Archive for David Ellis

Dividing Property In A Divorce – Tax Traps (Valuable 13 Part Series You Must Read To Understand Divorce And Taxes)

Dividing Property In A Divorce - Tax Traps

This valuable series on Dividing Property In A Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.

Dividing property during divorce may be one of the most difficult issues faced by tax planners. While most professionals are familiar with the general rule that property transferred during marriage and/or divorce proceedings is usually tax free [1], they may be less aware of the many thorny tax pitfalls that await the unwary. As with most tax matters, “the devil is in the details”. Issues such as how property is held, basis, depreciation, tax credit recapture, and holding period, are but a few of the problems that will confront tax practitioners in a divorce engagement.

Sometimes the tax impact of decisions made during divorce proceedings will not be realized, much less recognized, until many years down the road. Other times, the tax consequences may be just around the corner. The purpose of this course is to arm practitioners with the knowledge that will help them see what is coming down that road, or around that corner… while there is still time to do something about it.

I. The Big Rule – Code Section 1041 Overview

A. The Exchange of property between spouses and former spouses is generally tax free. If the property transfer is between former spouses, it must be incident to their divorce.1 Note: Code section 1041 is mandatory. There is no electing out of it. It also applies to the nonrecognition of loss as well as gain.

B. Transfer of property is incident to divorce if it:
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Dividing Property In Divorce Tax Traps – Part 13 In Series

Dividing Property In Divorce Tax Traps – Part 13

1. Taking Basis into Consideration When Dividing Property

Even though IRC Section 1041 generally allows for the tax-free transfer of property between spouses in a divorce, the basis of such property relative to its current (or projected) Fair Market Value is critical in determining an equitable division of the marital estate.

Example:  Fred and Ethel are engaged in divorce proceedings. The primary asset in the marital estate is a rental apartment building that they have owned for thirty years as community property.  The basis of the property is $200,000 and the fair market value of the building has been appraised at $800,000.

Sales Price of Land   $800,000
Less Fred’s Original Basis <$100,000>
Less Fred’s Additional Basis Transferred from Lucy <$100,000>
Net Gain    $600,000
Tax on Gain (assuming a combined Federal and State rate of 30%) $180,000
Fred’s Net After Tax Gain $420,000

Assume that it is agreed that Fred is to buy out Ethel’s 50% interest in the building for $400,000.  Such a transaction would be covered under the general provisions of IRC Section 1041 and would be tax-free to Ethel, with Fred assuming Ethel’s share of the building’s carryover basis.  Were Fred to sell the building he would likely have the following economic and tax consequences:

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IRS Providing Automatic Penalty Relief: 2019 And 2020 Returns 

DAVID ELLIS - IRS Providing Automatic Penalty Relief: 2019 And 2020 Returns

The IRS has announced that it will provide automatic relief from certain failure to file penalties and information reporting penalties for 2019 and 2020 taxable years. (Notice 2022-36) The IRS will determine whether a taxpayer qualifies and will automatically abate, refund, or credit the taxpayer’s account, as appropriate. No action on the taxpayer’s part is required.

Tax professionals should be ready to answer questions from clients who receive unexpected refund checks and/or IRS notices in the mail informing them of automatic changes to their IRS account.

The purpose of the relief is to allow the IRS to focus more of its resources on clearing its backlog, as well as provide relief to taxpayers affected by the COVID-19 pandemic.

To be eligible for the automatic failure to file penalty relief for the 2019 and 2020 taxable years, eligible entities must have filed their returns by September 30, 2022. The relief applies to:

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Dividing Property In Divorce Tax Traps – Part 12 In Series

DAVID ELLIS _ Divorce And Dividing Property

(Part 12 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)

D. Dividing Interest in S Corporations and Other Pass-Through Entities

A large percentage of closely held businesses are organized as “pass-through entities”.  This means that the income, loss, special deductions, and the like are reported on the individual tax return of the entities’ owner rather than the businesses themselves.  Common forms of pass-through entities that need to be allocated between spouses in a divorce situation include S Corporations, LLCs, and Partnerships.  Trust and estates, typically being separate property bequest, would not generally be expected to cause separate property issues.

