Volume 20, Number 6
September 2003

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By David L. Silverman

David L. Silverman is of counsel to the Tax and Trusts and Estates Group of Meltzer, Lippe & Goldstein, LLP, in Mineola, New York.

Tax planning in the context of divorce requires familiarity with sections 71 and 1041, the first of which governs the taxation of alimony (support) payments and the latter of which sets forth the general rule of nonrecognition with respect to property transfers incident to divorce.

Flexibility in tax planning for alimony payments. A payment will be deductible as alimony under section 215 only if it fits the definition of alimony or separate maintenance payment provided by section 71(b). Section 71(b) defines alimony or separate maintenance payments as payments made to or on behalf of a spouse pursuant to a written divorce or separation agreement. Among other requirements, such payments must terminate at the death of the payee spouse. Parties may, therefore, structure agreements so that alimony payments continue following what would otherwise have been a terminating event, such as the remarriage of the payee spouse. A provision requiring alimony payments even after the recipient spouse remarries might appeal to the payor spouse, since it would provide an incentive for the recipient spouse to remarry.

A frequent objective in structuring alimony payments is to time a diminution in payments with the emancipation of a child. However, section 71(c) provides that amounts paid for child support will not qualify as alimony, and the regulations make it clear that amounts will be treated as child support if they are either reduced "(a) on the happening of a contingency relating to a child or (b) at a time which can clearly be associated with such a contingency." nevertheless, the regulations create a presumption that has the effect of creating a safe harbor. Thus, temp. Treas. Reg. Section 1.71-it(c), q & a 18, provides that a reduction will be presumed to be "clearly associated" with a contingency relating to the child if (1) the payments are reduced within six months before or after the date when the child reaches the age of 18, 21, or the local age of majority; or (2) the payments are reduced on two occasions within one year, before or after another child of the payor attains the age of 18 through 24. If the payments are reduced under either of these circumstances, an amount equal to the reduction will not constitute alimony but will instead be treated as nondeductible child support unless the presumption is rebutted.

Nevertheless, since the regulations state that if the terms of the presumption are not met, "reductions in payments will not be treated as clearly associated with the happening of a contingency relating to a child of the payor," the presumption has the effect of creating a safe harbor: reductions outside the presumption will not turn otherwise qualifying alimony payments into nondeductible child support. Therefore, a termination seven months before a child reaches the age of 21 will not result in recharacterization, but a termination five months prior to the attainment of the same age will result in recharacterization. Although multiple reductions will trigger recharacterization under the second part of the test, circumstances may necessitate multiple reductions. When multiple reductions would, but for tax consequences, be considered, the parties may be able to achieve a better overall economic result by (1) scheduling only a single reduction; (2) foregoing the second reduction; (3) calculating the present after-tax value of the second foregone reduction; and (4) reducing the payee's share of the net marital estate by the amount determined under (3).

Rev. Rul. 2002-22 and notice 2002-31 clarify the tax treatment of transfers of stock options and deferred compensation rights incident to divorce. The question arises whether section 1041 will operate to prevent a recognition event when stock options or deferred compensation rights are transferred incident to divorce, and whether the assignment of income doctrine will operate to provide that the transferor is taxed on the income recognized upon exercise of the options or receipt of the deferred compensation. In rev. Rul. 2002-22, the service examined these issues.

In the factual situation presented in rev. Rul. 2002-22, spouse a, employed by corporation y, received (1) nonstatutory stock options as part of a's compensation, and (2) rights to future income from two unfunded, nonqualified deferred compensation plans. With respect to the stock options, no amount had been included in a's gross income because the options did not have a reasonably ascertainable fair market value upon grant within the meaning of treas. Reg. Section 1.83-7(b). Rev. Rul. 2002-22 first stressed the breadth of section 1041 and concluded that the transfer of the Options and rights to retirement payments were not taxable events. The service reached this conclusion despite the fact that normally, under section 83, the exercise or arm's length disposition of a nonstatutory stock option results in income inclusion to the extent the fair market value of the stock subject to the option exceeds the price paid. While recognizing that the transfer of stock options pursuant to divorce might well be considered an "arm's length disposition," the ruling declined to hold that the transfer of such options resulted in income to the transferor.

That conclusion did not resolve the question of who would be taxed upon exercise of the options or receipt of the retirement payments. Although the assignment of income doctrine ordinarily imposes tax on the person who earned the income, "the courts and the service have long recognized that the doctrine does not apply to every transfer of future income rights." applying the assignment of income doctrine in the context of divorce, the service concluded, would be "inappropriate" because it would be inconsistent with the policy behind section 1041. Therefore, the service concluded that the non-employee spouse would recognize income at the time the options were exercised. The service also found that the ownership rights acquired by the non-employee spouse would yield income to the transferee non-Employee spouse under section 83(a) of the same character and to the same extent as if that non-Employee spouse had been the person who provided the services. Similarly, the transferee spouse would be required to include in income amounts realized from deferred compensation rights in the taxable year in which payments were made to the transferee spouse.

Notice 2002-31, 2002-19 i.r.b. 908, a companion announcement to rev. Rul. 2002-22, contains a proposed revenue ruling that discusses the federal insurance contributions act (fica) and federal unemployment tax act (futa) consequences of the transfers described in rev. Rul. 2002-22. First, the proposed ruling concludes that the transfer of nonstatutory stock options and nonqualified deferred compensation from an employee to a nonemployee spouse incident to divorce does not result in a payment of wages for fica and futa tax purposes. Second, the proposed ruling concludes that, for fica purposes, when the non-Employee spouse exercises nonstatutory stock options, fica tax will Be imposed on that non-employee spouse to the extent that the fair market value of the stock received exceeds the exercise price of the Option. Because the compensatory Interests transferred under section 1041 to the non-employee spouse remain taxable for employment tax purposes, the income recognized by the non-employee spouse is remuneration for employment and wages for purposes of income tax withholding under 3402. The proposed ruling states that futa taxation issues will be treated in a manner similar to that provided for fica issues.

- This article is an abridged and edited version of one that originally appeared on page 11 of NewsQuarterly, Summer 2002 (21:4).
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Effectively Representing Your Client Before the "New" IRS: A Practical Manual for the Tax Practitioner with Sample Correspondence and Forms; Sales and Use Tax Deskbook; The State and Local Tax Lawyer; Property Tax Deskbook; A Comprehensive Analysis of Current Consumption Tax Proposals; State and Local Taxation of Banks and Other Financial Institutions; TaxCite: A Federal Tax Citation and Reference Manual; Value Added Tax: A Model Statute and Commentary.

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