Breaking up is hard to do.

How to handle divorce-related stock redemptions.

When a closely held business is a major marital asset, it can be a roadblock to an easy division of property when the spouses divorce. In such circumstances, a CPA can recommend a stock redemption as a way to equalize the property settlement between spouses. However, conflicting court cases have created uncertainty as to which spouse will be taxed when a redemption is divorce-related. At issue is whether the redemption is considered a third-party transfer subject to IRC section 1041. CPAs who advise divorcing clients must understand when a divorce-related redemption is considered a section 1041 third-party (not desirable) transfer so they can help the client avoid this treatment as well as the potential problems conflicting legal decisions have created.

STOCK REDEMPTIONS AND SECTION 1041

Under section 1041, a transfer of property by one spouse to a former spouse is not a taxable event if it is incident to (as a result of) a divorce. Under temporary regulations section 1.1041-1T(c), a transfer of property to a third party on behalf of a former spouse also is not taxable if it is required by the divorce or separation instrument. However, the transfer is taxable to the nontransferring spouse.

Example. To satisfy the terms of his divorce decree, Howard transfers corporate stock to an attorney in payment of the legal fees of his former spouse, Wanda. The stock has a fair market value of $10,000 and a basis to Howard of $1,000. Under temporary regulations section 1.1041-1T(c), Wanda is taxed on a $9,000 capital gain because the transfer was (1) on her behalf and (2) required by the couple's divorce decree. The IRS considers two transfers to have taken place: The first deemed transfer is from Howard to Wanda; the second is from Wanda to the third party, her attorney. Section 1041 tax-free treatment applies only to the first transfer; the second is taxable to Wanda.

(Note: A deemed transfer is one that does not actually occur but is assumed by the code or regulations to have taken place.)

When a closely held corporation is a significant part of a couple's assets, typically the divorcing spouses agree the business should be 100% owned by the spouse who is active in running the business. The inactive spouse's stock is redeemed to equalize the settlement. The question is whether the transfer of stock to the corporation is on behalf of the active spouse. If it is, then the redemption is considered to be a third-party transfer subject to temporary regulations section 1.1041-1T(c).

Example. Sylvia and Bert each own 50% of Xanadu Corp. Because Sylvia runs the company, the divorce decree requires Xanadu to redeem Bert's stock. If the redemption is considered a third-party transfer, Bert is deemed to transfer the stock to Sylvia; then Sylvia is deemed to transfer it to Xanadu in a redemption. The first transfer is tax-free under section 1041. The redemption from Sylvia is taxable. Since Sylvia owned 100% of the stock immediately before and after the redemption, the redemption is taxed to her as a dividend under IRC section 302(d). The exhibit on page 118 illustrates how the deemed transfers under the temporary regulations compare with the actual redemption.

THE NINTH CIRCUIT VIEW

Arnes v. United States (981 F2d 456 [9th Cir. 1992]) was the first case involving divorce-related stock redemptions and section 1041. The case followed the divorce of John and Joann Arnes. Before the divorce, the couple jointly owned 100% of the stock of Moriah Valley Enterprises, Inc., which in turn owned a McDonald's franchise in Ellensburg, Washington. Because McDonald's has a policy that requires a franchise to be 100% owned by its owner-operator, John and Joann agreed John would own 100% of Moriah after the divorce.

The property settlement agreement required Moriah to redeem Joann's stock and required John to guarantee the redemption. In 1988, Moriah redeemed Joann's stock; she reported a capital gain on her 1988 tax return. Subsequently, Joann filed a refund claim on the grounds the redemption was not taxable to her under section 1041. When the IRS denied her claim, she sued for a refund in the U.S. District Court for the Western District of Washington. The district court decided in Joann's favor and the IRS appealed to the Ninth Circuit Court of Appeals, which affirmed the district court decision.

The Ninth Circuit considered the redemption to be a third-party transfer under temporary regulations section 1.1041-1T(c). Since the redemption was required by the couple's property settlement agreement, the key issue was whether Joann's transfer was on behalf of John. The court concluded the transfer was on John's behalf because it relieved him of the obligation to purchase Joann's shares. According to the court, the obligation to purchase the stock was John's, not the company's. This appears to be a substance-over-form argument because the property settlement agreement did not specifically require John to purchase the shares. However, as the court noted, the agreement did require him to guarantee the corporation's obligation to purchase Joann's stock.

