by Ken Luer
In my last article, I discussed this topic: If the divorce-related buyout of the Departing Spouse’s interest in a company will be paid in installments, what terms should the Departing Spouse request (and the Remaining Spouse anticipate)? Now, let’s consider an important follow-up question: Is the interest paid by the Remaining Spouse on that installment note deductible by him or her for tax purposes? This answer is of interest to both parties, since the benefits of deductibility would leave more money in the Remaining Spouse’s cash flow.
A 1997 U.S. Tax Court Case (Seymour v. Commissioner, 109 T.C. No. 14; relied on in Armacost v. Commissioner, T.C. Memo. 1998-150) provides a framework for answering this question. In Seymour, the property settlement resulted in the husband acquiring his ex-wife’s interest in the closely-held corporation along with a variety of other assets, while the wife received $300,000 in cash and a 10-year installment note in the principal amount of $625,000, together with 10% interest. The IRS took the position that interest on the Note was non-deductible “personal interest”, on the theory that IRC Section 1041 provides that no taxable gain or loss is recognized on a property transfer incident to a divorce and, therefore, this debt was “personal” in nature.
The Seymour court rejected the IRS’s position and held “that Section 1041 does not require Petitioner’s indebtedness to his former wife to be characterized as personal interest….” Rather, the court explained, the nature of the interest paid must be examined and allocated according to the IRS’s tracing rules, which allocate the debt among the properties purchased and place different types of non-personal interest into specific categories with differing tax results, including those commonly known as “investment interest” or “trade or business interest”. (In a nod to irony, the court noted that in an earlier case the IRS had prevailed in its position that similar interest payments were taxable income to the receiving spouse because Section 1041’s rule that the property transfer is not taxable was not relevant to the analysis concerning interest on the corresponding debt. (Gibbs v. Commissioner, T.C. Memo. 1997 – 196)).
“Investment interest” is generally defined as interest on debt allocated to property held for investment, such as dividends, royalties and the like not derived in the ordinary course of a trade or business, or derived from a trade or business in which the taxpayer does not materially participate. Investment interest is not fully deductible from ordinary income but, rather is deductible only to the extent of the taxpayer’s net investment income. On the other hand, “trade or business interest”, meaning interest on debt incurred in connection with a trade or business in which the taxpayer materially participates, is fully deductible against the taxpayer’s ordinary income.
Accordingly, determining the category(ies) into which the Remaining Spouse’s installment debt fits is critical to determining the deductibility of interest on that debt. The IRS’s guidance is that the taxpayer must make a “reasonable allocation” of the installment debt among different assets which may lead to different tax consequences.
As is the case with many tax issues, the determination depends on the particular facts of the situation. And the form of the business entity may make a difference, depending on whether it is a tax “pass-through” entity (e.g., LLCs, S corporations, limited partnerships) or a non-pass- through C corporation. These are issues which must be carefully considered by a qualified business attorney or CPA in structuring the installment note portion of a marital property settlement.
Ken Luer is a partner in the Business & Corporate Law Department of Ervin Cohen & Jessup LLP. His expertise includes mergers & acquisitions, equity and debt financings, business law, and I/P and technology licensing.