Articles - Virginia Tax Lawyer - Partnership

Divorce and Taxation

Many concerns go through one’s mind when he or she is a party to an impending divorce. Whether concerns with regard to the custody of his or her child or children, division of the marital assets, or the allocation of debt between a husband and wife, all of these concerns, and many more not mentioned here, are justifiable and warrant the attention and consideration of someone who is involved in a pending divorce proceeding. However, another important consideration, which, if overlooked, could significantly impact one’s financial situation, is the federal tax treatment of distributions made on behalf of either a husband or wife to his or her then spouse.1 Generally, a transfer between a husband and wife, incident to a divorce, will not result in a taxable event in which the receiving spouse will have to report the assets which he or she receives from the transferring spouse as income. A transfer from a former spouse to his or her former spouse is considered incident to a divorce if it takes place within one (1) year after the date on which the marriage ceases or it is related to the cessation of the marriage.

A potential tax issue arises in the event a third party distributes assets on behalf of either a husband or wife to his or her spouse incident to a divorce, rather than the husband or wife directly transferring assets to the spouse. For example, imagine a situation where a husband is the sole owner of a profitable corporation. Husband and wife are in the process of obtaining a divorce, and it has been determined that the husband needs to distribute a specified sum to his wife to equalize the assets owned respectively by the husband and wife. If the husband has sufficient liquid assets, such as cash in a bank account or one or more other assets which could easily be converted to cash, then it should not present an issue for the husband to transfer the total of the specified sum directly to his wife. Now, however, suppose that the husband’s major asset is his interest in the corporation and the husband does not have sufficient liquid assets to directly transfer the total of the specified sum to his wife, as required. Therefore, the husband decides he will satisfy the distribution to his wife with cash held in a corporate bank account. On its face, it might not seem to matter whether the asset is transferred directly from the husband or on behalf of the husband by the corporation. However, as related earlier in this article, the exception to taxation incident to a divorce is for transfers from one spouse to the other spouse, and the exception does not explicitly include the situation in which a spouse directs his or her wholly-owned corporation to distribute the assets on his or her behalf to the spouse. This difference in the transferring party, husband versus a corporation solely owned by husband, however subtle and insignificant it might seem, could be the difference between no taxable income to wife (in the scenario where husband is the transferring party) versus potential taxable income to wife (in the scenario where husband’s wholly-owned corporation is the transferring party). With reference to the above example, if the wife wishes to expressly avoid a situation where the assets she receives in connection with the divorce will be treated as taxable income to her, then she should make sure the divorce settlement specifically addresses the tax treatment of the transfer, and, the wife, or her legal counsel, should make sure it is characterized as a transfer of the specified sum first from the husband’s wholly-owned corporation to the husband and then secondly a transfer of the specified sum from the husband directly to the wife. By structuring the transfer in this manner, the transfer from husband to wife, step two in the process, clearly falls within the above-referenced exception set forth in the Internal Revenue Code.2

No matter the value of the assets to be transferred between spouses in connection with their divorce, it can be assumed, in most, if not all, instances, that the receiving spouse will wish to avoid, to the fullest extent possible, having to pay federal income taxes attributable to assets he or she receives pursuant to a divorce settlement. As this article shows, among the many concerns to contemplate in connection with a divorce, it is important not to overlook the potential federal tax implications which may arise from transfers made in connection with a divorce. Someone who is in the process of obtaining a divorce should seek the advice of his or her legal counsel, or other tax advisor, regarding the potential federal tax implications of any proposed divorce settlement prior to agreeing to such a settlement.

1Note, it is not within the scope of this article to discuss the potential state income tax implications arising from transfers between spouses (or former spouses) incident to a divorce.
2Note, it is not within the scope of this article to address the potential federal or state tax implications to husband arising from the transfer from husband’s wholly-owned corporation to husband described in step one of the above transfer process.