Divorce escrow accounts taxed to transferor of funds.

The proper taxation of income in an escrow account has always involved some uncertainty. Since the enactment of Sec. 468B(g) in the Tax Reform Act of 1986, it has been clear that someone would owe tax on a current basis on any income earned in the account. That subsection indicates that regulations are to be issued to provide "for the taxation of any such account or fund whether as a grantor trust or otherwise." However, proposed regulations recently issued under Sec. 468B dealing with qualified settlement funds did not provide guidance for accounts and funds governed by Sec. 468B(g).

A recently issued private letter ruling (unnumbered at press time but scheduled for release about Dec. 18, 1992) sheds some light on the Service's thinking in this area. The ruling involved a divorce settlement, pursuant to which Spouse A was directed to transfer shares of stock to Spouse B in exchange for cash. However, until the court issued a final judgment on the amount of cash required to be paid by B for the stock, the cash remained in escrow.

Citing only Secs. 61(a)(4) and 451(a) (and not Sec. 468B(g)). the IRS indicated that the interest income earned in the account should be taxed to the "owner (either A or B) of the funds." After acknowledging that legal ownership of the funds was not determined until the final judgment by the appeals court--more than two years after the escrow had been created--the Service abruptly concluded that B would be taxed on the income while the funds were in escrow.

Thus, while not setting forth any rule to be followed as a precedent, the Service held that when a contributor (B)places funds in escrow pending the outcome of litigation that could result in the funds either being returned to the contributor or distributed to the payee (A), the income earned until the ownership of the funds is legally resolved is taxed to the contributor (B). Until formal guidance is issued in the form of regulationst this represents at least a reasonable approach to handling such issues. The important thing is that the treatment of funds placed in escrow be anticipated in advance by the tax and nontax advisers, so that neither party to the escrow arrangement is surprised by the consequences. From Robert B. Coplan, Esq., Washington, D.C.