The division of interest in pass-through entities, is subject to the general rules of IRC Section 1041 (nonrecognition of gain/loss, carryover of basis, etc.).  However, ownership of pass-through entities—especially in the form of a closely held business, can be a double edge sword.  Issues that should be taken into consideration, include but are not necessarily limited to the following:

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Dividing Property In Divorce Tax Traps – Part 11 In Series

DAVID ELLIS _ Dividing Property In Divorce

(Part 11 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)

C.Transfers of Closely Held Businesses

In a divorce, it is often the case that the family business will be one of the most valuable assets in the marital community.  Generally, the transfer of the stock in a closely held business will enjoy the protection of Section 1041 in the context of divorce.  Likewise, the basis and holding period will carry over to the transferee spouse, thereby deferring the recognition of any gain or loss to him/her.[1] However, the transfer of closely held stock can be accomplished through various means, under a variety of circumstances, with the resulting tax burden born in some cases by the transferor spouse, and at other times by the transferee spouse.

1. Cash Buyout

The simplest scenario in a divorce related transfer of a closely held business would be a cash buy out of one spouse by the other.

Example: Barney and Betty are in the process of divorcing.  They own 100% of the stock in a granite quarry that they acquired during the marriage.  The stock has an appraised value of $500,000.  As part of the divorce agreement it is decided that Barney will buy out Betty’s interest for $250,000.  The basis of the shares in total is $50,000.  Barney proceeds to buy out Betty’s interest for $250,000.  In accordance with IRC Section 1041, no gain or loss is recognized on the transfer.  Barney’s basis in the stock is increased from $25,000 to $50,000.

2.Stock Redemptions for the Family Business

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Dividing Property In Divorce Tax Traps – Part 10 In Series

Dividing Property In Divorce Tax Traps – Part 10

(Part 10 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)

Miscellaneous Issues

Recapture of Depreciation

In general, there is no recapture of depreciation on Section 1041 transfers.

1.Transfers between spouses are treated as gifts.[1]

a) Property transferred by gift does not require recapture at the time of the gift.[2]

(b)Recipient spouse is responsible for recapture, if and when property is sold at a gain.

Example:

Fred and Ethel are divorcing. They own a retail frozen yogurt shop as community property.  As part of the global property settlement the business and related equipment is divided. There are three (3) machines used for making the frozen yogurt—each one has an original purchase price of $2,500.  Each machine has been fully depreciated using MARCS 5-year straight line.  Several years after the divorce is final, Ethel sells each machine at a local flea market for $500.  Ethel will recognize $1,500 in Section 12 45 recapture, calculated as follows:

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Dividing Property In Divorce Tax Traps – Part 9 In Series

Dividing Property In Divorce Tax Traps – Part 9

(Part 9 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.) 

d.Losses of S Corporations

Both passive and active owners of S Corporations can only deduct losses to the extent that they have basis in the stock of the S Corporation.[1] Generally, taxpayers acquire basis in S Corporation stock by receiving pass throughs of profits, making capital contributions, or making loans directly to the S Corporation.[2]

When the owners of S Corporation stock receive pass through losses that are in excess of their basis, such losses are carried over until the stockholders re-establish enough basis in the stock to deduct the loss in whole or in part.[3]

(1) S Corporation losses follow the stock.[1]

For transfers of S Corporation stock incident to a divorce after 2004, any concomitant losses escheat to the spouse obtaining or keeping the stock.

(2)Carry over losses following the stock are treated as if they were incurred by the S Corporation in the subsequent year.[1]

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Dividing Property In Divorce Tax Traps – Part 8 In Series

Dividing Property In Divorce Tax Traps – Part 8

(Part 8 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.) 

C. Losses And Other Carry Forwards

Tax losses and other carry forwards such as investment interest expense are easy to overlook in divorce proceedings, but often may be of extreme economic value. Remarkably, in many cases the tax law offers no specific guidance as to how such items are to be allocated between divorcing spouses. In such cases the practitioner must fall back on the general rules governing state property law, be it community property, equitable distribution, case law where available, English Common Law, or if all else fails, common sense.

1.Carry Forwards of Net Operating Losses

a) Community Property States

In community property states, the allocation of net operating loss carry forwards follows the usual rules for allocating community [1]

(1)Earned income is split evenly between spouses

(2)Rules for unearned income vary by state

(3)Expenses paid out of community funds are split evenly[2]

(4)Expenses paid out of separate funds are allocated to the spouse who pays them (54)

Example:

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Dividing Property In Divorce Tax Traps – Part 7 In Series

DAVID ELLIS - Dividing Property In Divorce Tax Traps – Part 7

(Part 7 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.) 

