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. …