Gift Tax Implications in a Divorce

Take-Away: Gift taxes can be a surprise to some individuals who have just completed their divorce. While most transfers of assets incident to a divorce do not cause a federal gift tax, there are some circumstances when a surprise taxable gift can occur.

Background: Many attorneys who handle divorces are unaware of the potential gift tax implications that can arise with a divorce settlement. Without special treatment provided by the Tax Code, assets transferred to a former spouse incident to a divorce settlement, or to children of the marriage, will be like any other irrevocable transfer of assets and thus be subject to the imposition of a federal gift tax. While the individuals going through a divorce usually do not feel gratuitous towards the other, it is important to remember that the Tax Code does not require any donative intent in order to impose the federal gift tax on the transfer of wealth.

Tax Code Exclusions from Gift Tax: There are three statutory authorities under which a transfer of assets incident to a divorce are excluded from federal transfer taxation.

1. IRC 2516: This is the primary source under which a transfer of assets to a former spouse pursuant to a divorce escapes federal gift taxation. IRC 2516 provides:

Where spouses enter into a written agreement relative to their marital and property rights and divorce occurs within the 3-year period beginning on the date 1 year before such agreement is entered into (whether or not such agreement is approved by the divorce decree,) any transfers of property or interests in property made pursuant to such agreement-

To either spouse in settlement of his or her marital or property rights, or

To provide a reasonable allowance for the support of issue of the marriage during minority

shall be deemed to be transfers made for a full and adequate consideration in money or money’s worth.

2. IRC 2512(b): A transfer of assets that does not qualify under IRC 2516 may still avoid federal gift taxation if the transfer is made in full consideration for surrendered rights.‘ Again, donative intent is not required for a federal gift tax to be imposed. [Regulation 25.2511-1(g)(1).] The release of future support rights can constitute ‘adequate consideration’, and thus can avoid taxable gift treatment. However, to constitute ‘adequate consideration’ the support rights that are released must be assigned an economic value. Accordingly, a taxable gift will arise to the extent of the excess of the value of the transferred property over the exchanged value of that support obligation. [Revenue Ruling 77-514.]

The benefit of IRC 2512(b) exclusion from the federal gift tax is that property can be transferred, which would otherwise be outside the scope of IRC 2516, to a child of the marriage after their age of majority and not be treated as a taxable gift- just so long as the value of the transferred asset is equal to the child’s rights being released. However, since child support rights generally cannot be fully released, and because there is no generally accepted valuation methodology for legal support rights, this Tax Code section is not a widely used for the transfer of assets to minor children as a part of a divorce settlement.

Example: A divorce agreement provided for an annuity to be created for the wife, with the remainder to pass to the spouses’ adult children. The husband established that the wife actively bargained for and she relinquished her support rights in exchange for the full present value of the annuity. Consequently, there was no taxable gift by the husband to the wife. Yet, with those same facts, because the wife had relinquished her support rights in exchange for the annuity, she would be deemed to have made a taxable gift of the remainder to her adult children in the amount of her relinquished support. [Revenue Ruling 79-363.]

3. IRC 2043(a): Corresponding to IRC 2516, this Tax Code section provides that transfers at death in fulfillment of such obligations created under a divorce settlement agreement are also deemed to be for ‘full and adequate consideration.’ IRC 2043(b)(2) now provides that effective after July 18, 1984, for purposes of IRC 2053(a)(3) a transfer of property that satisfies the requirements of IRC 2516(1) will be considered made for ‘adequate consideration in money or money’s worth.’ Thus, the relinquishment (or promised relinquishment) of marital rights in a decedent’s property in favor of a third-person does not result in a taxable distribution at the decedent’s death with respect to the transferred property. Instead it is treated as a deductible as a payment on an executory contract of the decedent’s estate.

Harris Rule: Prior to the adoption of IRC 2516, there were a series of court cases that addressed the transfer of assets to a spouse or children of the marriage pursuant to a divorce decree entered by a court. These cases acknowledged how such a court-ordered transfer of assets might not be sufficiently voluntary to be properly subject to the federal gift tax. The key case was Harris v. Commissioner, 340 U.S. 106 (1950). This Supreme Court decision cited principles much broader than IRC 2516 which, as noted, has technical and timing limitations. Known as the Harris Rule, it leads to the legal conclusion that no taxable gift exists where the transfers are made pursuant to the parties’ Property Settlement Agreement, which in turn was incorporated into the divorce decree which the divorce judge had approved as an order of the court. [See McMurtry v Commissioner, 203 F.2d 659, 1st Cir 1953.] In short, court ordered transfers of property made incident to a divorce judgment are involuntary transfers that are not subject to gift taxation.

