Young v. C.I.R. - 240 F.3d 369 (4th Cir. 2001)

Rule:

26 U.S.C.S. § 1041 provides that no taxable gain or loss results from a transfer of property to a former spouse if the transfer is incident to the divorce. 26 U.S.C.S. § 1041(a)(2), and that a transfer of property is incident to the divorce if it is related to the cessation of the marriage. 26 U.S.C.S. § 1041(c)(2). The statute does not further define the term related to the cessation of the marriage, but temporary Treasury regulations extend a safe harbor to transfers made within six years of divorce if also pursuant to a divorce or separation instrument, as defined in 26 U.S.C.S. § 71(b)(2). Temp. Treas. Reg. § 1.1041-1T(b) (2000). Section 71(b)(2) defines a divorce or separation instrument as a decree of divorce or separate maintenance or a written instrument incident to such a decree. 26 U.S.C.S. § 71(b)(2) (1994).

Facts:

Petitioner Louise Young and appellee John Young were married in 1969 and divorced in 1988. The following year they entered into a Mutual Release and Acknowledgment of Settlement Agreement (1989 Settlement Agreement) to resolve their equitable distribution of property claim and all other claims arising out of the marital relationship. Pursuant to this agreement, appellee delivered to petitioner a promissory note which was secured by a deed of trust on 71 acres of property that appellee received as part of the same 1989 Settlement Agreement. In October 1990, appellee defaulted on his obligations; petitioner then brought a collection action where the court entered judgment in her favor. Appellee only made partial payment, thus prompting petitioner to initiate steps to execute the judgment. Before execution, however, the parties entered into a Settlement Agreement and Release (the 1992 Agreement), which provided that appellee would transfer to petitioner, in full settlement of his obligations, a 59-acre tract of land, of that he collateralized in his promissory note. Pursuant to the 1992 Agreement, appellee retained an option to repurchase the land, whom he assigned the option to a third party who exercised the option. On her 1992 and 1993 federal income tax returns, petitioner reported no capital gain from the sale of the property nor the portion of the sale of the land that went directly to pay her attorneys' fees. At the same time, appellee did not report any gain from his transfer of property, to satisfy his then obligation to petitioner. Thus, the appreciation of this property went untaxed despite the occurrence of a taxable event, i.e., the transfer or the sale. Respondent Commissioner of Internal Revenue asserted deficiencies against both parties. Each then petitioned the Tax Court, which consolidated the two cases. After trial, the Tax Court ruled that the capital gain was properly taxable to petitioner under 26 U.S.C. § 1041(a)(2) (1994). Because the Tax Court held that the 1992 property transfer was incident to the divorce, it concluded that appellee realized no gain through his transfer of this property to his former spouse. Rather, according to the Tax Court, petitioner took appellee’s adjusted basis in the land and should have recognized a taxable gain upon the subsequent sale of that property. In addition, the portion of the proceeds from the sale, which was paid directly to her attorneys, must be included in petitioner’s gross income. Petitioners appealed both rulings.

Issue:

1. Did a 1992 transfer of land from appellee to petitioner constitute a transfer incident to their 1988 divorce for purposes of the nonrecognition of gain rules? 
2. Was petitioner required to include within her gross income the contingent fees paid directly to her attorneys from the proceeds of her subsequent sale of that land?

Answer:

1. Yes. 2. Yes.

Conclusion:

The appellate court answered both questions in the affirmative. Thus, tax court's order was affirmed in all respects. The court held that the transaction occurred only because petitioner was the seller's former spouse and was enforcing her rights growing out of the dissolution of their marriage. Specifically, the 1992 transfer was related to the cessation of the marriage, thus neither party recognized a gain or loss on the transfer. The court further held that petitioner took the same basis in the land that the couple had when they were married. Likewise, the appellate court agreed that petitioner's direct assignment of the contingent fees paid did not relieve her of tax liability on the income.