When the CEO of Continental Resources, Harold Hamm, divorced from his wife, Forbes published an article about the possible tax consequences. The settlement ordered Hamm to pay his former wife $995.5 million. Forbes asked the obvious question: with this kind of hefty transaction, the tax man must surely get his share, right? Not quite. According to law, transfers of property between spouses during a divorce are virtually tax free. Good news for the Hamms. However, there are often unseen tax burdens later on.
Code § 1041 of the U.S. Internal Revenue Code lays out the rules for the taxation of marital property when it is transferred between spouses. Within the code, the “General Rule” states: “No gain or loss shall be recognized on a transfer of property” between spouses or former spouses. One can assume that during a matrimonial case, there are no worries over taxes involved in transferring property. In many cases, this is true. But there are some important things to consider before dividing marital assets. Below is an outline of some of the major issues that may cause tax consequences. For a more in-depth discussion of these issues, please follow the link at the bottom of this post to read our whitepaper.
Carryover basis is a method used to determine the tax basis of an asset when it has been transferred from one individual to another. In a divorce, the spouse that receives an asset also takes the carryover basis of the asset. Because the carryover basis can have later unforeseen tax consequences, it must be accounted for in division.
Often in a divorce, property which is subject to depreciation is split between parties. These assets can include buildings, machinery, equipment, furniture, computers, etc. When dividing property, it is crucial that depreciation values be taken into account and what future effects of value and taxation they may have.
Liabilities on Property
Many properties divided during a divorce have liabilities attached. Because, as we have seen above, § 1041 states that a transferred property between spouses is neither subject to gain or loss, when an asset has liabilities attached to it, these too are passed during a transfer. The tax consequences of such transfers can have disastrous effects.
Transferring to a Trust
Section § 1041 includes an exception to the “General Rule.” If a property with liabilities is placed into a trust (such as a nongrantor trust) which is then given to a spouse during the divorce, the liabilities are assumed by the trust. When this is the case, the spouse who is transferring to the trust will recognize a gain when the trust assumes the liabilities.
Passive income are assets gained or lost from non-active earnings. Generally these occur in situations where a person has a share in rental properties or in certain businesses where there is no material participation. Passive income has some strange tax rules around it (U.S. Code § 469). For example, passive losses are deductible—but only in relation to the gains. Also, losses that are not deducted can carry over and accumulate—these are known as suspended losses.
Things can become more complex when these types of passive assets are transferred during a divorce. Generally, when passive income is transferred, passive and suspended losses are added to the carryover basis before the transaction.
Incident to Divorce
A transfer of property which is “incident to divorce” is a transfer which is tied to and dependent on the divorce. To be specific, the IRS considers a transfer incident to divorce if it either occurs one year after the date on which the marriage ceases, or is related to the end of the marriage.
All of the taxation challenges above are exceptions. Even though the property transferred is, technically, “incident to divorce” in some way they are not immune to taxation. This is because many of these instances of taxation occur when the property is liquidated: whether it be stock, real estate, or other property. So, though the property transferred is incident to the divorce, the money bound up in it, is not.
When we consider the possible taxation scenarios above, Mrs. Sue Ann Hamm’s $995.5 million from her divorce may end up being much less. As New Age philosophers recommend, one should “think from the end” when looking at dividing properties during a divorce. One must ask what these assets and properties will be worth after the transfer if your client sells them. Is the division of property truly equitable? Or will the losses from tax erase that fairness?
These are complex and difficult questions to answer. Enlisting the help of an expert with a wide range of knowledge in valuation, forensic accounting, and matrimonial disputes, will be incomparably helpful to get to the real numbers behind property transfers so that a spouse receives what is truly fair.