th Cir. 1975)], McIntosh [85 T.C. 31 (1985)] and more, where courts adjudicating a federal tax case must examine ownership rights under differing state laws. This is precisely the situation Congress intended to stop with the enactment of §1041.
The Service cited Rev. Rul. 87-112 in PLR 8813023 (Dec. 29, 1987) [regarding Hazel Balding] in which the Service ruled that three annual payments to a former spouse in exchange for relinquishment of marital claims against a military retirement benefit were taxable to the recipient. The Tax Court held the payments were not taxable under §1041(a) [Hazel Balding, 98 T.C. 368 (1992)].
Section 1041 applies to transfers of property, whether real or personal, tangible or intangible (Treas. Reg. §1.1041-1T(a), Q&A 4). "Property" is not defined in §1041 or in §7701 (definitions). Yet other areas of the Code define property for specific purposes and administrative and judicial definitions have evolved. For example, services rendered or to be rendered are not property [Id. and Treas. Reg. §1.351-1(a)(1)(i)]. Patents are property [Dennis, 473 F.2d 274 (5th Cir. 1973)]. A carved-out oil payment right was "property;" though a pure income right, it did have a present value and was an interest in property [H.B. Zachry Co., 49 T.C. 73, 81 (1967)]. Thus, "property" can exist in many forms. The type of taxable income which would be recognized on a realization event does not negate the fact that "property" exists. Income from property is taxable to the owner of the property. [Helvering v. Horst, 311 U.S. 112 (1940)].
Section 1041(a) is broad and clear. No gain or loss is to be recognized. The transfer of a property interest to a spouse (or former spouse if incident to a divorce) is not a realization event. Rev. Rul. 87-112 should be withdrawn and replaced.
A draft of a proposed ruling is enclosed.
PROPOSED REVENUE RULING
26 C.F.R. section 1.1041-1T: Treatment of transfer of property between spouses or incident to divorce (Also sections 61, 454; 1.61-7, 1.454-1.).
The Service has reconsidered its position in Revenue Ruling 87-112 [1987-2 C.B. 207]. Revenue Ruling 87-112 is superseded.
Transfer of property between spouses or incident to divorce. The deferred, accrued interest on U.S. savings bonds is not includible in the transferor's gross income in the taxable year in which the transferor transfers the bonds to the transferor's spouse or former spouse in a transfer described in section 1041(a) of the Code. The transferee's basis in the bonds immediately after the transfer is equal to the transferor's basis in the bonds.
Rev. Rul 95-_____
(1) If a taxpayer transfers United States savings bonds to the taxpayer's spouse or former spouse in a transfer described in section 1041(a) of the Internal Revenue Code, must the taxpayer include the deferred, accrued interest on the bonds in gross income in the year of the transfer?
(2) What is the basis in the bonds of the taxpayer's spouse or former spouse immediately after the transfer of bonds?
A, an individual who uses the cash receipts and disbursements method of accounting, held Series E and EE bonds with maturity dates after 1994. The bonds were registered in A's name and purchased entirely with A's funds. A had not elected pursuant to section 454 of the Code currently to include in income any interest accrued on the bonds. In taxable year 1994, as part of a divorce property settlement, A transferred the bonds to B, A's former spouse. B redeemed the bonds in 1995.
LAW AND ANALYSIS
I.R.C. section 61(a) provides that, unless otherwise excluded by law, gross income means all income from whatever source derived, including interest.
Under section 454(c) and Treas. Reg. section 1.454-1(a), if a taxpayer holds a United States saving bond issued at a discount and redeemable for fixed amounts increasing at stated intervals, the increase in redemption value is includible in gross income as interest income for the taxable year in which the bond matures, is redeemed, or is disposed of, whichever is earlier, unless the taxpayer elects under section 454 to report this interest income in the years in which increments in the redemption value of the bond occur.
Rev. Rul. 55-278, 1955-1 C.B. 471 holds that interest accrued on bonds prior to reissue to transferee is includible in transferor's income for the taxable year in which a gift was made. Similarly, Rev. Rul 54-143, 1954-1 C.B. 12 holds that the transferor recognizes interest accrued on bond upon transfer of interest in bond to daughter.
Section 1041(a) of the Code provides that no gain or loss will 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 to the former spouse is incident to the divorce). The effect of section 1041 is to defer the tax consequences (recognition of gain or loss) until the transferee disposes of the property.
The House Committee Report accompanying the addition of section 1041 to the Code states, "...in general, it is inappropriate to tax transfers between spouses. This policy is already reflected in the Code rule that exempts marital gifts from the gift tax, and reflects the fact that a husband and wife are a single economic unit." Thus, under section 1041, Congress gave taxpayers a mechanism for determining which of the spouses will pay the tax upon the ultimate disposition of an asset. The spouses are free to negotiate between themselves whether the "owner" spouse will first cash in the bonds, recognize the accrued interest income, and then transfer the proceeds from that sale to the transferee spouse, or whether the owner spouse will transfer the bonds to the transferee spouse who will recognize all of the accrued interest as income upon a subsequent taxable disposition of the bonds.
Treas. Reg. section 1.454-1(a) and Revenue Rulings 55-278 and 54-143 were issued prior to the addition of section 1041 to the Code, and thus could not contemplate Congressional intent with respect to transactions governed by section 1041. The subsequent statutory provision, which expressly governs transactions within the scope of section 1041, supersedes prior general authority. Accordingly, the rule of section 1.454-1(a) of the regulations for dispositions of interest-deferred obligations does not apply to transactions governed by section 1041.
Section 1041(b)(1) of the Code provides that, in the case of an transfer of property described in section 1041(a), for purposes of subtitle A, the property will be treated as acquired by the transferee by gift. Section 1041(b)(2) provides that, in the case of any transfer of property described in section 1041(a), the basis of the transferee in the property will be the same as the adjusted basis of the transferor.
(1) The deferred, accrued interest on United States savings bonds is not includible in the transferor's gross income in the taxable year in which the transferor transfers the bonds to the transferor's spouse or former spouse in a transfer described in section 1041(a) of the Code.
(2) The transferee's basis in the bonds immediately after the transfer is equal to the transferor's basis in the bonds. The deferred, accrued interest as of the date of transfer remains deferred, accrued interest in the hands of the transferee.
(3) Revenue Ruling 87-112 is superseded.