Tax Court applies sec. 1041 nonrecognition provisions to stock redemption.
Sec. 1041 provides that no gain or loss shall be recognized on property transfers between spouses or former spouses incident to their divorce. The transferee adopts the transferor's adjusted basis in the property. Temp. Regs. Sec. 1.1041-1T(d), Q&A-11, specifies that these nonrecognition and basis rules apply even if the transferee pays the transferor consideration for the property. A property transfer to a third party "on behalf of" a spouse or former spouse also qualifies under Sec. 1041, if the divorce or separation agreement requires the transfer, the transfer is pursuant to a request of the other spouse or the other spouse consents in writing to the transfer. In these situations, the property is considered as directly transferred to the nontransferring spouse, who is then considered as immediately transferring the property to the third party. Finally, the nontransferring spouse's deemed transfer does not qualify for gain nonrecognition under Sec. 1041 (Temp. Regs. Sec. 1.1041-1T(c), Q&A-9).
Prior to Sec. 1041, courts addressed the tax consequences of the redemption of one shareholder's stock that left a remaining shareholder with a majority interest. There is no economic difference to the corporation between using a stock redemption and using a dividend distribution to the remaining shareholder to fund the acquisition of the selling shareholder's stock. The selling shareholder can obtain capital gain treatment from the redemption or from selling to the remaining shareholder. However, the remaining shareholder will have ordinary income from the dividend. Therefore, the best approach is to have the corporation redeem the selling shareholder's stock. To prevent abuses, the Tax Court has ruled that such a redemption is a constructive dividend to the remaining shareholder if the latter had a "primary and unconditional" obligation to purchase the redeemed shareholder's stock (Enoch, 57 TC 781 (1972)).
In Read, William and Carol Read owned all of the voting and almost all of the nonvoting stock of MMP Corporation. Their divorce judgment ordered Carol to sell all of her MMP stock to William, or, at his election, to MMP or its employee stock option plan. William elected for Carol to sell the stock to MMP. In 1986, MMP paid Carol $200,000 and gave her a note for the balance of $638,724, which was to be paid over 12 years with 9% interest. William guaranteed the note. Carol transferred all of her stock to MMP in 1986.
Carol did not report any income on the stock transfer, except for the interest she received on the note. MMP deducted the interest payments. William did not report any income relating to Carol's stock transfer. The IRS determined that the principal payments for the stock were long-term capital gain to Carol; William had a constructive dividend for the principal and interest payments made to Carol, and MMP could not deduct the interest payments. Both William and Carol argued that the "on behalf of" standard of Temp. Regs. Sec. 1.1041-1T would be satisfied only if William had a "primary and unconditional" obligation to purchase Carol's stock such that he received a constructive dividend when MMP redeemed her stock; Carol claimed he had such an obligation, and William claimed he did not. The Service's main concern was to avoid whipsaw; however, it maintained that Carol's position that she should not recognize gain under Sec. 1041 was superior to William's position that he should not have a constructive dividend. Of course, William's constructive dividend (taxed as ordinary income) would result in more tax than if taxed as capital gain to Carol. Finally, William and MMP conceded that the IRS's tax determinations should be sustained if the Tax Court ruled that the Sec. 1041 nonrecognition provisions applied to Carol's stock transfer to MMP.
The Tax Court first ruled that the primary and unconditional obligation standard should not be used in a corporate redemption in a divorce setting to determine if the "on behalf of" standard is satisfied for Sec. 1041 purposes. The court pointed out that the primary and unconditional obligation standard determines the tax consequences to the stockholder whose stock is not being redeemed, but Sec. 1041 applies to the transferring spouse whose stock is being redeemed. Also, the tax consequences to the nontransferring spouse are not determined by Sec. 1041. In addition, Sec. 1041, its regulations and legislative history intend broad application of the nonrecognition policy on transfers of property incident to a divorce, and none of these sources imposed the primary and unconditional obligation standard.
The court then ruled that, under the ordinary meaning of "on behalf of," which is "in the interest of" or "as a representative of," Carol did act on behalf of William, because she implemented his election under the divorce judgment in transferring her stock to MMP. Next, turning to the remaining requirements of Temp. Regs. Sec. 1.1041-1T(c), Q&A-9, the court ruled that, given William's election, Carol's stock transfer to MMP was required by the divorce judgment. The Tax Court therefore concluded that Carol's transfer qualified for nonrecognition under Sec. 1041. However, the court did not rule on the Service's determinations against William and MMP. Instead, the court sustained these determinations, because William and MMP agreed to them if the court ruled Sec. 1041 applied to Carol's transfer.
The concurring opinion in Read, which received six votes, stated that William would have a constructive dividend on MMP's redemption of Carol's stock. Under Sec. 1041 and Temp. Regs. Sec. 1.1041-1T(c), Q&A-9, he takes her basis in the stock she is deemed to transfer to him and is deemed to immediately transfer it to MMP. Therefore, William constructively receives the redemption payment, which is taxed as a constructive dividend under Secs. 302(d), 301(a) and 316. (MMP had sufficient earnings and profits.)
There were four dissenting opinions in Read. The main argument was that Sec. 1041 applies only if William had a primary and unconditional obligation to purchase Carol's stock. If he did, he has a constructive dividend on MMP's redemption of her stock. If not, she has capital gain. In either case, only one taxpayer is taxed. However, the concurrence pointed out that only one taxpayer is taxed under the majority's approach.
Read results in ordinary income to the nontransferring spouse in a stock redemption in a divorce setting. Clearly, capital gain to the transferring spouse instead would be preferable. This might be achieved if the spouses simply agreed that the corporation would redeem one spouse's stock in a complete termination under Sec. 302(b)(3) and (c)(2)(A). The absence of an election in the divorce judgment might avoid satisfying the "on behalf of" requirement of Temp. Regs. Sec. 1.1041-1T(c), Q&A-9; therefore, Sec. 1041 would not apply. An even better outcome would be no tax to either spouse. This could be achieved if one spouse simply purchased the stock of the other spouse. Sec. 1041 would apply to the sale and the buyer would take the seller's basis prior to the transfer. Therefore, the seller would exclude gain and the buyer would postpone recognition of gain. Of course, the buyer would not be able to use the corporation to finance this purchase.
FROM PETER C. BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI (NOT ASSOCIATED WITH KPMG LLP)
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|Author:||Barton, Peter C.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2000|
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