A divorce ordinarily involves a transfer of cash or other property in exchange for the release of support or other marital rights as part of executing a marital settlement agreement. Under IRC Section 1041 the transfer of property between spouses or former spouses (if incident to divorce) is generally not treated as a taxable exchange. Confusing tax results can occur where the non-recognition rule of 1041 applies even where the marital parties are acting at arms’ length and full consideration is paid for the property. If 1041 applies, no step up in basis is received by the acquiring party in exchange for the consideration.
Section 1041 does not specifically address the tax treatment where a transferred asset, incident to a divorce, includes the rights to future income (e.g., the transfer of a bond or CD also entitles the owner to the accrued interest yet to be paid). Moreover, 1041 does not address the tax consequences of asset transfers involving the right to receive income (e.g. AR, contingent fees, and deferred compensation).
§ 1041 Is Overridden by ERISA for the Transfer of Qualifying Retirement Plans
Quite often one of the most valuable assets acquired during marriage are retirement plans like, deferred comp, IRA’s, Retirement plans qualified under ERISA, and similar tax-preferred benefits. Over time, Congress has enacted various statutory provisions to regulate the tax treatment of divorce generated transfers of future retirement and other tax preferred plan benefits to non-owner/participant spouses which override both the reach of § 1041 and general assignment of income principles.
ERISA generally dictates that retirement benefits cannot be assigned. However, a carve out to this prohibition exists in regards to divorce via a mechanism called a QRDO. Under ERISA § 206(d)(3)(B)(i) and IRC § 414(p)(1)(A) a “qualified domestic relation order” (QDRO) is a court order that carves out and recognizes the right to receive retirement distributions in the name of the spouse that did not earn the retirement funds at some point in the future. It assigns a right to receive, all or a portion of the benefits payable in regards to a retirement plan participant spouse to a non-participant spouse if the QDRO meets certain information and other requirements. A QDRO is ordinarily negotiated as part of a marital property settlement agreement. In order for a spouse to grant a share of a retirement benefit subject to ERISA to an ex-spouse, the terms delineated in the martial settlement agreement are required to comply with a myriad of requirements laid out in IRC Section 414(p). In addition Section 457 deferred compensation plans for governmental and certain non-profit employees can also be qualified domestic relation order rules. QDRO’s are not required for a divorced-based IRA transfer.
Division of pension plan befits planning considerations:
- If one of the parties has creditor problems, it is important to realize that ERISA plans are generally not subject to creditor claims. The same is not always true of IRA although some states have enacted laws to provide creditor protection for IRAs.
- If one of the spouses has health problems or believes because of their family healthy history, they will most likely live longer, and a defined benefit plan is at issue. By the healthier spouse retaining or being granted benefits under a QDRO, a greater lifetime financial benefit can be achieved and other assets from the martial estate can equalize the property distribution if necessary and if not a cash settlement and promissory note could be utilized.
- Be careful that an IRA is not liquidated in order to give a divorcing spouse their ½ interest but rather a trustee to trustee transfer is utilized via a QRDO. In Bunney v. Commissioner – United States Tax Court, T.C. Memo. 2003-233, the Tax Court dealt with a vindictive spouse’s attempt to enjoy revenge against his ex-spouse in a divorce. After the court determined the wife was entitled to half of the husband’s IRA. The husband liquidated the IRA and paid 50% of the cash to his ex-spouse. The husband incorrectly anticipated that his ex would be legally responsible for both the income taxes and the associated early withdrawal penalty on the 50% of the distribution she received. To the surprise of the husband, the tax court held that the husband was responsible for the income tax on 100% of the funds withdrawn from the IRA and for the 10% early withdrawal penalty. The vindictive husband wound up paying all of the taxes and penalties, while his ex-spouse received an $111,600 tax free distribution from the IRA.
Generally, an Ex-spouse has two choice of methods to receive an ERISA benefit of a spouse under a QDRO. They can choose that any current distributions should be rolled into an IRA, or they can choose to leave the funds in the ERISA plan and draw upon those benefits in the future at retirement. In deciding which option makes the most sense, the following issues should be considered:
- If the recipient spouse has creditor problems, staying with an ERISA plan benefit account would provide better asset protection.
- If the participant spouse is not 100% vested in the ERISA plan, it is ordinarily financial beneficial to stay with an ERISA plan account until full vesting is achieved.
- A comparison should be made of the historic and anticipated future rates of return and risks level encountered in staying with the ERISA plan and this same analysis extended to what is available in an IRA.
- If the ERISA plan is sponsored by a family business that is controlled by the ex-spouse, the recipient spouse might want to consider rolling the plan benefits into an IRA to establish control over the benefits.
When a Taxpayer Assigns Future Income, Tax Liability Shifts to the Assignee
Ordinarily the taxpayer that earned income is taxed on it. However, where a taxpayer assigns an income producing asset, the tax liability on any future income stream shifts to the assignee. To reconcile between the non-recognition principles of § 1041 and anti-assignment of income principles, it is necessary to turn to administrative guidance and case law.
The IRS generally takes the position that income received subsequent to a transfer of a right to future income is taxable to the transferee. Any attempt by the transferee spouse to take the position that § 1041 makes the income nontaxable because there was a relinquishment of marital rights in exchange for it would be rejected by the IRS, unless the transferee spouse can establish that the income they received had already accrued while in the possession of the transferor spouse and therefore it is rightfully taxable to the transferor under general anti assignment of income holdings (consider accrued bond interest prior to the date the asset is transferred for example). In Kochansky v. Commissioner the divorcing spouses agreed via marital settlement that they would share a contingent fee that was pending to the husband’s law practice. The Court held the portion received by the wife was taxable to the husband as it was non assignable personal services income via general anti assignment of income tax law principles.