After losing in district court, the IRS assessed a deficiency against John Arnes, asserting that the redemption was taxable to him as a dividend under IRC section 302(d). John disagreed and petitioned the U.S. Tax Court, which decided in his favor. The IRS lost both cases--the redemption was not taxed to either party.

THE TAX COURT VIEW

Since the Ninth Circuit decision in Arnes (Arnes I) in December 1992, three Tax Court cases have involved divorce-related stock redemptions: Hayes v. CIR (101 TC 593) was decided in December 1993; Blatt v. CIR (102 TC 77), in January 1994; and Arnes v. CIR (102 TC 522 [Arnes II]), described above, in April 1994.

The Hayes case, like Arnes I, involved a McDonald's franchise. According to their separation agreement, Mr. Hayes was required to purchase Mrs. Hayes' stock. This agreement was incorporated into the divorce judgment of an Ohio state court. After the judgment became effective, the parties decided the corporation should redeem Mrs. Hayes' stock. The Ohio court subsequently entered a replacement order to correct the original decision. The Tax Court found the order was not valid under Ohio law and made its decision as if the original order had not been replaced. Therefore, based on the original divorce judgment, Mr. Hayes had a primary and unconditional obligation to purchase his wife's stock. Since the corporation satisfied his obligation, the court concluded Mr. Hayes was taxable on a constructive dividend transaction the IRS treats as a dividend for tax purposes even though the corporation has not declared a formal dividend.

In Blatt, the divorce decree ordered the redemption of Mrs. Blatt's stock with no guarantee by Mr. Blatt. Nevertheless, Mrs. Blatt relied on Arnes I in asserting that the redemption should be tax-free to her under section 1041. The court, however, distinguished the case from Arnes I because of the guarantee by John Arnes. Since there was no such guarantee in Blatt, the redemption was not on behalf of Mr. Blatt and therefore was taxable to Mrs. Blatt.

The Blatt case was a reviewed decision (examined by more than one Tax Court judge), resulting in three concurring opinions and one dissenting opinion. The most controversial aspect of the majority decision was a statement that the court disagreed with the Ninth Circuit in Arnes I--without giving a reason. All three concurring opinions objected to this part of the decision. In the dissenting opinion, Judge Parr disagreed with the majority conclusion in Blatt that the redemption was not on Mr. Blatt's behalf. In Judge Parr's view, Mr. Blatt was obligated by the divorce decree to divide the marital property. The redemption relieved him of further marital distributions.

Arnes II also was a reviewed decision, resulting in three concurring opinions and two dissenting opinions. The case focused on whether the redemption resulted in a constructive dividend to John Arnes. The majority opinion concluded the redemption was not a constructive dividend because it did not relieve John of a primary and unconditional obligation. His guarantee of the corporate payment to Joann was only a secondary obligation.

Since the case was appealable to the Ninth Circuit, another issue was whether the court was required to follow Arnes I. The majority concluded the court was not required to do so because that case did not address the constructive dividend issue. Both dissenting opinions, however, disagreed. Judge Ruwe disagreed with the majority because he believed the Ninth Circuit "has already passed on the determinative legal issue."

WHERE WE STAND

These conflicting decisions have created a state of confusion on how section 1041 applies to divorce-related stock redemptions. The critical issue is whether a stock transfer to a corporation by a spouse not active in running the business is on behalf of the active spouse. According to the Ninth Circuit, a transfer is made on a person's behalf if it satisfies an obligation or liability of that person, such as the transfer Howard made on Wanda's behalf in the earlier example to pay her legal fees. The Tax Court used the same definition in Blatt, noting that Mr. Blatt was not obligated to purchase the stock because he did not guarantee the redemption.

The difference between the two courts seems to involve the type of obligation that must be satisfied. In Arnes II, the Tax Court used the "primary and unconditional" standard in concluding that John was not subject to tax on a constructive dividend as a result of the redemption. Was the court saying a transfer is made on someone's behalf only when it satisfies that person's primary and unconditional obligation? Unfortunately, the court left that question open to speculation by stating in a footnote that it was not expressing an opinion on whether the on-behalf-of standard is the same as the primary-and-unconditional-obligation rule for constructive dividends.

