Tax Law and Business Organization Strategy

Divorce and Transfer Tax Consequences

Some unique gift, estate, and generation-skipping transfer tax issues surround divorce or separation. The following issues should be taken into account.

Gift taxes

Property settlements must be reviewed in light of the possible imposition of a gift tax. The Internal Revenue Code provides for an unlimited marital deduction for transfers between spouses. However, transfers after divorce do not fall into this exception.

The tax laws do provide some gift tax protection for property settlements entered into after a divorce is finalized. For example, transfers for settlement of property rights or child support are exempt from gift tax if:

  • The parties enter into a written agreement. The agreement does not need to be approved by the court.
  • The transfers are payments of cash or property in settlement of spousal martial rights and a “reasonable allowance” of support rights of a minor child of the marriage.
  • The agreement must be entered into within a period beginning two years before the divorce and one year after the divorce. The agreement, but not the transfer of assets, must occur during this three-year period.

Also, the Supreme Court has ruled that divorce-related transfers founded on a court decree are involuntary and, therefore, are not voluntary taxable transfers for gift tax purposes. However, if the divorce decree merely declares the marriage terminated but does not approve the property transfer, the IRS could still argue that the transfer is a gift.

If the parties fail to enter into a written agreement, but make the transfers prior to a final decree of divorce becoming effective, the gift tax marital deduction may eliminate any gift tax on the transfer.

If a divorce agreement requires that one spouse fund the college education of the couple’s children, care should be taken to make sure the payments are made in a manner that does not produce a taxable gift. For example, instead of reimbursing an ex-spouse for the cost of tuition, the payment should be made directly to the institution, for which the tax code allows an unlimited gift tax exclusion for tuition only. Other payments for the child’s education may be covered by the $12,000 annual exclusion. As part of a divorce decree, the couple might also consider pre-funding college costs for children (especially younger children) by using Section 529 Plans. The rules permit donors to pre-pay up to five years of annual exclusion gifts to fund a Section 529 Plan.  


Estate Taxes

Divorce agreements often do not pay sufficient attention to the estate tax implications. The Internal Revenue Code provides for an unlimited marital deduction for death transfers to a spouse, but it does not provide any marital deduction for transfers to an ex-spouse. A liability accruing pursuant to a divorce settlement agreement is not necessarily a deductible debt of a decedent’s estate. It is important to make sure the divorce documents create an enforceable debt against the estate to generate an estate tax deduction, rather than a taxable transfer.

If the decedent’s obligations are based on a court decree,the post-death obligations would be deductible. However, if the court did not require the property transfers (e.g., transfers to support a step-child),the post-death transfers may not be deductible for estate tax purposes, unless they were entered into for “adequate and full consideration.”

Transfers satisfying the gift tax requirements listed above will be treated as an expense of the estate. Thus, if former spouses have a written agreement that satisfies the three-prong test, testamentary transfers to a former spouse pursuant to the agreement are treated as deductible claims against the estate.


Gift splitting

The law permits a spouse to elect to be treated as the donor of a gift, even when the other spouse is the sole transferor. In order for the “gift splitting” to apply, the donor must file a gift tax return, on which the spouse consents to the treatment of the gifts as made one-half by that spouse. The return must be filed by the donor spouse, even if a gift tax return was not otherwise required (e.g., when only annual exclusion gifts were made). Gift splitting for any year applies to all gifts and cannot be made on a gift-by-gift basis. If gift splitting is elected, the spouses have joint and several liability for any gift tax that may be due.

Because of this rule, consenting spouses should be very careful to assure that the value of the gifts are accurate.

If gift splitting was anticipated early in the year, divorce before year end will terminate the right to split gifts.

Using The Unified Credit

The unified credit should be viewed as an asset of a couple’s divorce estate when it comes to estate planning. For example, assume a wealthy wife agreed to or is required to make a significant property settlement for the benefit of a less wealthy second husband. She wants the funds to eventually revert to her children from a prior marriage. She could create a lifetime trust during the marriage for the benefit of the soon to be ex-spouse. Properly created, the trust would create no gift taxes. At the ex-husband’s death, his unified credit (which he might not otherwise have used in full) benefits her children by reducing the overall transfer taxes. A similar arrangement could be made through a generation-skipping trust and annual exclusion gifts using the couple’s combined generation-skipping and annual exclusion exemptions.


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