In divorce engagements involving a closely held business, the business is often the single largest asset in the marital estate. The financial condition of a closely held company can have a significant impact on the marital estate and the distribution of assets between the spouses. Larger and/or mature businesses may have provided the family with high income and cash flow for many years. Consequently, the marital estate may be very liquid or have ample assets for distribution between the spouses.

Startup or high-growth businesses, on the other hand, may have the opposite effect on the marital estate. They may have high asset value, but have depleted the family’s liquidity and not generated significant cash flow, as earnings are required to be reinvested into the business. In cases where the business has liquidity, effective tax planning can generate the funds to reach a settlement between the community or in equitable distribution.

If the settlement is structured properly, cash otherwise locked inside a corporation can be used to redeem a spouse’s stock ownership interest in a closely held business at capital gains tax rates. If it is structured improperly, one spouse may be deemed to have received a constructive dividend and likely no cash with which to pay the tax. While dividends are currently taxed at capital gains rates, there is no guarantee that will continue forever. With the top ordinary income tax rate rising to 39.6% (from 35% previously), achieving capital gain treatment while creating liquidity is a double benefit.

Finally, creating capital gain income is a significant planning tool if long- or short-term capital loss carryforwards exist.

Sec. 1041 governs transfer between spouses in divorce

Transfers between spouses (or ex-spouses if incident to a divorce) are effectively treated as gifts with carryover basis, and the holding period is also transferred to the recipient spouse. These transactions are treated as transfers, not sales, for tax purposes, even if the transaction is structured as a sale.

Conflict in application of Sec. 1041 to stock redemptions

If the application of Sec. 1041 to transactions in a divorce is so clear and straightforward, why is there such conflict in its application to stock redemptions occurring in connection with a divorce? There are at least four sources of guidance contributing to the conflict over the taxation of stock redemptions occurring in connection with or in relation to a divorce. These are as follows:

1. Temp. Regs. Sec. 1.1041-1T(c), Q&A-9 (issued in 1984), which states that transfers of property to third parties on behalf of a spouse (or former spouse) qualify under Sec. 1041, except for redemptions of stock;
2. Two IRS letter rulings: 9046004 (a court-ordered stock transfer to an ex-spouse followed by a redemption would not be recharacterized as a redemption of the transferor’s stock) and 9427009 (transfer of stock to wife under a divorce decree followed by wife’s redeeming the stock was not taxable to the husband, but was taxable to the wife);
3. Six court cases:
1. Hayes, 101 T.C. 593 (1993) (wife did not recognize gain on transfer of stock incident to divorce, but the husband had to recognize constructive dividend treatment);
2. Blatt, 102 T.C. 77 (1994) (redemption of stock owned by wife under a divorce decree did not qualify for nonrecognition treatment);
3. Arnes, 981 F.2d 456 (9th Cir. 1992) (Arnes I), aff’g No. C90-728C (W.D. Wash. 4/11/91) (wife did not have to recognize gain from a stock redemption made under a divorce decree);
4. Arnes, 102 T.C. 522 (1994) (Arnes II) (in a separate case involving the same stock transaction as Arnes I, the husband did not receive a constructive dividend from the stock redemption);
5. Read, 114 T.C. 2 (Feb. 2000) (wife did not recognize gain upon her redemption of stock to the corporation she and her husband jointly owned because she was acting on her husband’s behalf);
6. Craven, No. 99-12803 (11th Cir. 6/19/00) (a wife’s redemption of her stock under a divorce decree was not taxable to her); and
4. Temp. Regs. Sec. 1.1041-2T (issued in 2001).

A detailed analysis of these cases, private letter rulings, and regulations is beyond the scope of this brief article, but they are worth reading if a stock redemption is being contemplated. Taxpayers and the IRS have had mixed results and much conflict. However, in 2003, the IRS issued Regs. Sec. 1.1041-2(c)(1), which is very taxpayer friendly.

Road map to a successful stock redemption: Regs. Sec. 1.1041-2

Regs. Sec. 1.1041-2(c)(1) indicates that if a divorce or separation agreement between the spouses or former spouses includes the following, the transferor spouse will be taxable:

1. (i) Both spouses or former spouses intend for the redemption to be treated, for Federal income tax purposes, as a redemption distribution to the transferor spouse; and
2. (ii) Such instrument or agreement supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other disposition of the stock that is subject to the redemption.

Regs. Sec. 1.1041-2(c)(2) relates to situations in which the nontransferor spouse will be taxable, including circumstances under which the nontransferor spouse will be deemed to have received a constructive distribution from the corporation followed by the deemed transfer of cash to the transferor spouse in redemption of his or her stock. If the divorce or separation agreement sets forth the following agreements of the parties, the transfer will be treated as a constructive distribution to the nontransferor spouse:

1. (i) Both spouses or former spouses intend for the redemption to be treated, for Federal income tax purposes, as resulting in a constructive distribution to the nontransferor spouse; and
2. (ii) Such instrument or agreement supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other distribution of the stock that is the subject of the redemption.

The 2003 regulations provide significant tax planning opportunities that may provide for creative settlement alternatives in difficult cases.