Reach of Sec. 1041 Nonrecognition Provisions Expanded

In Young, 240 F3d 369 (2001), aff'g 113 TC 152 (1999), the Fourth Circuit held that a taxpayer did not recognize gain on the transfer of appreciated land to his former spouse in settlement of his default on a promissory note. This result shifted the recognized gain to the former spouse on her sale of the land. Young is important, because it provides a precedent for gain nonrecognition for property transfers between former spouses that were not specified in the original property settlement.

Sec. 1041(a) and (b) provide that no gain or loss is recognized on property transfers between spouses or former spouses "incident to the divorce," and the transferee adopts the transferor's adjusted basis in the property. Sec. 1041(c) defines "incident to divorce" as transfers occurring within one year after the marriage ends or transfers "related to the cessation of the marriage." Sec. 1041 does not define "cessation of the marriage."

However, Temp. Regs. Sec. 1.1041-1T(b) provides a safe harbor for transfers made within six years of divorce under a Sec. 71(b)(2) divorce or separation instrument, or a modification or amendment to such decree or instrument. Sec. 71(b)(2) defines a "divorce or separation instrument" as a "decree of divorce or separate maintenance or a written instrument incident to such a decree." If the property transfer is not made pursuant to a Sec. 71(b)(2) divorce or separation instrument, it is presumed to be unrelated to the cessation of the marriage, unless the taxpayer can show that the transfer was made to effect the division of the marital property. (The courts use "marital property" to mean property the spouses owned when the marriage ended.)

Louise and John Young were married in 1969 and divorced in 1988. Their 1989 settlement agreement provided for the equitable distribution of their property and all other claims arising out of their marriage. Under this agreement, John gave Louise a $1.5 million promissory note, payable in five annual installments, plus interest. The note was secured by land he received in the 1989 settlement. In 1990, John defaulted on the note and Louise sued. They settled and in December 1992, he transferred the land to Louise in discharge of $2,153,845 in debts to her, including the principal, accrued interest and her legal fees. His basis in the land was $130,794. John retained an option to repurchase the land for $2,265,000, which he transferred to Investment Partners, who exercised the option almost immediately.

The Service issued deficiencies against both John and Louise on over $2 million of gain on the land, pending the Tax Court's ruling. John and the IRS argued that the Sec. 1041 nonrecognition provisions applied to his transfer; Louise argued that Sec. 1041 did not apply. If John prevailed, Louise would be taxed on the gain from her sale. If Louise prevailed, John would be taxed on the transfer to Louise.

The Tax Court first noted that the parties stipulated, and the court agreed, that the 1989 settlement was incident to the divorce decree because it divided the marital property. The court then ruled that the 1992 settlement was also incident to the divorce decree, because it resolved a dispute arising under the 1989 settlement and completed the division of marital property. The court interpreted "incident to" as "implementing the terms of." It concluded that John's transfer of the land satisfied the regulations' safe harbor. Also, even if the regulations were not applicable, the transfer satisfied the "related to the cessation of the marriage" requirement. Therefore, Sec. 1041 applied to John's transfer, and Louise's gain on her sale of the land was recognized.

Affirming the Tax Court, the Fourth Circuit emphasized two related points: (1) the 1992 settlement provided explicitly that it was to "fully settle" all claims under the 1989 agreement; and (2) John's promissory note was not a completed transfer until he paid the obligation in full, whether as originally provided or with appreciated land. The Fourth Circuit also noted that neither the statute nor the regulations limit Sec. 1041 to only one post-divorce transfer "if two or more are 'incident to divorce' or necessary to complete the transfer of marital property." Finally, the Fourth Circuit distinguished Young from Letter Ruling 9306015, in which the husband sold his one-half interest to his former spouse, even though the divorce decree provided that the spouses' personal residence would be sold to a third party. The Service held that Sec. 1041 did not apply to his sale. Because he had no obligation to sell his interest to his former spouse, his sale did not "effect the division" of marital property. In contrast, John transferred the land to Louise to satisfy his obligation to her that arose from the 1989 agreement, thereby enforcing her rights due to the cessation of their marriage.

The dissent argued that the 1992 agreement was not "incident to" the 1988 divorce decree, because neither the decree nor the ensuing 1989 marital property division required the land transfer specified in the 1992 agreement. Instead, the completion of the property division occurred when Louise accepted the note in 1989; therefore, any payments on the note were not a division of marital property. Consequently, the dissent concluded that Sec. 1041 did not apply and John owed tax on the land transfer to Louise.

On a separate issue, the Fourth Circuit joined the majority of circuits in holding that Louise had to pay tax on contingent legal fees paid directly to her attorneys. This assignment-of-income issue is discussed fully in Kenseth, 114 TC 399 (2000).

To obtain Sec. 1041 nonrecognition treatment, under Young, for property transfers between former spouses not specified in either the divorce decree or implementing agreement for dividing the marital property, taxpayers must prove that the transfers settle claims or complete transfers specified in those documents. Satisfying this standard will satisfy the language of the statute and the temporary regulations. Future cases will determine how the Tax Court will apply Young to other situations, and whether other circuits will follow Young.

From Peter C. Barton, MBA, J.D., CPA, University of Wisconsin–Whitewater, Whitewater, WI (not affiliated with Summit International Associates, Inc.)