In the case of Matzkin and Schroeder v. Commissioner, TC Memo 2020-117,[1] the Tax Court ruled that a taxpayer could not increase his basis in an LLC (Dental Care Alliance, LLC, or DCA) interest by the amounts he had paid his former spouse Georgeann as part of the divorce to obtain full ownership.  The Tax Court found that this was part of the property settlement for federal tax purposes and such payments do not add to the basis of the asset in question.

Eventually Stephen’s 70% interest in the dental practice LLC was transferred by Steven into an S corporation of which he was the only shareholder, SRM Consulting, LLC (SRM).

In Steven Matzkin’s divorce his interest in the LLC, which contained his dental practice, was assumed to be $21 million. The interest was ruled to be a marital asset under Florida law, and it was proposed to divide such assets 50/50 between the two soon to be former spouses.

But, as the opinion notes, the interest in the LLC was not an asset that Georgeann wanted, nor one she could realistically be given, noting in a footnote:

Georgeann had no professional experience in dentistry, and the DCA partnership agreement required consent from a majority of its managers to admit a new partner. Steven controlled DCA and did not want to be in business with his ex-wife.[2]

Thus, the opinion noted:

The letter accordingly anticipated that Steven would pay Georgeann her $10.5 million share by making upfront cash payments, by executing a promissory note, and by paying Georgeann's share of the couple's liabilities.[3]

The final agreement followed this outline, described as follows by the Tax Court:

A document executed four days later, captioned “Partial terms of the Matzkin agreement related to Equitable Distributions and Spousal Support,” reflected similar terms regarding Steven's indirect interest in DCA. It provided that Steven would make a lump-sum payment to Georgeann and execute a note secured by his interest in the partnership. Interest only would be due on the note, with the principal payable in October 2014 or when DCA was sold (if earlier). The document stated that, if DCA were sold within 18 months for a price exceeding $30 million, then Georgeann would receive half of Steven's pro rata share of any proceeds above $30 million. It specified that Georgeann would receive no alimony apart from Steven's payments on the promissory note, which would “be deemed non-modifiable and non-taxable alimony.”

On December 16, 2008, Georgeann and Steven signed a marital settlement agreement (agreement) formalizing the terms of their divorce and the division of their assets. While specifying somewhat different cashflows from the earlier drafts, the agreement followed those drafts by recognizing Georgeann's right to property representing half the value of Steven's indirect interest in DCA. The agreement called for a cash downpayment and monthly payments on a $5.4 million promissory note. Like the previous drafts it provided that, if DCA were sold within 18 months and Steven's share of the proceeds exceeded $21 million (approximately), Georgeann would receive 50% of any excess. If DCA were sold the promissory note would be accelerated, becoming payable in full 30 days after Steven received proceeds.

The agreement referred to the payments described above as “non-modifiable alimony for * * * [Georgeann's] support and maintenance.” However, it provided that Steven's payment obligations were not terminable on either party's death or on Georgeann's remarriage. It explicitly stated that Steven's payments were not intended to be taxable to Georgeann or deductible by him for income tax purposes. The agreement recited that it recorded the parties' “final, complete, and exclusive understanding regarding * * * [their] marital separation, dissolution, and property settlement and supersede[d] any prior or contemporaneous agreement, understanding, or representation, oral or written.”[4]

In 2012 the dental practice was sold:

On May 24, 2012, SRM sold its interest in DCA for $93,770,600. Gains from that sale passed through to Steven as SRM's sole shareholder. In June 2012, as required by the agreement, Steven satisfied the $5,462,312 remaining balance of the promissory note.[5]

On the 2012 income tax return Steven reported a gain on the sale of the interest and, in computing the gain, increased his basis in the LLC by amounts paid to his former spouse.  The IRS selected the return for examination and argued that the basis had been overstated, as such amounts did not increase the basis of Steven’s interest in the LLC.[6]

The IRS’s initial argument to reduce the basis was not accepted by the Tax Court.  The IRS noted that the payments were characterized in the agreement as alimony[7] for her support and maintenance and thus could not generate additional basis in the interest.[8]  But the Tax Court notes that Florida law refers to three types of alimony, one of which is lump sum alimony which is treated as a form of property settlement, and the Court ruled:

The agreement described Steven’s payments as being made for Georgeann’s “support and maintenance.” See Pipitone v. Pipitone, 23 So. 3d 131, 136 (Fla. Dist. Ct. App. 2009) (“Ordinarily, the trial court specifies whether lump sum alimony is for support or for equitable distribution.”). But the agreement also provided (with seeming inconsistency) that the payments would survive Georgeann’s death or remarriage. (Neither party contends that Steven’s payments should be considered “alimony” for Federal income tax purposes. See secs. 71, 215.) We find that the agreement is ambiguous and conclude that the parties’ negotiating history is relevant in dispelling the ambiguity.

The negotiating history makes absolutely clear that the parties desired to effect an equitable distribution of marital assets, including real estate, cash and securities, life insurance, personal property, and Steven’s indirect interest in DCA. The payments specified in the agreement are consistent with the parties’ understanding, as shown in the negotiating history, that $10.5 million of value would be placed on Georgeann’s side of the ledger on account of Steven’s indirect interest in DCA. Because it was impractical for Georgeann to receive a $10.5 million partnership interest in DCA, the parties agreed that she would be paid that value in the form of cash, a promissory note, and Steven’s discharge of her share of certain liabilities.

