March 22, 1995
The Honorable Bill Archer
Committee on Ways & Means
U.S. House of Representatives
Washington, DC 20515-6348
The Honorable Bob Packwood
Committee on Finance
United States Senate
259 Russell Senate Office Building
Washington, DC 20510-3702
Re: Proposal for Statutory Changes Concerning Tax Aspects of Divorce and Marriage
Dear Chairman Archer and Chairman Packwood:
The American Institute of Certified Public Accountants is pleased to present for your consideration a proposal for changes to the Internal Revenue Code concerning tax aspects of divorce and marriage.
The AICPA is the national professional association of Certified Public Accountants, with approximately 319,000 members. We formed a volunteer Domestic Relations Task Force to examine a number of recurring practical problems involving divorce and taxation which were identified by our member CPAs. The recommendations of this task force, with the support of the Individual Taxation Committee, have been approved by our Tax Executive Committee. In addition to these suggested statutory changes, we have also prepared regulatory proposals for consideration by the IRS.
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 urge you to 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 or if we can be of any assistance, please call me at (202) 467-3004 or Gerald W. Padwe, Vice President - Taxation, at (202) 434-9226.
Tax Executive Committee
cc: Hon. Sam Gibbons, Ranking Minority Member, House Ways &
John Buckley, Minority Chief Tax Counsel, House Ways & Means Committee
James D. Clark, Chief Tax Counsel, House Ways & Means Committee
Janice Mays, Minority Chief Counsel, House Ways & Means Committee
Phillip D. Moseley, Majority Chief of Staff, House Ways & Means Committee
Joseph Gale, Minority Tax Counsel, Senate Finance Committee
Hon. Daniel P. Moynihan, Ranking Minority Member, Senate Finance Committee
Lawrence O奪onnell, Jr., Minority Staff Director, Senate Finance Committee
Lindy L. Paull, Majority Staff Director, Senate Finance Committee
Mark Prater, Chief Tax Counsel, Senate Finance Committee
Kenneth Kies, Chief of Staff, Joint Committee on Taxation
Leslie B. Samuels, Assistant Secretary, Department of the Treasury
Committee on Ways and Means, U.S. House of Representatives
Committee on Finance, United States Senate
March 22, 1995
March 22, 1995
INDEX OF PROPOSED LEGISLATIVE CHANGES
for Amending I.R.C. §121
Regarding the Definition of Principal Residence For Purposes of Exclusion on Sale of Residence Incident to Divorce
for Amending I.R.C. § 1034
Regarding Time Period for Acquisition of Replacement Residence by Divorcing Spouses
for Amending I.R.C. §172
Regarding Characterization of Alimony for Net Operating Loss Purposes
Proposal for Amending I.R.C. §6013(e)(4)
Regarding AGI Threshold for Innocent Spouse Relief
Proposal for Enacting Legislation
Regarding Division of Carryover Tax Attributes Incident to a Divorce
1. Proposal for Amending I.R.C. §121由egarding Definition of Principal Residence for Purposes of Exclusion on Sale of Residence Incident to Divorce.
Present law. Section 121 provides for an election to exclude up to $125,000 of gain from the sale of a principal residence if the taxpayer if at least age 55 and has owned and resided in the residence for at least three of the preceding five years. Only one spouse is required to satisfy those tests in order to be eligible for the exclusion but that spouse alone must meet all the requirements. Married couples are entitled to only one $125,000 exclusion between them if they file jointly; if they file separately, they are entitled to only $62,500 each. Unmarried individuals are each entitled to exclusions of $125,000.
Reason for Change
Divorce is a unique transition for taxpayers. In most cases, one spouse must involuntarily abandon the marital residence. In many cases, as part of the property settlement, the residence is sold. Until then, the spouse who abandoned the residence may live in somewhat temporary lodging (e.g., rental). His or her last permanent residence was the marital residence. A safe harbor is needed in the law for such taxpayers to utilize §121 if the residence is sold pursuant to a divorce settlement. Divorces often take more than two years to complete. Further, it may take additional time to complete sale of the residence after the agreement is finalized. Thus, an extra year (i.e., three of six instead of three of five) is necessary to permit §121 qualification.
