Taxation on Property Transfers (IRC §1041)

The transfer of property that is not a gift is generally a taxable event requiring the transferor to recognize a gain or loss on the difference between its fair market value and adjusted basis. Prior to 1984, tax regulations required that appreciated property transferred to a non-transferor (receiving) spouse incident to a divorce result in a gain to the transferor. Since then, Internal Revenue Code (IRC) Section 1041, as part of the Tax Reform Act of 1984, does not recognize a gain or loss on the transfer of property between spouses, former spouses or trusts for the benefit of former spouses incident to divorce.

IRC §1041 includes all property in the marital estate that is transferred between spouses because of divorce. Assets and liabilities cannot be “cherry picked” because this section is mandatory for all transferred property. The section recognizes that these transfers occur over time and not just when the marriage ends. The regulation states that the transfer is related to the end of the marriage if (a) it is required under the divorce or separation instrument and (b) it takes place within six years from the date of the divorce. A transfer of property is incident to the divorce if the transfer (a) occurs not more than one year after the date on which the marriage ends or (b) is related to the end of the marriage. A divorce or separation instrument is defined in the regulations as the divorce decree and its modifications or amendments.

The transfer is subject to taxation if not related to the end of the marriage or when it is not required under a divorce or separation instrument and it occurs more than six years after the end of the marriage. However, the transfer can still be made without tax consequences upon failing either requirement if it can be shown that there were legal or business factors delaying the earlier transfer attempts such as disputes concerning the property value owned when the marriage ended or barriers connected to the property transfer. It must also be shown that the transfer was made immediately after these legal or business factors were resolved.

Tax court cases have supported the position that the transferor spouse escapes all tax consequence on proceeds received from the stock redemption under IRC §1041. In Arnes, the Tax Cound found that the transferor spouse, in this case the wife, did not have a tax liability under IRC §1041. The Appellate Court found that the wife did not receive a constructive dividend by selling her shares because her husband was not relieved of his “primary and unconditional”obligation under the divorce decree. If the non-transferor (receiving) spouse is released from this obligation, then the transferor spouse has met the legal standard for “constructively” receiving a dividend. Because both parties were not taxed and the tax avoidance was repeated in other Tax Court cases, the IRS issued proposed regulation5 that effectively closes the ‘loop hole’ thereby taxing someone on corporate stock redemptions incident to divorce.

Under IRC §1041, the transferor spouse must supply the non-transferor (receiving) spouse with adequate records that establish the adjusted basis and holding period of the property as of the date of the transfer. If the the transferor spouse does not provide adequate documentation, questions regarding the facts and circumstances of who controlled the asset records in the family will be asked.

IRC §1041 states that property transfers between spouses is not a taxable event. Courts generally disregard the tax liability unless the marital property (sale of the business or business interest) and resulting tax are imminent. A constructive dividend may be realized by the transferor spouse if stock is redeemed. A valuation analyst must know the tax impact in order to advice an attorney.

Other than in divorce, valuations by a business valuation analyst are important in financial, tax and litigation matters.

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