Stock redemptions pursuant to divorce: be careful.

Many closely held corporations are owned entirely by husband and wife. The corporations frequently employ both spouses and represent the largest single asset in the marriage community. When a marriage ends in divorce, what happens to the corporation? A commonly used technique is to have the corporation redeem all of one spouse's stock under Sec. 302. The difference between the redeeming spouse's basis in the stock and the redemption amount is taxed as a capital gain to that spouse. The requirement to redeem the stock will usually be made a part of the divorce decree and/or property settlement. However, depending on how the divorce decree or property settlement is worded, the redeeming spouse can end up with the cash, while the other gets stuck with the tax. Unfortunately, since most family law attorneys do not practice much tax law, this treatment can come as an unexpected, and perhaps ruinous, shock to the spouse left with a cash-poor corporation and a tax liability.

Consider the situation of Mr. and Mrs. Arnes. The Arneses co-owned a McDonald's franchise through their closely held corporation. McDonald's policy was that, on divorce, one spouse (the operator of the franchise) must be left owning 100% of the franchise. The corporation redeemed the wife's stock and she reported the capital gain on her tax return. Later, the wife filed an amended return, claiming the transfer of stock to the corporation was pursuant to divorce and, thus, covered by Sec. 1041. Sec. 1041 calls for nonrecognition of gain on transfers of property between spouses or former spouses incident to divorce. Mrs. Arnes took the position that her transfer of the stock to the corporation was a transfer of property to a third party on behalf of a spouse. Temp. Regs. Sec. 1.1041-IT, Q&A-9, specifically addresses the issue. Mrs. Arnes prevailed in district court and in the Ninth Circuit.

The IRS naturally then assessed Mr. Arnes with the tax. The Service reasoned that the corporation's redemption of his wife's stock was actually for his benefit. However, the Tax Court decided that Sec. 1041 did not apply and that Mr. Arnes should not be liable: "[T]he bright line is well established by court decisions, such as Wall v. United States, 164 F2d 462 (4th Cir. 1947) ... The line has been drawn in terms of whether the remaining shareholder blundered into incurring a direct and primary obligation to purchase the stock, which he belatedly attempts to shift to the corporation." Mr. Arnes was held to have no tax liability, since the corporate redemption was not on behalf of the taxpayer; there was no "primary and unconditional" obligation by Mr. Arnes to redeem. Thus, for now, neither Mr. nor Mrs. Ames has to include the redemption gain in income. (However, since the Tax Court's opinion is appealable to the Ninth Circuit, Mr. Arnes will probably get stuck with the tax.

What should practitioners do to avoid this inequitable result? First, get involved early in a client's divorce planning. (This is sound advice even when there is no jointly owned corporation to split up. Review all of the corporate records and any buy/sell agreements; see if there are obligations imposed on a spouse to purchase the other spouse's stock. Second, consider having the redemption early so it is not a part of the divorce decree or property settlement (though it would obviously be part of determining each spouse's share of property). Third, have the attorney drafting the property settlement or the language in the divorce decree make sure that the redemption is the sole responsibility of-the corporation. Fourth, have the parties agree, in writing, how the spouse being redeemed will treat the proceeds on his tax return. Finally, consider, incorporating an equalization agreement into the property settlement, so that if the IRS taxes one spouse for receiving a constructive dividend, the other spouse will be obligated to file for a refund and turn over the proceeds to the other spouse.