Explanation of Recommended Change
Section 121 would be amended so that, if a residence is sold pursuant to a divorce or separation, the eligible spouse(s) would be able to utilize the gain exclusion if during the six (instead of the present five) year period ending on the date of the sale or exchange, the residence was used by the taxpayer as his or her principal residence for periods aggregating three years or more.
2. Proposal for Amending I.R.C. §1034由egarding Time Period for Acquisition of Replacement Residence by Divorcing Spouses
I.R.C. §1034 allow a taxpayer to defer tax on gains from the sale of a principal residence, provided that the net sales proceeds are reinvested in a replacement home within two years, before or after, the sale. If a taxpayer abandons the residence prior to the sale, the provisions of §1034 no longer apply and gains are immediately taxable. When spouses divorce, one often abandons the residence. In that event, if he or she remains an owner at the time of the sale, that spouse will be ineligible for §1034 treatment. The spouse who remains in the residence remains eligible for gain deferral. Whether a spouse abandons the residence is a question of facts and circumstances.
Reason for Change
Divorce is a unique transition for taxpayers. In most cases, one spouse must involuntarily abandon the marital residence. In many cases, as part of the property settlement, the residence is sold. Until then, the spouse who abandoned the residence may live in somewhat temporary lodging (e.g., rental). His or her last permanent residence was the marital residence. A safe harbor is needed in the law for such taxpayers to utilize §1034 if the residence is sold pursuant to a divorce settlement. Given that divorces often take more than two years to complete, a three year period is necessary to continue Sec. 1034 qualification. This change will ease administration of the law.
Explanation of Recommended Change
The proposal would provide a safe harbor in the determination of principal residences in certain cases incident to divorce or separation. Specifically, the proposal provides that a residence would be treated as the taxpayer's principal residence at the time of sale if (1) the residence is sold pursuant to divorce or separation and (2) the taxpayer used such residence as his or her principal residence at any time during the three-year period ending on the date of the sale. The proposal is identical to §102 of the Tax Simplification and Technical Corrections Act of 1993 (H.R. 3419) (and §4101 of the Revenue Act of 1992 (H.R. 11)) except that the two year allowance would be increased to three years.
3. Proposal for Amending I.R.C. §172由egarding Recharacterization of Alimony for Net Operating Loss Purposes
In computing a net operating loss, nonbusiness deductions are taken into account only to the extent of nonbusiness income. Nonbusiness deductions are those which are unrelated to the taxpayer's employment and are not incurred in the conduct of a trade or business. See Treas. Reg. §1.172-3(a)(3) and I.R.C. §172(d)(4).
Alimony paid has been specifically held to be a nonbusiness deduction. In Thomas E. Monfore, 55 T.C.M. 787 (1988), the Tax Court held that the taxpayer's alimony payments arose solely from the marital relationship and thus were not related to employment or conduct of a business. The fact that business income funded the alimony payments was found to be irrelevant. The Court, however, did not discuss (and may not have even considered) the income-splitting aspect of alimony, which has long been the underpinning of I.R.C. §71.
Although no authority on point has been found, it is anticipated that an alimony recapture deduction under I.R.C. §71(f)(1)(B) would also be treated as a nonbusiness deduction based on the Monfore rationale.
Reasons for Change
We believe that alimony paid should be classified as a business deduction in computing a net operating loss. The payments ordinarily are made from earned or business income of the payor, which has the effect of permissible income-splitting between taxpayers.
As long as taxpayers adhere to the requirements of I.R.C. §71, they may divide income for tax purposes via alimony as they, in their sole discretion, so desire. Of course, alimony is taxed to the recipient; the disallowance of a net operating loss through the nonbusiness deduction classification effectively may prevent a corresponding deduction to the payor. This result is inconsistent with long-standing approach of §§62 and 71, providing for income and deduction of alimony. The only practical remedy is legislation which overturns the Monfore result.
