Stock redemption and divorce revisited.

When negotiating a divorce settlement, the issue of how to separate ownership of a couple's closely held business can cause significant problems. One option is for the corporation to redeem the stock owned by either of the spouses. The taxation of such a transaction, however, has been the subject of several court decisions. The latest decision has not definitively settled the issue.

William and Carol Read owned all the stock of Mulberry Motor Parts, Inc. (MMP). During their divorce negotiations, the couple decided William should own 100% of MMP and Carol should receive $838,724 (her stock's fair market value) of which $200,000 would be payable in cash and the rest in a note bearing 9% interest.

The divorce decree said William was to purchase Carol's stock or--at his option--have MMP or its ESOP purchase it. William elected to have the corporation purchase the stock. Carol reported no gain on the redemption even though her basis in the stock was zero. William also reported no income from the transaction. The IRS treated the redemption as a sale on Carol's tax return, creating a taxable gain, and as a constructive dividend (taxed as a dividend even though no cash was received) on William's return. It also denied the corporation an interest deduction. The IRS left it to the courts to decide which of the two outcomes was correct.

Result. For Carol and against William. Carol had argued that the redemption of her stock was a transfer incident to a divorce and nontaxable under IRC section 1041. William had argued that he should not be charged with a constructive dividend because the redemption did not fulfill a primary and unconditional personal obligation to buy the stock. A divided Tax Court ruled William had received a constructive dividend, saying his argument applied the wrong standard. The unconditional obligation standard does not apply. The appropriate standard was whether the transfer was to a third party on behalf of the former spouse. If the transfer was on William's behalf, it would be recast as a nontaxable transfer to him followed by his transfer of the stock to the corporation--resulting in a taxable constructive dividend. If the transfer was not on William's behalf, it was a redemption from Carol that would be taxable as a sale.

The temporary regulations under section 1041 provide that a transfer is on behalf of a former spouse if it is

* Required by the divorce decree.

* Pursuant to a request by the former spouse.

* Ratified by the former spouse.

According to the Tax Court, the stock redemption in this case qualified under the first two options since the divorce decree said the husband would purchase the stock or designate the corporation as the buyer. The result is that Carol received the cash and the note without any tax consequences whereas William had to report these items as a constructive dividend. The Tax Court also held that MMP was not entitled to deduct the interest it paid on the note to Carol.

As a result of the court's decision, William ended up with a significant tax liability. Based on prior precedent, this could have been avoided if the divorce decree had specified MMP was required to redeem the stock. If the decree also had required William to guarantee payment or to be secondarily responsible for acquiring the stock, the outcome would have been less certain.

* Carol M. Read, et al. v. Commissioner, 114 TC no. 2.

Prepared by Edward J. Schnee, CPA, Phi), Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.