Incorporation by Reference Protection: Subsequent federal court decisions have held that a settlement agreement between the spouses that becomes part of the court judgment for purposes of the Harris Rule simply by incorporation by reference into the divorce decree, as long as the court had the power to review and approve the agreement, will avoid gift taxation. Accordingly, many believe that Harris effectively exempts the transfer of assets from federal gift tax as long as the transferor’s obligations are determinable and enforceable under the terms of the court signed Judgment of Divorce.

Maybe: One outlier case to the contrary is Spruance v. Commissioner, 60 Tax Court 141, affirmed 505 F.2d 731 (3rd Cir. 1974). There, the Tax Court warned that “Harris did not incorporate a broad rule that all transfers based on a court decree need not be supported by adequate consideration and that all involuntary transfers are free from gift tax.” In Spruce, the Court held that remainder interests given to the martial children in a divorce settlement trust- and receivable by them as adults-were taxable gifts by their parent. This reasoning, however, had not since been cited by courts or the IRS, so it is not clear if this case remains a reliable statement of the law.

Merger v. Incorporation: A technical rule that divorce lawyers argue about (sometimes incessantly) is whether a separate property settlement agreement should be merely incorporated into the Judgment of Divorce, or ‘incorporated and merged’ into the Judgment of Divorce. If only incorporated, then the property settlement agreement remains a separate contract that can be sued upon, and is subject to a much longer statute of limitations if its provisions need to be enforce in later court proceedings. With the property settlement agreement being merged into the Judgment of Divorce, the agreement ceases to have separate legal significance. There is a shorter period of time in which to challenge or enforce the terms of a Judgment of Divorce, but the provisions of the Judgment are more likely to be treated as being involuntarily ordered by the divorce court, providing greater ‘cover’ if gift tax consequences are a concern.

Testamentary Transfers: The same transfer tax concerns can arise with the deductibility of a transfer upon the ex-spouse’s death that is required pursuant to a property settlement agreement. [IRC 2053.]This question was addressed in Leopold v. United States, 510 F.2d 617 (9th Cir. 1975.) In this case, the Court found the deductibility of a testamentary bequest as required by the property settlement agreement and allowed it as a deductible estate expense. The decedent had three daughters, two from a prior marriage, and one from his second marriage (which had also ended in divorce.) Although the decedent made a bequest to the third daughter, the amount was uncertain. Consequently, the second ex-wife filed a creditor’s claim on her daughter’s behalf based upon the divorce settlement agreement. The Court reasoned that “under exceptional circumstances, it may be that a claim by someone who might otherwise inherit from the decedent should be deductible under 2053.” The Court thus allowed the deduction for the ex-wife’s claim with regard to the bequest. The third daughter was left nothing more than was required under the divorce settlement agreement and the second ex-wife appeared to take a smaller settlement in consideration for her ex-husband’s promise to leave a bequest to their daughter under his Will. Because the ex-wife bargained for the bequest to her daughter, it was held to be for ‘full and adequate consideration’ and therefore was a deductible estate expense.

Transfers to Children: A transfer to or for the benefit of the marital children, by contrast, only qualifies for the federal gift tax exemption under IRC 2516 if it ‘provides a reasonable allowance for the support of issue of the marriage during minority.’ A transfer above the level of legally required support, or when the children of the marriage are above the age of 18 years, will thus be treated as taxable gifts. Since there is no guidance from the IRS on the ‘value of legally required support’, the presumption is that it is intended to adhere to state law on a parent’s child support obligation. As such, any value provided under a judgment of divorce to marital children, which may be enjoyed after the age of majority, is not exempt under the statute, and thus a taxable gift. For example, if a trust is required to be created and funded under the divorce settlement agreement and the trust continues beyond the child/children’s age of minority, then a taxable gift would be made of the present value of that post-age 18 interest in the trust.

Conclusion: Most divorce settlements are reached without much thought being given to the gift tax implications of when, and how, assets are transferred between former spouses, or transfers that are made on behalf of children of the marriage. While IRC 2516 provides a fair amount of ‘cover’ from federal gift taxes that might arise from transfers incident to a divorce settlement, that Tax Code section does have its limits, especially with regard to its 3-year rule. Incorporating and merging a Property Settlement Agreement into a Judgment of Divorce may provide additional relief from gift taxes in reliance the Harris Rule. The point is that exposure to federal gift taxes does exist; it just has to be planned for in order to be avoided.