Section 1041 does not apply across the board to every possible transfer between spouses. The internal revenue code specifically contains exceptions that lead to transfers between H and W that do not qualify for 1041. Case law and IRS guidance continually defines and adjusts the reach and application of Section 1041. Where a transfer is removed from the reach of § 1041, the IRC may dictate the tax treatment that will apply to a transfer rather than the non-recognition (gift) provisions of § 1041. Where neither § 1041 and the IRC does not dictate alternative tax treatment, a common law doctrine might control.
§1041 Does Not Apply to Negative Basis Property
Section 1041 does not apply to transfers of negative basis property to trusts for the benefit of an ex-spouse incident to divorce. While § 1041 would appear to apply to a transfer of negative basis property in trust between H and W or formerly married parties where the transfer is incident to divorce, § 1041(e) overrides the normal non-recognition “gift” treatment of 1041 and requires the transferor spouse to recognize a gain where the liabilities transferred exceed the adjusted tax basis of the property transferred in trust. The basis of the property funded to the trust is increased by any gain so recognized.
An exception to § 1041(e) appears to exist for grantor trusts. In PLR 9230021, the IRS opined that the grantor transferor spouse that remained fully taxable under § 674 was not required to recognize gain upon transferring a partnership interests that had liabilities in excess of the transferor spouses’ partnership basis to a trust he created for the benefit of his ex-spouse.
§1041 Does Not Apply to Negative Basis Partnership Interests
Ordinarily when a partner’s allocable share of a partnership’s liabilities is greater than the adjusted basis of his partnership interest and he or she transfers this negative basis property to a third party a taxable gain would result. Such a transaction will receive non recognition “gift” treatment under § 1041 if between former spouses and incident to a divorce. The same is true where only a portion of a spouse’s negative basis partnership interest is transferred between former spouses and incident to divorce.
Careful planning as to whether a transfers of negative basis property to an ex-spouse outright or in trust will have adverse income tax ramifications is necessary, but it may be possible to plan and structure around potential income tax problems.