4. Individual Retirement Account (IRA) Transfers

Except for purposes of calculating the 10% early withdrawal penalty,[1] IRAs are not considered Qualified Plans and therefore there is no requirement that a QDRO be in place to avoid tax on their division in divorce proceedings.[2]

  1. a) IRA transfers between spouses are tax free if pursuant to a decree of separate maintenance or divorce (or written instrument related thereto).[3]
  2. b) A QDRO will not protect against early withdrawal penalty from nonqualified retirement plan such as an IRA, SEP or SIMPLE.[4]
  3. c) Letter Ruling 9344027

Although IRS Letter Rulings are binding only on the parties to which they are addressed, the author is of the opinion that the aforementioned should serve as a cautionary tale to any parties dividing IRAs in a divorce.

The ruling concerns two divorcing taxpayers that had entered into written separation agreement.  The taxpayers resided in a community property state.

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Dividing Property In Divorce Tax Traps – Part 6 In Series

DAVID ELLIS - Dividing Property In Divorce Tax Traps – Part 6

(Part 6 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In A Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.) 

2. How QDRO (Qualified Domestic Relations Order) Distributions are Taxed

a)The alternate payee assumes the same rights and responsibilities as the plan participant. When a distribution is made to a plan participant’s spouse or former spouse, it is taxed to such spouse or former spouse.[1]

Tax Trap Alert: When distributions are made to a dependent of a plan participant, they are not taxed to such dependent, but rather they are taxed to the plan participant.[2]

b)Basis is allocated on a prorated formula between the participant and the participant’s spouse or former spouse according to present value formulations.[3]

c).QDRO distributions not subject to early withdrawal penalty. Age of the alternate payee does not matter for QDRO distributions. No early withdrawal penalty [4]

Tax Trap Alert: Although QDRO distributions from qualified plans are not subject to the 10% penalty for early withdrawal, the same does not hold true for IRA’s, SEP’s, or SIMPLE plans regardless of any domestic relations court order.[5]

Tax Trap Alert: In the author’s experience, it is not unusual for an alternate payee to rollover distributions under a QDRO into an IRA. Assuming the alternate payee does not meet the age (or one of the other exceptions), subsequent distributions from the IRA will be subject to the 10% early withdrawal penalty. Practitioners should take care to call this tax pitfall to the clients’ attention prior to the rollover of the QDRO distribution into an IRA.

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Dividing Property In Divorce Tax Traps – Part 5 In Series

Dividing Property In Divorce Tax Traps - Part 5

(Part 5 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In A Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)  

Example: Rob Sr. and Mary are divorced. Mary and their son Rob Jr. continue to live in the former marital residence while Rob Sr. lives across town in an apartment. Rob Sr. pays the mortgage payment on the home.

Since Rob Sr. no longer uses the home as his principal residence, he cannot deduct the mortgage interest attributed to the payments under the principal residence mortgage interest rules. However, since Rob Jr. lives in the home, Rob Sr. can deduct the mortgage interest (assuming it otherwise qualifies) under the rules that allow mortgage interest for a second home to be deductible by a nonresident spouse when a direct family member continues to live in the residence.

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Dividing Property In Divorce Tax Traps – Part 4 In Series

Dividing Property In Divorce Tax Traps – Part 4 In Series

(Part 4 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In A Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)  

Dividing Property In Divorce Tax Traps – Part 4

  1. Mortgage Interest and Real Estate Taxes. An issue that practitioners frequently face in divorce situations is allocating the deduction between spouses for mortgage interest and taxes when one spouse has moved out of the residence and separate returns are being filed.
    • If spouses are still legally married at year’s end and a joint return is filed, there is no need to allocate deduction, even if spouses are living apart
    • If separate returns are filed and mortgage interest and/or real estate taxes paid from a joint account, half of the payment is allocated to each spouse.[1]
    • Interest and real estate taxes paid from separate accounts are deemed to be paid by the spouse who owns the account.[2]
    • In community property states, expenses paid from community property funds are generally allocated one half to each spouse.[3] Community property rules vary from state to state. Practitioners may need to consult legal counsel as to community property rules in their state. For example, in California, the marital community for tax purposes ends when the spouses separate with the intention not to reunite.[4] In other states, the community does not end until the date of divorce. In community property states, expenses paid from noncommunity funds are allocated to the spouse who paid them.
    • Interest payments must be “qualified” in order to be deducted. Often in a divorce situation, one of the spouses will move out of the house and establish a second residence, while continuing to contribute to the mortgage payments.

The question then arises as to if non-resident spouses can deduct their share of the mortgage interest, since they are no longer using the house as their principle residence.

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