Academic journal article Journal of Accountancy

Employment Benefits and Divorce: Who Pays the Tax?

Academic journal article Journal of Accountancy

Employment Benefits and Divorce: Who Pays the Tax?

Article excerpt

EXECUTIVE SUMMARY

* FOR MANY COUPLES, THE MONEY THEY HAVE in employee benefit plans represents the most valuable asset accumulated during their marriage. Dividing these funds in the event of a divorce is a complex process fraught with serious tax implications CPAs need to be aware of to counsel divorcing clients.

* UNDER IRC SECTION 1041, TRANSFERS BETWEEN spouses in a divorce are generally tax-free. But the code is silent on what happens if the transfer includes unpaid income, encouraging the IRS to apply a court-developed assignment of income doctrine to tax the person making the transfer. For IRA or qualified plan transfers, a Court-issued qualified domestic relations order (QDRO) can override the assignment of income doctrine.

* THE TIMING OF THE QDRO CAN HAVE MAJOR TAX implications. A spouse transferring qualified plan benefits before the court issues a QDRO may not only disqualify the plan but can also cause negative tax consequences.

* WITH THE POPULARITY OF STOCK OPTIONS, virtually every state now considers vested options to be marital property. Some courts are even going after unvested options. A client who transfers a nonqualified option to a former spouse under a divorce decree is taxed at the time of the transfer.

* THE TRANSFER OF AN INDIVIDUAL'S INTEREST IN AN IRA to a former spouse under a divorce decree is not taxable to the individual. The interest is treated as the former spouse's IRA. To qualify for tax-free treatment, the transfer must be of the participant's interest in the IRA and must be made under an IRC section 71(b)(2) divorce or separation instrument.

Baby boomers have trillions of dollars invested in employee benefit plans. For many couples, these benefits represent the most valuable asset they have accumulated during their marriage. Dividing the spoils in a divorce is fraught with serious tax implications that CPAs should examine carefully. This article provides an in-depth look at the rules CPAs need to know--including IRC section 1041--so they can counsel divorcing clients on the tax implications of retirement plan balances in a property settlement.

RULES OF THE ROAD

Section 1041 provides tax-free treatment for property transfers between spouses in a divorce. But what if the transferred property includes unpaid income? For example, section 1041 doesn't address accrued interest on bonds. The code's silence has encouraged the IRS to apply the court-developed assignment of income doctrine to tax the person transferring the accrued income. Under this doctrine, income will be taxed to the owner of the property regardless of who enjoys the income.

But should this doctrine apply if there is no underlying asset? For example, in a transfer of rights to receive part of a monthly retirement benefit, the property transferred is simply the benefits to be paid. Does the "no gain or loss rule" in section 1041 cover this kind of transfer? The IRS has taken the position that assignment principles prevail over section 1041 when a taxpayer transfers the right to receive income, but the issue is unsettled because the IRS is facing some opposition in the courts.

Two key factors in some transfers of employment benefits are whether a court-issued qualified domestic relations order (QDRO) is in effect and the timing of the order. For IRA or qualified plan transfers, a QDRO can override the assignment of income doctrine. But the IRS will continue to apply assignment principles to other types of benefits such as nonqualified plans.

PERSONAL SERVICES INCOME

It is a long-standing precedent that a taxpayer may not escape the tax burden on income assigned to another (Lucas v. Earl, 2 USTC [paragraph] 496 (USSC, 1930); Helvering v. Eubank, 40-2 USTC [paragraph] 9788 (USSC, 1940)). It is possible to escape this rule only when a taxpayer also transfers the property that is the source of the income. For example, a shareholder can escape being taxed on dividends only by transferring the underlying stock. …

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