Although Steven’s payments were made over time, they may be considered components of lump-sum alimony payable in installments. See Rood, 103 T.C.M. (CCH) at 1670; Donoff v. Donoff, 691 So. 2d 1091, 1092 (Fla. Dist. Ct. App. 1997); Paetzold v. Paetzold, 673 So. 2d 888, 889 (Fla. Dist. Ct. App. 1996); Turner v. Turner, 529 So. 2d 1138, 1143 (Fla. Dist. Ct. App. 1988). Considering the text of the agreement and its negotiating history, we conclude that the alimony it specified is “[l]ump-sum alimony * * * in the nature of a final property settlement * * * [that] creates a vested right which survives death and is not terminable on the recipient party’s remarriage.” Rood, 103 T.C.M. (CCH) at 1670 (quoting Filipov, 717 So. 2d at 1084).[9]

But even though the Court rejected the view, the Court found that a proper analysis of the matter would lead to the same result as the IRS was arguing for.

The Court notes that the issue is determining the basis in the partnership interest in question, so the opinion looks at the relevant provisions and determines no provision allows Steven to treat the payments to Georgeann as an increase in his basis in the interest:

A partner’s basis in a partnership is generally determined under section 705, captioned “Determination of Basis of Partner’s Interest.” Upon formation on January 1, 2008, SRM’s basis in DCA presumably equaled Steven’s basis in DCA. See sec. 705(a) (cross-referencing sections 722 and 742). Section 705(a)(1) provides that a partner’s initial basis is increased by the sum of the partner’s distributive share of “(A) taxable income of the partnership as determined under section 703(a), (B) income of the partnership exempt from tax under this title, and (C) the excess of the deductions for depletion over the basis of the property subject to depletion.” Steven’s payments to Georgeann 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 section 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 secs. 722, 752(a). But Steven’s payments to Georgeann and his divorce lawyer did not result in DCA’s receipt of any money or other property. Nor did SRM (or Steven) assume any of DCA’s liabilities.

Petitioners characterize Steven’s payments as “acquisition costs” and contend that they generate basis under section 742, which provides that “[t]he basis of an interest in a partnership acquired other than by contribution” shall be determined under the Code’s general basis rules. See sec. 742 (cross-referencing sections 1011-1022). But SRM owned 70% of DCA both before and after the divorce. Neither Steven nor SRM “acquired” any interest in DCA (from Georgeann or anyone else) in consequence of these payments.[10]

Although the taxpayer was correct that the payments were property settlement, the Court points out the simple fact that payments of property settlement do not create basis.

…[W]hile we agree with petitioners that Steven’s payments to Georgeann were part of a property settlement, it does not follow that his payments generated additional basis in DCA. The conclusion would be the same (if perhaps more obvious) if the key marital asset consisted of publicly traded stock rather than a partnership interest. For example, assume that Steven owned $21 million of IBM stock, which the parties regarded as a marital asset whose value was to be split 50%-50% between them. If Georgeann received $10.5 million of IBM stock in the property settlement, Steven could not plausibly contend that his basis in his retained IBM shares should be increased by $10.5 million. And the result would be no different if Steven retained all the IBM shares and paid Georgeann the value of her 50% interest in cash.

As it was, the key marital asset was a 70% interest in a partnership that supplied technical support services to dentists. In theory, the property settlement could have awarded Georgeann a 35% interest in the partnership, but that was impractical for numerous reasons: Georgeann had no expertise in that business, admission of a new partner would require consent of a majority of its managers, and Steven did not want to be in partnership with his ex-wife. So the spouses sensibly agreed to have Georgeann receive the value of her $10.5 million share in cash rather than in kind. Steven’s payments in fulfillment of that obligation did not generate additional basis in DCA, just as they would not have generated additional basis if the asset in question had been publicly traded stock.[11]

And, in a footnote, the Court gives another example that I suspect CPAs run into far more often and also cites IRC §1041(b) which provides the general carryover basis rules for all property settlement items:

Alternatively, assume a divorcing couple that has marital assets consisting of a house worth $1 million and $1 million of cash. If the husband received the house and the wife received the cash, the husband’s basis in the house would be unchanged; he could not increase his basis by the $1 million received by the wife. See sec. 1041(b) (providing a transferred basis rule). The result would be the same if the husband received the house, the couple split the cash, and the husband gave the wife a $500,000 promissory note for her share of the house. It is immaterial whether the $1 million received by the wife consists of cash or cash plus a promissory note; in neither event can the husband claim additional basis in the house.[12]

Taxpayers quite often have a hard time understanding the results described in this case—after all, the taxpayer just paid his/her former spouse cash to get ownership of what would have been that spouse’s interest had the property remained jointly held. And, quite often, they weren’t exactly happy about making those payments to a former spouse, so getting no basis for the payments seems doubly unfair.

But this is the trade-off for not having any gain recognition on these transactions for the spouse receiving the cash—IRC §1041 allows spouses to divide property without a tax consequence, and that includes both favorable and unfavorable consequences to a specific spouse.

[1] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, August 5, 2020, https://www.ustaxcourt.gov/UstcInOp2/OpinionViewer.aspx?ID=12303 (retrieved August 6, 2020)

[2] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, p. 3

[3] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, pp. 3-4

[4] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, pp. 4-5

[5] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, p. 6

[6] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, pp. 6-7

[7] Note that the IRS was not arguing this was deductible alimony for federal tax purposes, as it both would payable to Georgeann’s estate if she died before full payment was made and the agreement specifically provided it was not taxable to Georgeann.  Either provision in the agreement is sufficient, for pre-2018 divorce document, to render a payment not alimony (see prior IRC §72(b)(1)(B) and (D)).

[8] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, p. 11

[9] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, pp. 10-11

[10] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, pp. 12-13

[11] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, pp. 13-15

[12] Matzkin and Schroeder v. Commissioner, TC Memo 2020-117, p. 14