Alimony and Payments to Divorce Lawyer Did Not Increase Basis of Marital Property

(Parker Tax Publishing August 2020)

The Tax Court held that payments a taxpayer made to his ex-wife and his divorce lawyer did not increase his basis in a limited liability company, which he owned and subsequently sold during his divorce in order to provide his ex-wife with her share of the marital assets. The court rejected the taxpayer's argument that he should be entitled to capitalize those payments on the theory that he was removing a cloud on his title to assets that might be subject to collection action if he defaulted on certain obligations to his ex-wife. Matzkin v. Comm'r, T.C. Memo. 2020-117.

Background

In 2003, Steven Matzkin, a dentist by profession, formed Dental Care Alliance, LLC (DCA), a partnership for federal income tax purposes. DCA is a dental support organization that provides services to affiliated dentists around the country. On January 1, 2008, Steven assigned his 70 percent membership interest in DCA (the entirety of his interest) to SRM Consulting, LLC (SRM), an S corporation of which he was the sole shareholder. SRM thereafter owned a 70 percent membership interest in DCA. When Steven formed DCA he was married to Georgeann Matzkin. In May 2008, after more than 20 years of marriage, Steven filed for divorce. Steven's 100 percent interest in SRM (and by extension his 70 percent indirect interest in DCA) constituted marital assets under Florida law. An appraisal performed in 2007 valued DCA at $30 million; Steven's 70 percent indirect interest was thus assumed to be worth about $21 million.

The couple's principal assets were $4.6 million in cash and securities, $6 million in real estate, $1 million in life insurance, artwork and furniture with a value to be determined, and Steven's indirect interest in DCA, with an assumed value of $21 million. Originally, the couple was going to split the assets 50-50, but Georgeanne did not want, and could not realistically be given, a $10.5 million partnership interest in DCA. So the couple agreed that Steven would pay Georgeann her $10.5 million share by making upfront cash payments, by executing a promissory note, and by paying Georgeann's share of the couple's liabilities. They further agreed that Steven would make a lump-sum payment to Georgeann and execute a note secured by his interest in the partnership. Interest only would be due on the note, with the principal payable in October 2014 or when DCA was sold (if earlier). If DCA were sold within 18 months for a price exceeding $30 million, then Georgeann would receive half of Steven's pro rata share of any proceeds above $30 million. The couple agreed that Georgeann would receive no alimony apart from Steven's payments on the promissory note, which would "be deemed nonmodifiable and non-taxable alimony."

In January 2009, a Florida trial court adopted the couple's agreement and entered a final judgment of divorce. Steven paid legal fees exceeding $160,000 in connection with the divorce and the negotiations leading up to it. Steven remarried and, on May 24, 2012, SRM sold its interest in DCA for $93,770,600. Gains from that sale passed through to Steven as SRM's sole shareholder. On their joint federal income tax return for 2012, Steven and his wife reported net long-term capital gain of $85,735,315 on the sale of SRM's interest in DCA. The IRS selected their return for examination and adjusted the gain upward by almost $5.4 million and determined a deficiency of $804,000.

Steven and his wife contested the deficiency, arguing that SRM was entitled to additional basis in DCA, and thus a downward adjustment to net capital gain, by virtue of Steven's payments to Georgeann and his attorney in connection with the divorce. Steven and his wife took their case to the Tax Court.

Before the Tax Court, the attorney who represented Steven in his divorce testified on the nature of Steven's payments, which were described in the divorce agreement as non-modifiable alimony for Georgeann's support and maintenance. Neither the IRS nor Steven contended that Steven's payments should be considered alimony for federal tax purposes.

Instead, Steven asserted that Georgeann's claim to an equitable share of marital assets constituted a "cloud hanging over" Steven's title to his partnership interest. He anticipated that DCA would eventually be sold, and as seller he would need to convey good title to the buyer. Steven characterized the payments he made to Georgeann and his divorce lawyer as made "in order to retain clear title over the DCA membership interests which he retained." He cited the principle that amounts paid to defend or perfect title to real or personal property are amounts paid to acquire or produce property and must be capitalized.

Analysis

The Tax Court began by noting that the agreement between Steven and Georgeann was ambiguous and, thus, the parties' negotiating history was relevant in dispelling the ambiguity. The negotiating history, the court observed, made absolutely clear that the parties desired to effect an equitable distribution of marital assets, including real estate, cash and securities, life insurance, personal property, and Steven's indirect interest in DCA. Although Steven's payments were made over time, the court determined that they were components of lump-sum alimony payable in installments.

The court then looked at factors that would increase a partner's basis in a partnership. The court noted that, upon formation on January 1, 2008, SRM's basis in DCA presumably equaled Steven's basis in DCA. Code Sec. 705(a)(1) provides that a partner's initial basis is increased by the sum of the partner's distributive share of (1) taxable income of the partnership as determined under Code Sec. 703(a), (2) income of the partnership exempt from income tax, and (3) the excess of the deductions for depletion over the basis of the property subject to depletion. Steven's payments to Georgeann and his divorce lawyer, the court said, did not affect SRM's distributive share of DCA's income or deductions. Accordingly, the court concluded that the payments did not increase or otherwise affect SRM's basis under Code Sec. 705(a)(1).

The court also rejected Steven's argument that Georgeann's claim to an equitable share of marital assets constituted a "cloud hanging over" Steven's title to his partnership interest and payments to retain clear title to that interest constituted amounts that should be capitalized. It found this argument unpersuasive for several reasons. First, the payments to Georgeann and to the divorce lawyer were made by Steven, not by SRM, which owned the 70 percent partnership interest in DCA. It did not appear to the court that SRM incurred any expenses to "clear title" to its ownership interest. Steven did not satisfactorily explain, the court said, why his payments, if capitalizable at all, should not be capitalized to his basis in SRM, rather than to SRM's basis in the partnership. Second, the court said, even if Steven had owned a direct partnership interest in DCA, Georgeann's claim to marital assets did not cloud his title, and his payments to her were not made to defend or perfect title to personal property. When Steven filed for divorce, the court observed, Georgeann accrued a claim for an equitable share of the marital assets. This claim did not cloud Steven's title to any particular asset that he owned, be it real estate, bank accounts, stocks and bonds, works of art, or partnership interests. Rather, the court noted Georgeann accrued a claim to receive her equitable share of the value of the marital assets. According to the court, it was up to the parties (or the divorce court absent agreement) to decide which assets would be conveyed to Georgeann to satisfy her claim to that value. Even if Georgeann had desired an ownership interest in DCA, the court noted, her recourse against Steven to secure an equitable share of marital assets would not have included the ability to compel a reallocation of partnership interests.

The court reviewed the rules for capitalizing amounts paid to defend or perfect title to personal property and found that Georgeann never questioned Steven's title to the indirect interest he held in DCA (or to any other personal property). In effect, the court said, Steven was arguing that any debtor who honors his obligations is entitled to capitalize those payments on the theory that he is removing a cloud on his title to assets that might be subject to collection action if he defaulted. That is plainly not the law, the court stated, because if it were, every payment by a partner on a personal debt would increase his basis in the partnership.

Finally, with respect to Steven's complaint that if the court did not allow a basis increase in DCA, he would have no way of recovering the costs of his divorce against his taxable income. The court responded that this was correct and unsurprising because Steven agreed to a property settlement through which Georgeann received an equitable share of the marital assets and spousal payments made pursuant to a property settlement are not tax deductible.

For a discussion of the tax treatment of transfers of property between spouses incident to a divorce, see Parker Tax ¶14,250.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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