Planning for divorce-related stock redemptions.

• Author: Ellentuck, Albert B.

Under Sec. 1041(a), the general rule is that neither gain nor loss is recognized on transfers of property between spouses in a divorce. Instead, any gain or loss is deferred and the transferred property's basis and holding period carry over to the spouse receiving the property. Therefore, a transfer of ownership of a closely held business in divorce does not trigger gain or loss if it is directly between the spouses.

Example 1. Transferring appreciated stock between divorcing spouses: D and R jointly own 100% of a small manufacturing company. The stock is worth $100,000. As part of their divorce settlement, they agree that R will sell D her 50% marital interest in the company stock for $50,000. The basis of the shares sold is $1,000.

D pays R $50,000, and R releases all claims on the corporation's stock. No gain or loss will be recognized on the transaction because it meets the requirements of Sec. 1041. D's basis in the stock is his original $1,000 basis plus a $1,000 carryover basis for the shares acquired from R. He would be responsible for any gain or loss on the ultimate disposition of the stock.

According to Regs. Sec. 1.1041-2, the federal income tax consequences of a divorce-related stock redemption depend on whether the redemption is treated as a constructive distribution.

Taxing a Redemption That Is Not a Constructive Distribution

Assuming the redemption is not treated under applicable tax law as a constructive distribution to the other spouse (see the discussion later in this section), the transaction between the transferor spouse (the spouse who actually transfers shares to the corporation in exchange for redemption proceeds) and the corporation is taxed under the normal stock redemption rules (Regs. Sec. 1.1041-2(a)(1)). Therefore, to the extent of a C corporation's earnings and profits (E&P), the transferor spouse treats the redemption proceeds as a dividend unless one of the exceptions under Sec. 302(b) applies. If an exception applies, the transferor spouse treats the redemption proceeds as proceeds from selling the stock.

Planning tip: In most cases, a redemption that qualifies for sale treatment will be preferable to one taxed as a dividend. While the rate on long-term capital gains and qualified dividends is the same, the redeemed shareholder's stock basis offsets the proceeds only to the extent the proceeds are not taxed as a dividend. Also, taxpayers with capital losses or capital loss carryovers generally will prefer sale (i.e., capital gain) rather than dividend treatment. Finally, taxpayers may prefer capital gain treatment since they can report the sale on the installment method, thus deferring part of the gain over subsequent tax years. If the transaction is a dividend, installment deferral would not be possible.

There are two points to consider if the redemption qualifies as a sale. First, if a deductible loss results, it may be a Sec. 1244 ordinary loss, rather than a capital loss, if the Sec. 1244 stock requirements are met. Second, if the redemption occurs before the divorce is final, it might be necessary for the transferor spouse to waive family attribution to qualify the redemption distribution as a complete termination of his or her interest in the corporation under Sec. 302(c).

When the redemption does not result in a constructive distribution to the nontransferor (the spouse who does not actually transfer shares to the corporation), it has no tax consequences for that spouse.

Example 2. Handling a redemption that is not a...