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

• Author: Ward, Earle H.

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...