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It takes Two to Tango…..but Maybe it Shouldn’t

Belot v. Comm’r, T.C. Memo. 2016-113, 2016 WL 3248031 (2016)

Facts: During their marriage, the parties operated a dance studio. The business consisted of an S corporation which was the actual studio, an LLC which operated a boutique selling dance clothing, and another LLC which owned the real estate on which the studio operated. The parties owned each of these entities in different percentages.

The parties were divorced in New Jersey in 2007. The decree incorporated an agreement signed by the parties, in which they agreed to convey interests in the entities so that each of them owned 50% of all three entities. The decree therefore left the divorcing parties as joint owners of the business.

Later in 2007, the wife filed a complaint against the husband, alleging that he had mismanaged the studio, and seeking to remove him as director and employee. This action was settled in 2008 by an agreement, in which the wife agreed to buy the husband’s interest in the business for $900,000 to be paid at closing, and $680,000 to be paid over 10 years.

The husband filed tax returns which claimed that the sale of the business under the 2008 agreement was a § 1041 exchange. When the IRS assessed a deficiency, the husband then appealed to the Tax Court.

Issue: Was the transfer required by the 2008 agreement a 1041 exchange?

Answer to Issue: Yes

Summary of Rationale: The IRS relied upon Reg. § 1.1041-1T(b), Q&A-7, which provides:

[1] A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in section 71(b)(2), and the transfer occurs not more than 6 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 6 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. [5]  For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one- and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.

(Bracketed numbers added.)

The IRS argued under sentence three that a § 1041 exchange must be related to a divorce or separation instrument, and that the transfer here was not so related. But the IRS ignored sentence four, which stated clearly that a transfer which is not made pursuant to divorce or separation instrument is only presumed to be unrelated to divorce, and that the presumption can be rebutted.

The IRS further argued that the presumption was not rebutted because the facts did not fall within sentence five. But that sentence states clearly that it is only an example of facts which would rebut the presumption. An example is not exclusive, so the fifth sentence was not a requirement which had to be met before the presumption could be rebutted.

A sale incident to divorce can be a § 1041 exchange. Young v. Comm’r, 240 F.3d 369, 374 (4th Cir. 2001). The IRS insisted that there were two disputes on the facts, a divorce and a business dispute, and that the 2008 agreement related only to the latter. The court disagreed, finding that the 2008 agreement was intended to remedy problems with the earlier divorce settlement. An agreement intended to resolve problems with a prior settlement is still related to the original divorce.

Finally, the policy behind § 1041 is “to defer, but not eliminate, the recognition of any gain or loss on interspousal property transfers until the property is conveyed to a third party outside the economic unit.” Id. at 375. The dance studio was not conveyed to a party outside of the economic unit. The policy behind the statute therefore suggested strongly that § 1041 should apply.

Lesson: Don’t leave divorcing parties as 50% joint owners of a business. Parties who are not willing or able to cooperate to run a family are probably likewise not willing or able to cooperate to run a business. The likely result of joint ownership is frustration, financial loss, and ultimately more litigation. Belot is a textbook example of why divorce decrees and divorce settlements should not leave the parties as joint owners of a business.

 

The couple in Belot would have saved themselves much money and considerable frustration by reaching in 2007 the settlement which they ultimately reached in 2008.

 

That having been said, it is good to know that when parties do unwisely agree upon joint ownership of a business, the problem can at least be fixed after the fact without burdensome income tax consequences.