Originally published on Forbes.com June 29th, 2013
The Tax Court decision in the case of Martin Toombs has one of those “What were they thinking ?” stories behind it. When a couple divides up their assets in a divorce, there is a third unseen party at the table – the tax collector. Fortunately, there is a Code Section that can keep the collector at bay – Code Section 1041, Code Section 1041 provides that no gain or loss is recognized on transfers of property incident to a divorce. That is why one of the two ways to get out of a burned out tax shelter that actually works is giving it to your spouse and getting a divorce. (The other way is even more extreme. Dying.)
The old tax shelter joke illustrates a subtlety of Code Section 1041 that is seldom appreciated. Each ex-spouse has carryover basis. A couple who wants to divide things equally who mixes and matches and comes to 50/50 on a fair market value split will likely not have an equal after tax split. My evidence for this is entirely anecdotal, but I am going to go out on a limb here and say that the typical couple that has any net worth at all, will have most of it in two things – tax deferred retirement accounts and home equity.
The former will generally have no basis at all. The latter can frequently be cashed in tax-free, thanks to high basis and the $250,000 gain exclusion. Of course the tax deferred retirement account might have many future years to grow tax deferred, which can make the whole matter rather confusing. It may well be that avoiding confusion was the purpose of the deal that Mr. Toombs made with his ex-spouse.
“Article V” of the amended MSA memorializes the former couple’s agreement that petitioner would acquire the right to receive a 50% interest in the “marital share” of Ms. Toombs’ TSP account incident to their divorce, with such funds being payable to him. Article V of the MSA also states: “Immediately upon such funds becoming available for withdrawal by Husband, Husband shall withdraw his entire share of the monies in the Thrift Savings Plan and pay such funds to Wife as partial payment of the monies owed to Wife for her share of the equity in the marital residence.”
“Article VII”, dealing with the marital residence, states: “Husband shall immediately cash in his share of Wife’s Thrift Savings plan and pay these entire funds to Wife”.
In addition “Article X” of the MSA states: “The parties agree that all allocations and transfers of property pursuant to this divorce proceeding are intended to be non-taxable events except as otherwise provided herein.” Article X of the MSA further states: “The parties shall execute any documents necessary to insure the non-taxable status of said property allocation herein.” Petitioner’s divorce attorney discussed Article X of the MSA with petitioner at the time of petitioner’s divorce.
Sadly, they forgot to ask the silent third party about that non-taxable event. You can split up the retirement accounts and the home equity any old way you want. When you withdraw money from the retirement account, that you don’t roll over, you are going to have a taxable event. And it is one of those taxable events that generates a 1099.
Mr. Toombs laid the whole divorce agreement and the inevitable 1099 on a commercial taxpayer to puzzle out the correct answer.
Petitioner paid a commercial tax return preparer to prepare his 2007 Federal income tax return. Petitioner discussed his divorce with his preparer and provided the preparer with a Form 1099-R, Distribution From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., showing a “Gross distribution” of $25,248 and a “Taxable amount” of $25,238. Pursuant to his preparer’s advice, petitioner included the $25,248 gross distribution in his 2007 gross income and claimed a $24,248 alimony deduction representing the payment he made to his former spouse in that year.
That answer was so wrong that Mr. Toombs did not even advance it in Tax Court. Instead he had another theory.
According to petitioner, after he was awarded a 50% interest in his former spouse’s TSP account, he allegedly sold that interest back to the TSP pension administrator in exchange for $25,248 in “sales proceeds”. In petitioner’s view, the alleged “sale” of his 50% interest to the plan administrator in exchange for $25,248 was a transfer of property to a third party on behalf of his former spouse required by the divorce decree and, therefore, was a nontaxable event under section 1.1041-1T(c), Q&A-9, Temporary Income Tax Regs.
That did not work either. The Tax Court did cut Mr. Toombs a break when it came to penalties.
It is clear from the record that petitioner is not a tax expert or experienced in tax matters and relied reasonably and in good faith on his divorce attorney and return preparer to determine the treatment of the payment made to his former spouse.
What Were They Thinking ?
Not only is Mr. Toombs not himself a tax expert, it appears that he may never even have met one. If the money was coming out of the retirement account, either he or his wife was going to be taxable on it. What was the point of doing a QDRO to transfer the account to him, only to have him withdraw it and turn it over ?
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