Stock redemptions pursuant to divorce: be careful.

• Author: Colton, Gary S.

Many closely held corporations are owned entirely by husband and wife. The corporations frequently employ both spouses and represent the largest single asset in the marriage community. When a marriage ends in divorce, what happens to the corporation? A commonly used technique is to have the corporation redeem all of one spouse's stock under Sec. 302. The difference between the redeeming spouse's basis in the stock and the redemption amount is taxed as a capital gain to that spouse. The requirement to redeem the stock will usually be made a part of the divorce decree and/or property settlement. However, depending on how the divorce decree or property settlement is worded, the redeeming spouse can end up with the cash, while the other gets stuck with the tax. Unfortunately, since most family law attorneys do not practice much tax law, this treatment can come as an unexpected, and perhaps ruinous, shock to the spouse left with a cash-poor corporation and a tax liability.

Consider the situation of Mr. and Mrs. Arnes. The Arneses co-owned a McDonald's franchise through their closely held corporation. McDonald's policy was that, on divorce, one spouse (the operator of the franchise) must be left owning 100% of the franchise. The corporation redeemed the wife's stock and she reported the capital gain on her tax return. Later, the wife filed an amended return, claiming the transfer of stock to the corporation was pursuant to divorce and, thus, covered by Sec. 1041. Sec. 1041 calls for nonrecognition of gain on transfers of property between spouses or former spouses incident to divorce. Mrs. Arnes took the position that her transfer of the stock to the corporation was a transfer of property to a third party on behalf of a spouse. Temp. Regs. Sec. 1.1041-IT, Q&A-9, specifically addresses the issue. Mrs. Arnes prevailed in district court and in the Ninth Circuit.

The IRS naturally then assessed Mr. Arnes with the tax. The Service reasoned that the corporation's redemption of his wife's stock was actually for his benefit. However, the Tax Court decided that Sec. 1041 did not apply and that Mr. Arnes should...