A payee of alimony is entitled to claim a deduction in the same amount and year in which the payor of alimony must recognize recapture income pursuant to I.R.C. §71(f)(1)(B). The intent of §71(f)(1)(B) is to restore both the payor and payee to their respective positions prior to the subsequently disallowed alimony. If this deduction is treated as a nonbusiness item for net operating loss purposes, this statutory framework will be obviated, since the payee may be effectively prevented from receiving the full benefit of the recapture deduction.
For example, assume alimony is paid to a former spouse, who has no other income, pursuant to a divorce decree in the in the following post-separation years: year 1 - $40,000; year 2 - $40,000; year 3 - $0. Under I.R.C. §71(f), the payor would recognize alimony recapture income of $42,500 in year 3; the payee would be entitled to a deduction in year 3 of $42,500. The payee, however, who has already reported $80,000 in alimony income, would not be permitted any net operating loss carryback under Monfore.
The proposed statutory amendment to I.R.C. §172(d)(4) would specifically provide that alimony paid and the recapture deduction are business deductions for purposes of computing a net operating loss.
4. Proposal for Amending I.R.C. §6013(e)(4)由egarding AGI Threshold for Innocent Spouse Relief
The Tax Reform Act of 1984 liberalized the innocent spouse joint return relief provision by expanding the circumstances in which the relief may be granted. Overall, these provisions are a vast improvement on the prior law. However, there is one area of concern. I.R.C. §6013(e)(4) sets forth a gross income test for the innocent spouse rules; in essence, the current test is:
- AGI is $20,000 or less. If the innocent spouse's adjusted gross income for the taxable year immediately preceding the date of mailing the notice of deficiency (i.e., the preadjustment year) is $20,000 or less, relief is available if the understated tax liability exceeds 10% of the preadjustment year AGI.
- AGI is more than $20,000. If the innocent spouse's AGI for the taxable year immediately preceding the date of mailing the notice of deficiency is more than $20,000, the relief is available if the understated tax liability exceeds 25% of the preadjustment year AGI.
- If remarried. In addition, if the innocent spouse has remarried, the preadjustment AGI is calculated using joint AGI, whether or not the two file a joint return for the year.
Reason for Change
I.R.C. §6013(e)(4) sets differing standards for innocent spouses based on adjusted gross income, thus punishing innocent spouses earning more than $20,000. This section holds spouses earning more than $20,000 to a higher standard than those earning $20,000 or less. Under this provision, an innocent spouse who has earned income in excess of $20,000 is punished for this higher earned income. For example, the tax for a taxpayer earning $20,100 in the preadjustment year would have to be understated by more than $5,025 for any relief provisions to apply, while a taxpayer earning $19,999 would only need an understatement of $2,000. The current provision seems to imply that a spouse earning more than $20,000 per year should be more intelligent and should have known better than to get into a situation needing to use the innocent spouse provisions.
Therefore, the AGI threshold of 10% of adjusted gross income should apply to all innocent spouses regardless of their level of income. This treats all innocent spouses equally.
The preadjustment income of the person seeking innocent spouse relief should not include anyone else's income, such as a new spouse. This is another discriminatory provision. A person applying for innocent spouse status should not be treated differently whether remarried or single.
Section 6013(e)(4) is overly complex and can be easily simplified by eliminating subparagraphs B and D, and revising subparagraph A.
Section 6013(e)(4)(A) should be changed as shown below, removing the different percentage calculations based on different levels of adjusted gross income. This change would eliminate the need for §6013(e)(4)(B).
Section 6013(e)(4)(D) should be eliminated. This section includes the income of another spouse in computing the income of the "claiming spouse" for purposes of determining the AGI threshold.
The new §6013(e)(4)(A) should read:
(4) Understatement must exceed specified percentage of spouse income.
(A) Threshold. Adjusted gross income of $20,000 or less. If the spouse's adjusted gross income for the preadjustment year is $20,000 or less, This section shall apply if the liability described in paragraph (1) is greater than 10 percent of adjusted gross income in the preadjustment year.
(B) Adjusted gross income of more than $20,000. If the spouse's adjusted gross income for the preadjustment year is more than $20,000, subparagraph (A) shall be applied by substituting "25 percent" for "10 percent".
(C)(B) Preadjustment year. For purposes of this paragraph, the term "preadjustment year" means the most recent taxable year of the spouse ending before the date the deficiency notice is mailed.
