Tax Court applies sec. 1041 nonrecognition provisions to stock redemption.

• Author: Barton, Peter C.

In Read, 114 TC No. 2 (2000), a divided Tax Court ruled 9-7 that a corporation's redemption of a taxpayer's stock on behalf of her spouse incident to a divorce qualified for nonrecognition of gain under Sec. 1041. However, as a consequence, the spouse received a constructive dividend, resulting in ordinary income to the nonredeemed spouse, rather than capital gain to the redeemed spouse. Read, therefore, makes redemptions that qualify under Sec. 1041 inadvisable.

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...