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).
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:
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:
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.