(D) Computation of spouse's adjusted gross income. If the spouse is married to another spouse at the close of the preadjustment year, the spouse's adjusted gross income shall include the income of the new spouse (whether or not they file a joint return).
(E)(C) Exceptions for omissions from gross income. This paragraph shall not apply to any liability attributable to the omission of an item from gross income.
5. Proposal for Enacting Legislation由egarding Division of Carryover Tax Attributes Incident to a Divorce
There exist numerous carryovers of credits, losses, recapture items and suspended items which are presently difficult to determine and divide when a couple, previously filing a joint income tax return, obtain a divorce and file separate income tax returns in a subsequent tax year. Guidance exists with respect to the division of some carryover items through revenue rulings and regulations. However, numerous carryover items, and possibly some of the most frequently recurring items, have not been adequately addressed.
In those cases where guidance does exist (e.g., net operating losses, capital losses) extensive tracing rules are required. Under current statutes some carryover items have fifteen (15) year or even unlimited carryover periods. Thus, it is difficult to trace the origin of the carryforward items, let alone the effect of utilization or changes in these carryovers during the intervening tax years. The guidance which does exist with respect to the apportionment of carryover items, between spouses in the event of a divorce, does not produce tax simplification.
Proposal for Legislation
In the case of a divorce, carryover tax attributes should be divided into two groups: those which are dependent upon the existence of the property or activity (e.g., passive activity losses, §1245 recapture potential) and those which do not require the continued existence of the property or activity for the tax attribute to exist (e.g., capital loss carryover, net operating loss carryover). Those attributes, which require the existence of the property or activity, would attach to such property or activity and become a tax attribute belonging to the party that received the property or activity in the divorce. All other tax attributes would be divided equally between the parties to a divorce. With respect to this second class of tax attributes, if the parties do not desire an equal division of each such tax attribute, they could agree to a division of these attributes which is not equal or the Court could order such division. The allocation of these tax attributes, in a manner other than an equal division, would require the inclusion, in the first tax return following the divorce, of a written agreement signed by both parties or a court decree setting forth the unequal division.
Reasons for Change
Many compelling reasons exist to revise the present rules regarding the carryover of tax credits, losses and other items, as well as the application of characterization rules for gains and losses, in the case of property transferred pursuant to I.R.C. §1041. In summary, the reasons are:
- The government can be whipsawed by taxpayers taking conflicting positions following a divorce;
- Simplicity for the IRS in auditing carryovers;
- Due to the length of present carryover periods (i.e., 15 years), it is often difficult and costly to apply the existing rules in tracing and dividing the carryovers and the credits;
- Not all credits or carryovers have published guidance regarding their division in a §1041 transfer (i.e., alternative minimum tax credits for individuals);
- The proposed means of dividing carryovers and credits generally will not result in their utilization any faster than if still part of a joint return;
- Carryovers and credits are equivalent to marital property and future cash--the parties should be able to divide these tax attributes in a divorce as they see their respective interests to exist; and
- Simplicity for all parties concerned.
In a divorce the economic unit is severed for tax purposes. The number of divorces continues to increase annually in our society. The tax problems and complexities associated therewith are compounded by this increased number of divorces. Generally, a divorce can be viewed as an adversarial occurrence which controls the division of property.
In a divorce, certain carryforward items, and means of characterizing gain or loss, must be divided between the parties obtaining a divorce. These carryovers and characterization provisions include the carryover of tax credits (e.g., investment tax credits, foreign tax credits), the carryover of losses (e.g., net operating losses, capital losses), property subject to recaptures (e.g., §1245 property, §1231(c) property) and suspended items (e.g., passive losses, suspended Subchapter S losses). In addition to the aforementioned, other carryover items include deductions under §280A(c)(5) (vacation home expenses) and §163(d) (investment interest expense). For the purposes of this discussion, these items will collectively be referred to as "tax attributes." This list of tax attributes is not all inclusive.
