Originally published on Forbes.com May 7th, 2014
When you transfer property to your spouse or a former spouse incident to a divorce, no gain or loss is recognized. It has been that way since 1984. It’s a good rule that makes things simpler. There is a complicated side-effect though. Since it is a non-recognition transaction, there is no change in the basis of the property. So say you and your spouse bought a vacation home for $30,000 many years ago that is now worth $300,000. You borrow $150,000 to buy your spouse out when you split. You better like that house, enough to keep it indefinitely or use it as your main home for a couple of years, because you will have a $270,000 taxable gain if you sell it for $300,000.
Gina Weaver-Adams bumped into this no change in basis rule in a recent Tax Court decision. She was not dealing with a house, but rather a 401-k. There is some extra tax paperwork required to transfer a retirement account incident to a divorce, but the principle is the same. Ms. Weaver-Adams could have rolled the account over to her own IRA, but she wanted to take the money without paying taxes instead. She was disappointed – and penalized. Here is some of the story.
Petitioner was married to Michael Adams. On July 23, 2009, petitioner and Mr. Adams (ex-husband) were divorced by final decree (Divorce Decree) in California. Petitioner’s ex-husband participated in his employer’s 401(k), which was administered by Mercer Trust Co. (Mercer). Petitioner was named an alternate payee of the 401(k) pursuant to a Qualified Domestic Relations Order (QDRO) as part of the Divorce Decree. The QDRO provided that petitioner, as alternate payee, was liable for any income tax on distributions from the 401(k).
In 2009 petitioner requested and received a distribution of $103,098 from Mercer (Distribution) as the alternate payee. Mercer issued petitioner a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reflecting the Distribution and withheld $10,310 in Federal income tax and $1,031 in State income tax. Petitioner reported the Distribution on the tax return for 2009 as nontaxable pension and annuity income.
Ms. Weaver-Adams argued that her husband was indebted to her and paid her back by transferring the 401(k). She argued that the debt her husband owed gave her basis in the 401(k).
The Tax Court wasn’t buying it.
Petitioner’s assertion that she has basis in the 401(k) because she received the Distribution as part of the Divorce Decree is legally unsupported. Petitioner received the Distribution as a transfer of property made incident to divorce because it occurred within one year of the marriage ending and was related to the marriage ending. As a result, petitioner received her ex-husband’s adjusted basis, which was zero. Petitioner’s ex-husband contributed pre-tax dollars pursuant to the rules for tax-deferred 401(k) plans and therefore had zero basis in the 401(k)…..
The Distribution cannot escape taxation because petitioner erroneously believed that her ex-husband’s debt to her created basis in the 401(k).
Ms. Weaver-Adams had reported the distribution on her return, albeit incorrectly as non-taxable, so she was not hiding anything in a sense. Her theory had some common sense to it. So, I would have been inclined to let her go on the accuracy penalty. The IRS, on the other hand, seems to always assert the accuracy penalty if the threshold is met, at least on cases that go to Tax Court. The Tax Court usually backs them up, as it did in this case.
We understand petitioner to argue that she had reasonable cause for treating the Distribution as nontaxable income because she contends that she relied in good faith on the advice of her tax professional. Petitioner’s assertion is unsubstantiated. Petitioner did not demonstrate that a tax professional advised her to take the position that the Distribution was nontaxable income. Petitioner’s inclusion of an unauthenticated and unsigned document, purportedly created by her tax professional, does not substantiate her claim. Moreover, there is nothing in the record regarding whether the Distribution was nontaxable income. Additionally, there is nothing in the record demonstrating that petitioner provided the Form 1099-R to her tax professional.
Ms. Weaver-Adams was representing herself in Tax Court. It seems like a little coaching might have helped her build a better case on the penalty. The other thing I wonder is whether she might have got the penalty waived by Appeals if she settled at that level. Would love to hear from some people who do more controversy work than I do on that question.
You can follow me on twitter @peterreillycpa.