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Arnes defines an "on behalf of" redemption under sec. 1041.

Another trap for the unwary exists in Sec. 1041 since the Ninth Circuit affirmed a district court's decision in Arnes, 981 F2d 456 (9th Cir. 1992), aff'g DC Wash., 1988. A taxpayer-wife did not have to recognize the gain realized when, pursuant to a divorce decree, a corporation redeemed her 50% interest and issued additional stock (equal to the same number of shares redeemed) to the other 50% owner, her ex-husband, even though the wife transferred the shares redeemed directly to the redeeming corporation. The court characterized the redemption as being "on behalf of" the nontransferring ex-husband (as outlined in Temp. Regs. Sec. 1.1041-1t(c), Q&A-9), because it relieved the ex-husband of an obligation under the divorce settlement; as such, this transaction was deemed to be a constructive transfer to the ex-husband followed immediately by his transfer to the corporation (a third party).

The facts

In 1980, with $5,000 capital, John and Joann Arnes formed a corporation (Moriah) to own and operate a McDonald's franchise. The corporation issued 5,000 shares of common stock to them jointly. In 1987, the Arneses agreed to divorce. At that time, McDonald's informed the Arneses that their franchise agreement required 100% ownership by the owner/operator; joint ownership could not exist after their divorce. Their divorce settlement included an agreement under which Moriah would redeem Joann's common stock, paying a portion in cash, with the balance to be paid by Moriah, evidenced by a debt instrument personally guaranteed by John, in 120 installments.

Joann originally treated the transaction as an installment sale, subject to long-term capital gain treatment, on her 1988 individual return. However, in December 1989, she filed a timely claim for refund on the ground that the transfer was made pursuant to a divorce instrument and, as such, qualified for nonrecognition treatment under Sec. 1041. Both the District Court and the Court of Appeals granted her summary judgment. The decisions cited as authority Temp. Regs. Sec. 1.1041-1T, Q&A-9, which deals directly with the qualification under Sec. 1041 of transfers by one spouse (or former spouse) "on behalf of" another spouse (or former spouse). The regulation states that such a transfer of property will be treated as made directly to the nontransferring spouse (or former spouse) and the nontransferring spouse will be treated as immediately transferring the property to a third party. The court specifically noted that the deemed transfer from the nontransferring spouse (or former spouse) to the third party is not a transaction that qualifies for nonrecognition of gain under Sec. 1041.

The holding in Arnes appears to be consistent with Temp. Regs. Sec. 1.1041-1T. However, could this regulation, specifically Answer 9, be inconsistent with Sec. 1041? The General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (the legislation that enacted Sec. 1041) stated in part:

The current rules governing transfers between spouses or former spouses incident to divorce have not worked well and have led to much controversy and litigation. Often the rules have proved a trap for the unwary, as, for example, where the parties view property acquired during marriage (even though held in one spouse's name) as jointly owned, only to find the equal division of the property upon divorce triggers recognition of gain.

Furthermore, in divorce cases, the government often gets whipsawed. The transferor will not report any gain on the transfer, while the recipient spouse, when she or he sells, is entitled under the Davis rule to compute his or her gain or loss by reference to a basis equal to the fair market value of the property at the time received. The Congress believes that to correct these problems, and make the tax laws as unintrusive as possible with respect to relations between spouses, the tax laws . . . should be changed.

In light of this, the interpretation found in the temporary regulations, and specifically the answer to Question 9, does appear suspect. Therefore, the court's reliance on these temporary regulations could be misplaced.

Nonetheless, in the absence of a successful challenge to the validity of the temporary regulations, tax practitioners are forced to live with the result in Arnes. The court's decision makes it clear that Joann is not taxable on the proceeds received on redemption. It further stated that "[t]he transfer of $450,000 from the corporate treasury need not escape taxation, if we hold, as we do, that Joann is not required to recognize any gain on the transfer of her stock, because it is subject to [Sec.] 1041. The tax result for joann is the same as if she had conveyed the property directly to John." This leads to the question of what is the proper tax result for the nontransferring spouse (John)? Note: Before appealing this decision to the Ninth Circuit, the Service asserted a claim against John in order to ensure that the gain did not escape taxation.

The regulation cited in Arnes, when read literally, indicates that "the transfer of property will be treated as made directly to the nontransferring spouse (or former spouse) and the nontransferring spouse will be treated as immediately transferring the property to the third party." (Emphasis added.) A further issue is whether this third party must be unrelated, or do the rules applicable to attribution dividends under Sec. 301, redemptions under Sec. 302, S corporation distributions under Sec. 1368, etc., apply.

Ownership by Joann Arnes, a former spouse, is clearly not attributed to John. However, if joann's transfer must be treated as first being made to John, and immediately thereafter John is deemed to have transferred the stock to a corporation controlled by him, under Sec. 302, the distribution is deemed to be a dividend (subject, of course, to any accumulated earnings and profits (E&P)).

Additionally, if Moriah was an S corporation, the distribution ordering rules contained in Sec. 1368 must be considered in order to determine the nature of the taxable income (e.g., distribution of accumulated adjustments account, previously taxed income, E&P and/or basis).

The fact that the Arnes decision poses more questions than it answers is not an uncommon phenomenon. Consider an earlier Tax Court decision, Balding, 98 TC No. 27 (1992). (See the Tax Clinic item, "Assignment of Income and Divorce," TTA, Sept. 1992, at 601, for an analysis of the Balding decision.) Balding dealt with the assignment of income doctrine as it related to future pension benefits (marital property) relinquished pursuant to divorce and the overriding nature of Sec. 1041. This decision clearly stated that Sec. 1041 takes precedence over the anticipatory assignment of income doctrine. However, the court failed to address whether the relinquishing spouse would be required to include one-half of the recipient spouse's pension benefits in her gross income as they are paid to the recipient spouse or would the recipient spouse be required to include 100% of the pension benefits in his income, as received, without any adjustment to basis for the amount paid to the relinquishing spouse.

Sec. 1041, as interpreted by both Arnes and Balding, is clearly a powerful section that can trap the unwary. Ironically, the congressional authors of Sec. 1041 supposedly enacted this section to correct such flaws in the prior law. To that end, Sec. 1041 statutorily overrides numerous tax concepts.

More likely than not, the concept of "on behalf of" as contained in Temp. Regs. Sec. 1.1041-1T is simply an anomaly that applies only in the context of Sec. 1041; as such, the tax result attendant to a transfer "on behalf of" is intended to be exactly the same to the nontransferring spouse as it would have been to the transferring spouse or former spouse. Conversely, a compelling argument can still be made for a characterization consistent with other Code sections.

The court's decision went to great lengths to recite the facts; however, it stopped short of detailing the significance (or lack thereof) it attached in arriving at its decision. it is the author's opinion that the court failed to outline the "critical path" it employed in arriving at the conclusion that Joann's sale of previously jointly held stock constituted a redemption "on behalf of" John. Needless to say, the application of Arnes would be much easier had the court taken the time to express its feeling with respect to the facts recited. Hopefully, the answers to these questions will be found in John Arnes's Tax Court case.
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Author:Ward, Earle H.
Publication:The Tax Adviser
Date:Sep 1, 1993
Words:1403
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