Posted by Jorge Guerrero, CPA
In a divorce or separation agreement, retirement benefits are transferred between spouses through what is known as a “qualified domestic relations order (QDRO).” Using a QDRO, the court orders payment of benefits from one spouse who has an interest in a plan to the other spouse who originally did not. Normally, distributions are taxable when made from pension plans holding pre-tax contributions such as 401(k), 403(b), and IRAs. The transfer of an interest is similar to a qualified rollover in that as long as the destination account is a similar type of retirement account, the transfer is not taxable. For example, the divorce court orders Sally’s employer to transfer a 50% interest of her 401(k) to Bill’s IRA as part of the divorce decree. Since both Sally and Bill’s accounts are qualified tax deferred retirement accounts, no tax is due for either party. However, if Bill’s retirement account is a Roth IRA, an after-tax account, he would follow Roth conversion rules and report the transfer as income but face no penalties. Sally would not report any income from the transfer because according to Code Section 402(e)(1)(A) distributions that are not rolled over to a similar qualified retirement plan are taxable to the alternate payee not the participant spouse.
Now assume that Bill takes the money he received from the interest in Sally’s 401(k) and invests it into his landscaping business. The distribution once again is not taxable to Sally. Bill however must follow the rules governing distributions from qualified retirement plans. In other words, the distribution is reported as income to Bill and if he is under age 59 ½, he would be subject to penalties.
As one might expect investment transfers often have hidden tax consequences. If the investments received are mutual funds or investment partnerships, there is the possibility of unexpected income distributions such as capital gain distributions at year end. It is not uncommon for an investment partnership to report income from dividends, interest, capital gains or event rental income. To make matters worse, these distributions are often reinvested so no cash is received. In these cases, understanding the investment’s history is important to tax planning. It is important to make estimated tax payments to avoid unnecessary tax surprises including underpayment penalties.
When transferring investments between spouses it is important for the receiving spouse to receive the basis information of any investments. According to IRS rules, the receiving spouse steps into the shoes of the transferring spouse. In other words, receiving spouse’s basis in the investment the basis is that of the transferring spouse. The IRS requires the basis to be set at ZERO If it cannot be proven. This means a stock sold for $10,000 with zero basis creates a $10,000 capital gain! If the spouse could prove that the basis was $8,000, the gain reported becomes $2,000. Getting support for basis from the transferring spouse is critical for this reason.
Business Use Property
The act of transferring “business use property” may cause a tricky situation in that knowing the original cost of the property is helpful but may not tell the whole story. Just as with investments, the receiving spouse takes the basis of the transferring spouse. A depreciation schedule showing the book value of the property is the most important piece of information that the receiving spouse needs. This report will give the receiving spouse the book value and alert the spouse of any Section 179 or Bonus Depreciation taken on the property. If the receiving spouse does not continue to use the property for business purposes, any Section 179 or Bonus deprecation taken previously may be subject to recapture rules.
For example, Sally receives a small tractor from Bill’s lawn service as part of their divorce. Bill purchased the tractor for his schedule C business for $2,500 two years earlier and claimed a section 179 deduction for the entire amount on their jointly filed tax return. Sally plans to use the small tractor to maintain the landscaping of her home. Since Sally does not plan to use the tractor for business purposes, she must recapture the Section 179 depreciation taken on her tax return as income. If Bill just depreciated the tractor and did not take the section 179 deduction, Sally’s basis in the tractor would be the $2,500 less the depreciation Bill deducted on their return.
The act of dealing with a divorce can be a very traumatic experience. The temptation to rely solely on your attorney may be unwise when many assets are involved. Having an experienced tax professional involved during the process may not seem like a wise investment at the time but with proper planning, the tax saved down the road is often much more than the fees paid.
If you want to learn more about how your situation is affected by the tax code, please contact one of our experienced professionals.