Going forward, the confusion can be cleared up either judicially or administratively. If, in a case with a fact pattern similar to that of Arnes II, the Tax Court view is upheld by another appeals court, there will be a conflict between appellate courts. The U.S. Supreme Court would then have to clear up the conflict. But since the conflicting cases all involve interpretations of temporary regulations section 1.1041-1T(c), the IRS could also solve the problem by amending the regulation. The AICPA tax division favors this approach. In a 1995 hearing of the National Commission on Economic Growth and Tax Policy, the AICPA suggested the Treasury Department add two examples to the regulation. As the sidebar on this page describes, the examples accept the Tax Court's view that the active spouse be taxed on the redemption only when he or she has a primary and unconditional obligation to purchase the stock.

PLANNING CONSIDERATIONS

Until the confusion is cleared up, however, CPAs must advise their divorcing clients based on existing law. The basic tax planning issue is whether applying section 1041 to the redemption is or is not desirable. In the typical divorce-related redemption, section 1041 is not desirable. If it applies, the inactive spouse is not taxed, while the active spouse is taxed on the fair market value of the stock at ordinary income rates.

If section 1041 does not apply, the active spouse is not taxed and the inactive spouse is taxed only on the excess of the stock's fair market value over its basis--at lower capital gains rates. When advising clients involved in a divorce, CPAs should generally make sure the divorce agreement is structured so the stock redemption is not taxed under section 1041 (except in those situations where such treatment may be desirable, as discussed later).

Example. Jeff and Donna each own 50% of Tyler Corp. Their divorce decree requires Tyler to redeem Donna's stock, which has a fair market value of $110,000 and a basis to her of $10,000. If the redemption is considered to be on behalf of Jeff, it will be taxed to him as a dividend. If the redemption is not considered to be on Jeff's behalf, it will be taxed to Donna as a sale of her stock to the corporation. Jeff is in the top federal tax bracket of 39.6%. A capital gain is taxable to Donna at the long-term rate of 20%. Jeff's tax would be $43,560 ($110,000 x .396). Donna's tax would be only $20,000 ([$110,000 - $10,000] x .2).

Another reason for taxpayers to avoid section 1041 is the availability of the installment method. If a redemption is to be carried out on a deferred payment basis, the inactive spouse can defer tax by using the installment method. However, if the redemption is taxed as a dividend to the active spouse, installment sale treatment is not available.

Avoiding section 1041, however, may involve a conflict between tax and nontax considerations. It seems clear section 1041 will not apply when the redemption is not required by the divorce or separation instrument. However, for nontax reasons, the inactive spouse probably will insist that either the active spouse or the corporation be required to purchase the stock.

If the redemption is required by the divorce or separation instrument, then--to avoid section 1041--the active spouse should not be obligated to purchase the stock or to guarantee the redemption., The inactive spouse may find this acceptable if the corporation is capable of redeeming the stock with an immediate cash payment. However, if the redemption is to be carried out on a deferred payment basis, the inactive spouse may insist the active spouse guarantee the transaction.

If the redemption must be carried out on a deferred payment basis and guaranteed by the active spouse, the tax consequences are not completely predictable. There is a risk the active spouse will be taxed under Arnes I. To protect the active spouse, the settlement agreement can require the inactive spouse to reimburse the active spouse if he or she is taxed on the redemption. The parties also can request a ruling from the IRS. Although an IRS ruling would eliminate the risk, the parties would incur a substantial cost to obtain the ruling.

Another possibility for the deferred payment scenario is for the CPA to advise the client to structure the property settlement so the deferred payments are treated as alimony. Both parties would have to agree to consider the payments alimony and satisfy the requirements of IRC section 71. The payments then would be from the active spouse to the inactive spouse and could not extend beyond the inactive spouse's death. Alimony is taxable to the inactive spouse as ordinary income and deductible by the active spouse. This alternative is especially advantageous when the inactive spouse is in a lower tax bracket than the active spouse. If the active spouse must rely on the corporation as the source for the alimony payments, the CPA may want to recommend a subchapter S election so the required funds can be withdrawn from the company as tax-free distributions. The funds also can be withdrawn from a C corporation as compensation. However, compensation is subject to payroll taxes and the IRS can reclassify it as a dividend if it is unreasonable.

