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Schroeder v. Commissioner (T.C. Memo. 2020-117)

On August 5, 2020, the Tax Court issued a Memorandum Opinion in the case of Schroeder v. Commissioner (T.C. Memo. 2020-117). The primary issue before the court in Schroeder was whether payments that petitioner-husband made to his petitioner-ex-wife and his divorce lawyer had the effect of increasing the basis in an LLC indirectly owned by petitioner-husband.

Petitioner-husband (PH) founded the partnership DCA, LLC in 2003. In 2008, PH assigned his 70% membership interest in DCA, LLC to SRM, LLC, an S corporation of which he was the sole shareholder. PH was married for 20 years to petitioner-ex-wife (PEW) for 20 years prior to filing for divorce in 2008 (5 months after transferring his interest in DCA, LLC to SRM, LLC).

An appraisal performed in 2007 valued DCA, LLC at $30m, and so PH’s indirect 70% interest in DCA, LLC was assumed to be $21m. The assets, including the ownership of SRM, LLC were divided equally, and instead of receiving a 35% share in SRM, PH agreed to pay PEW $10.5m through cash, a promissory note, and paying PEW’s share of the couple’s liabilities.

The settlement agreement specified that PEW would receive no alimony, aside from the payments made on the promissory note which were “non-modifiable and non-taxable alimony.” However, the settlement agreement provided that PH’s payment obligations were not terminable on either party’s death or on PEW’s remarriage. It explicitly stated that PH’s payments were not intended to be taxable to PEW or deductible by PH for income tax purposes.

SRM, LLC sold its interest in DCA, LLC for $94m in May 2012. In June 2012, PH paid off the remaining balance of promissory note ($5.5m). The petitioners reported long-term capital gain of $86m on the sale. The IRS selected the return for examination and adjusted the gain upward by $5.5m, and ultimately sent the petitioners a notice of deficiency reflecting the adjustment and determining a deficiency of $800,000. The petitioners timely filed a petitioner with the Tax Court arguing that SRM is entitled to additional basis in DCA (and a corresponding downward adjustment of the petitioners’ net capital gain) by virtue of PH’s payments to PEW and PH’s divorce attorney.

The Nature of the “Alimony” Payments

The Tax Court examined Florida law to determine what types of alimony were permitted to determine whether the payments under the promissory note were appropriately classified as alimony. Rood v. Commissioner, T.C. Memo. 2012-122. The Tax Court determined that Florida permits “lump-sum” alimony, which is the payment of a definite sum and is in the nature of a final property settlement; hence, an award of lump-sum alimony creates a vested right which survives death and is not terminable on the recipient party’s remarriage. Id. (citing Filipov v. Filipov, 717 So.2d 1082, 1084 (Fla. 4th DCA 1998)). The Tax Court concludes that although PH’s payments were made over time, they may be considered components of lump-sum alimony payable in installments.

Effect (or not) of Costs of Divorce on Basis of Partnership

A partner’s initial basis in a partnership is increased by the sum of the partner’s distributive share of taxable income of the partnership as determined under IRC § 703(a), exempt income of the partnership, and the excess of the deductions for depletion over the basis of the property subject to depletion. IRC § 705(a)(1). PH’s payments to PEW and his divorce lawyer did not affect SRM’s distributive share of DCA’s income or deductions. Accordingly, these payments did not increase or otherwise affect SRM’s basis under IRC § 705(a)(1).

The basis of a partner’s interest is also increased by any subsequent “contribution of property, including money, to the partnership,” and by a partner’s assumption of partnership liabilities. See IRC § 722; IRC § 752(a). PH’s payments to PEW and his divorce lawyer, however, did not result in DCA’s receipt of any money or other property. Nor did SRM (or PH) assume any of DCA’s liabilities.

The petitioners characterize PH’s payments as “acquisition costs” and contend that they generate basis under IRC § 742, which provides that the basis of an interest in a partnership “acquired other than by contribution” is determined under the general basis rules of the Code. See IRC § 742 (cross-referencing IRC §§ 1011-1022). However, SRM owned 70% of DCA both before and after the divorce. Neither PH nor SRM “acquired” any interest in DCA (from PEW or anyone else) in consequence of these payments.

As a consequence, PH’s payment of alimony and attorney’s fees in no way increased the basis of the partnership or otherwise affected the amount of his capital gain.

(T.C. Memo. 2020-117) Schroeder v. Commissioner

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