Tax attributes can be divided into two types, which for this discussion will be referred to as "Type A" tax attributes and "Type B" tax attributes. Type A tax attributes are those attributes which are dependent upon the existence of the activity or property by which they were originated. As an example, passive activity loss carryovers generally require that the activity or substitute property (i.e., an installment note) be in existence in order for the carryover to exist. Should the activity be terminated or sold, the carryover item is generally deductible. This is also true for certain Subchapter S carryovers, but not for all tax attributes produced by a Subchapter-S corporation. It would also include recapture items under §§1245, 1250 and 179. Type A tax attributes are easily identified with the property or activity that produced the tax attribute and can carryforward with the property or activity when they are divided in a property settlement.
Type B tax attributes are not dependent upon the continued existence of the property or activity that produced the tax attribute. As an example, a net operating loss will continue to carry over even though the activity that produced the loss has been disposed of or terminated. The same is true for capital loss carryovers and other forms of tax attributes. Even if the property or activity that produced the tax attribute should be in existence, the tax attribute would still be classified as a Type B tax attribute if it could exist without the continued existence of the property or activity.
Because Type A tax attributes are closely tied to an activity or property and can easily be identified with that property or activity, these tax attributes should attach to the property in a divorce. Thus, passive activity losses, suspended Subchapter S losses and recapture items under §§1245, 1250 and 179 would necessarily be attached to the property with which they are associated. If a particular property will continue in some form of joint ownership, the Type A attributes would be allocated to the parties in proportion to such ownership.
Type B tax attributes may or may not be traced to a particular piece of property or an activity that is divided by the parties in a divorce. As such, the tax attributes do not attach to such property or activity. These tax attributes would be divided equally by the parties to a divorce, unless the parties enter into an agreement to allocate the Type B tax attributes in a different manner. The allocation could also occur by court order.
Tax attributes are the equivalent of marital property since they may be converted into cash through their utilization. Like all other marital assets or property, tax attributes should be subject to division by the parties to the divorce as if the tax attributes were property. However, Type A tax attributes are so closely associated with the property which generated the particular tax attribute, they should continue to be associated with the property and divided in the same manner as that particular property is divided.
As previously noted, the division of property and tax attributes in a divorce occurs in an adversarial setting. Thus, the division of tax attributes by the parties should be considered as occurring in an arm's length transaction.
From the government's perspective, the equal division of Type B tax attributes should be favorable. First, the division is easily audited. This would reduce those situations where a party to the divorce utilizes tax attributes that did not actually belong to that party under the current tracing rules. Furthermore, the equal division of the attributes will generally result in slower utilization of the tax attributes. In some cases, a spouse may receive tax attributes which that individual will never be able to utilize but which could have been utilized by the other spouse. As an example, a wife may receive half of the investment interest expense carryover but be unable to use the carryover since her spouse received all of the assets producing investment income. If the parties are able to agree to the allocation of the Type B tax attributes, or a court order allocates the tax attributes, again, the government is not actually injured. First, the parties will most likely allocate the tax attributes to whom they were otherwise attributable under the existing tracing rules. In any event, the tax attributes generally will be utilized no sooner than if the parties had remained married and filed a joint tax return. Because divorces are adversarial by nature, the chances of trafficking in tax attributes are minimal.
This approach promotes tax simplification. Under the current procedures which exist for allocating certain tax attributes, one must reconstruct the carryover item from its origin. This can at times be difficult, confusing and costly with respect to professional fees. Because some carryovers have unlimited carryover periods, or a fifteen year carryover period, the reconstruction and determination of carryover items can be very difficult. Other carryover items can be very complex to compute and presently no guidance exists with respect to the division of these tax attributes. As an example, the alternative minimum tax credit involves personal exemptions and itemized deductions in making the computation. It is virtually impossible to divide the personal exemptions and some itemized deductions in recomputing the credit to determine to whom the credit belongs. For all of these reasons, the procedures suggested above promote simplicity. Simplicity is very important since divorces cut across our entire social and economic structure.
Finally, the division of Type B tax attributes could be accomplished by court order or by a written agreement signed by both parties. In either event, to claim the division of Type B attributes, other than equally, the party claiming an allocation of the Type B tax attributes, other than an equal allocation, would have to include a copy of the agreement, or the court order, in the first tax return, filed by that party, following the divorce.