Sale of Marital Businesses to Former Spouse Qualifies for Nonrecognition Treatment

(Parker Tax Publishing June 2016)

The Tax Court held that, because neither Code Sec. 1041 nor the regulations limits application of Code Sec. 1041 to a single division of marital property, a taxpayer's sale of his portion of marital businesses to his ex-wife, subsequent to a divorce settlement, qualified for nonrecognition treatment. The court concluded that Code Sec. 1041 can apply to divisions of marital property accomplished through a sale, and the fact that the lawsuit (brought sixteen months after the settlement) that led to the sale was filed in a different court was irrelevant. Belot v. Comm'r, T.C. Memo. 2016-113.

Facts

In 1989, Joseph Belot and his wife, Ms. Belot, opened a traveling dance school, for which they reported income and expenses on Schedule C, Profit or Loss From Business. In 1996, they incorporated the business as Gotta Dance, Inc. Ms. Belot was the sole shareholder of Gotta Dance. In 1997, Joseph and Ms. Belot formed Gotta Dance Boutique, LLC (Boutique), which sold dancewear and accessories. They each owned 50 percent of Boutique. In 1999, Joseph and Ms. Belot formed Jobee Realty, LLC (Jobee), a partnership that held and leased real estate. Ms. Belot owned 49 percent and Joseph owned 51 percent of Jobee. The couple jointly made decisions with respect to Gotta Dance, Boutique, and Jobee (collectively, the businesses).

In 2006, the couple began divorce proceedings and, pursuant to a court order in early 2007 (the 2007 divorce agreement), they equalized their ownership interests in Gotta Dance and Jobee. Ms. Belot transferred 50 percent of the stock in Gotta Dance to Joseph and Joseph transferred a 1 percent interest in Jobee to Ms. Belot. Once these transactions were complete, Joseph and Ms. Belot each owned a 50 percent interest in Boutique, Gotta Dance, and Jobee.

Toward the end of 2007, Ms. Belot filed a lawsuit against Joseph and Gotta Dance, arguing that Joseph had mismanaged the business. She sought to remove him from Gotta Dance and to compel him to sell his shares of Gotta Dance either to the corporation or to her. In 2008, Joseph and Ms. Belot entered into a settlement agreement (the 2008 settlement agreement) in which Ms. Belot agreed to buy all of Joseph's interests in Gotta Dance, Boutique, and Jobee for a total of $1,580,000. Joseph and Ms. Belot executed a stock and membership interest purchase agreement which allocated the total $1,580,000 among the interests in the various businesses.

Upon auditing Joseph's tax return for 2008, the IRS assessed a deficiency relating to the 2008 sale of the businesses to Ms. Belot, saying the sale resulted in taxable gain. Joseph argued that the sale qualified for nonrecognition under Code Sec. 1041.

Tax-free Transfers Between Spouses Incident to a Divorce

Code Sec. 1041 generally provides that no gain or loss is recognized on a transfer of property from an individual to a spouse, or former spouse, but only if the transfer is incident to the divorce. Reg. Sec. 1.1041-1T(b), includes the following considerations to be taken into account in determining when a transfer of property is considered incident to a divorce:

(1) A transfer of property is treated as related to the end of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in Code Sec. 71(b)(2), and the transfer occurs not more than six years after the date on which the marriage ceases.

(2) A divorce or separation instrument includes a modification or amendment to such decree or instrument.

(3) Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than six years after the cessation of the marriage is presumed to be not related to the cessation of the marriage.

(4) This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage.

IRS Arguments

According to the IRS, the 2008 settlement agreement did not qualify for nonrecognition treatment under Reg. Sec. 1.1041-1T(b) because the transfer did not relate to the divorce instrument. The 2007 divorce agreement, the IRS said, resolved all of the property issues between Joseph and Ms. Belot and Ms. Belot's dissatisfaction with the first settlement agreement led to the second settlement agreement which was basically a business dispute. In form and in substance, the IRS pointed out, the division of the marital businesses made by the second settlement agreement was a sale.

The IRS also argued that the fact that Ms. Belot filed the 2008 lawsuit in a superior court rather than the family court showed that the lawsuit concerned a business dispute, not a marital dispute.

Tax Court's Analysis

The Tax Court held that Joseph's sale to Ms. Belot of his interests in the marital businesses pursuant to the 2008 settlement agreement qualified for nonrecognition treatment under Code Sec. 1041. The court disagreed with the IRS's contention that the transfer of the marital property under the second settlement agreement did not relate to the divorce instrument. The court noted that, while Reg. Sec. 1.1041-1T(b) provides that there is a presumption that Code Sec. 1041 does not apply to any transfer not pursuant to a divorce or separation instrument, it also provides that this presumption may be rebutted by showing that the transfer was made to effect the division of property owned by the former spouses at the time the marriage ended. The court observed that James and Ms. Belot made two attempts to satisfactorily divide their marital businesses. The first attempt was the 2007 divorce agreement and, when that agreement quickly proved unsatisfactory, the couple entered into the 2008 settlement agreement.

With respect to the IRS's argument that the 2007 divorce agreement resolved all of the property issues between Joseph and Ms. Belot, the Tax Court noted that neither Code Sec. 1041 nor the regulations limit application of Code Sec. 1041 to one, or the first, division of marital property. Similarly, the court observed, neither Code Sec. 1041 nor the regulations bars application of Code Sec. 1041 to divisions of marital property accomplished through sales.

With respect to the IRS's characterization of Ms. Belot's dissatisfaction with the first settlement agreement as a business dispute, the court noted that Code Sec. 1041 and the regulations can apply to marital property which consists of business-related property.

Finally, the court rejected the IRS's argument that because the lawsuit filed by Ms. Belot after the 2007 divorce agreement was not filed in the family court, that showed the lawsuit concerned a business dispute, not a marital dispute. The application of Code Sec. 1041 to a transfer resulting from the settlement of a lawsuit, the court said, is not determined by the forum in which the lawsuit is filed.

For a discussion on transfers of property between spouses, 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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