There are, however, circumstances where section 1041 treatment may be desirable, such as when the business is a C corporation with no earnings or profits. In this case, the redemption is tax-free to the inactive spouse. It also is nontaxable to the active spouse to the extent of the stock basis. Any amount in excess of the basis is taxed as a capital gain. The same result also can be achieved with an S corporation with no preelection earnings or profits. If the CPA decides section 1041 treatment is desirable, the active spouse should have a primary and unconditional obligation to purchase the inactive spouse's stock.

PLAN CAREFULLY

Given the complexity, CPAs should stay abreast of new developments in this area. Before advising a client on a divorce-related stock redemption, CPAs should review recent court decisions for any that are relevant to this fast-changing area. As discussed above, the current situation can be cleared up either judicially or administratively. However, as the law stands now, CPAs must help their clients plan divorce-related stock redemptions carefully to avoid unanticipated--and undesirable--tax consequences.

EXECUTIVE SUMMARY

* WHEN A CLOSELY HELD CORPORATION IS A MAJOR marital asset, divorcing spouses typically agree the corporation should be 100% owned by the spouse who is active in the business. To equalize the property settlement, the inactive spouse's stock can be redeemed by the corporation.

* THE REDEMPTION GENERALLY IS TAXED to the inactive spouse as a sale of the stock to the corporation. However, in Arnes v. United States, the inactive spouse argued that the redemption was on behalf of the active spouse and should be taxed to him under temporary regulations section 1.1041-1T. The Ninth Circuit Court of Appeals agreed and the inactive spouse was not taxed.

* AFTER LOSING IN THE NINTH CIRCUIT, the IRS taxed the active spouse on the redemption, claiming it was a dividend. The active spouse disagreed and took the case to the Tax Court, which said he should not be taxed. Thus, neither spouse was taxed on the redemption.

* THE ARNES CASES, ALONG WITH TWO OTHER Tax Court cases, present a confusing picture for CPAs as to which spouse is taxed on a divorce-related stock redemption. For planning purposes, the redemption generally should be taxed to the inactive spouse. In light of the conflicting cases, this result is assured only if the active spouse is under no obligation to purchase the stock.

The AICPA's Recommended Solution

In a 1995 hearing of the National Commission on Economic Growth and Tax Policy, the AICPA tax division first recommended adding two examples to temporary regulations section 1.1041-1T(c). The examples clarify when the active spouse will be taxed on a divorce-related redemption. In testimony at a January 1998 hearing of the House Ways and Means Committee, the AICPA reiterated its 1995 proposal.

Example 1. A and B obtain a divorce. The divorce agreement divides the couple's interest in X Co., a 100%-owned closely held corporation, equally between A and B. The agreement further provides that the parties will cause X Co. to redeem B's stock subsequent to the property division by giving him a note in payment. A is obligated to guarantee X Co.'s payment of the note. The divorce agreement specifies that the property division settle all claims between A and B. The division of X Co. stock is a transfer of property between spouses, which is subject to the rules of section 1041. The subsequent redemption of B's stock, however, is not a transaction between spouses and will be characterized as a redemption between B and X Co. Thus, the redemption from B will be governed by the provisions of IRC sections 301 and 302.

Example 2. C and D obtain a divorce. The divorce agreement awards the couple's entire interest in Y Co., a 100%-owned, closely held corporation to C. The agreement further provides that D will receive from C a note in the amount of $X,XXX to equalize the division. C causes Y Co. to redeem D's interest and assume payment of the note. The award of Y Co. stock to C and the receipt of the note by D is a transfer of property between spouses and is subject to the rules of section 1041. The subsequent redemption of the stock from C and assumption of the note by Y is on C's behalf and is not controlled by section 1041, since C had the primary and unconditional obligation to acquire D's stock, which was fulfilled by Y Co. Thus, the redemption from C will be governed by the provisions of section 301.

Randy Swad, CPA, PhD, CBA, is professor of accounting at California State University, Fullerton. His e-mail address is [e-mail].