ivorce is never easy for any of the parties involved. The divorcing spouses must consider how the split will affect themselves, their children, the disposition of their marital property and other financial arrangements. CPAs need to be able to ease the transition by advising clients on the tax consequences of property settlements that take place as a result of the divorce. Under IRC section 1041, the transfer of property between spouses “incident to a divorce” is generally tax-free. However, when the transfer involves a third party such as a closely held corporation, the tax consequences may be less predictable.
For example, Tom and Mary jointly own the Widget Corp. Under their divorce agreement, Mary agrees to accept $100,000 for her stock, which has a basis of $10,000. Instead of Tom buying the stock directly from Mary, they agree that Widget Corp. will redeem her stock for cash, leaving Tom as the sole shareholder. With a third-party redeeming the stock, which spouse should pay the tax on the appreciation of the stock’s value? In cases involving spouses and their closely held corporations, the courts have held conflicting opinions on the answer to this question. A recent case, Read v. Commissioner, 114 TC No. 2 (2000), adds to the controversy—and confusion for CPAs—surrounding third-party transfers.
SOME ESSENTIAL BACKGROUND
Congress enacted section 1041 to negate the effects of the U.S. Supreme Court ruling in U.S. v. Davis, 370 U.S. 65 (1962), where the Court held that a spouse transferring appreciated property in a divorce must recognize gain on the appreciation for tax purposes, thereby allowing the nontransferring spouse to receive a basis in the property equal to its fair market value (FMV). If the transferring spouse failed to report the gain on the transfer, the government might be “whipsawed” (the appreciation in value could escape taxation; see box below) since the recipient spouse took an FMV basis.
Section 1041 provides that taxpayers will recognize no gain or loss on transfers of property between spouses in a divorce. The transferring spouse’s basis in the transferred property carries over to the recipient spouse. Section 1041, whose intent is to treat the husband and wife as a single economic unit, does not eliminate tax on any appreciated property; it merely defers the tax until the property is transferred outside the economic unit to a third party.
DIRECT TRANSFERS TO A THIRD PARTY
Temporary regulations section 1.1014-1T(c), Q&A 9 provides three situations in which a property transfer to a third party on behalf of a spouse qualifies for nonrecognition of gain under section 1041, provided all the section’s other requirements are met.
The divorce or separation agreement requires the transfer to the third party.
The transfer to the third party is done according to the other spouse’s written request.
The other spouse gives the transferor written consent for the transfer to the third party.
In those situations, the property transfer will be treated as made directly to the nontransferring spouse. He or she will then be considered to have immediately transferred the property to the third party. In Tom and Mary’s case, the deemed transfer from wife to husband is one that qualifies for nonrecognition of gain under section 1041; the deemed transfer from Tom to the Widget Corp. is not a transfer that qualifies for nonrecogniton of gain.
Example. Assume a husband owes a note at the bank and his wife transfers appreciated stock to the bank to settle the debt. Under Q&A 9, she is treated as transferring the stock to her husband, who then transfers it to the bank. The deemed transfer from wife to husband falls under section 1041, but the husband’s deemed transfer to the bank does not. In this example, only the husband benefits from the third-party transfer because it releases him from his obligation.
In third-party transfers involving closely held corporations, the scenario changes. If the wife transfers her stock directly to the corporation and receives assets in return, she is clearly benefiting from the transfer—the corporation is transferring assets directly to her.
Different courts have applied different standards to third-party transfers. The government was whipsawed in Arnes I and Arnes II when a divorcing couple transferred appreciated property to a corporation and withdrew assets without any tax consequences.
A husband and wife named Arnes owned all the stock of a corporation that operated a McDonald’s franchise. They resided in Washington, a community property state. The McDonald’s franchise agreement required 100% ownership by the owner–operator. When the couple began divorce proceedings, McDonald’s informed them only one spouse could retain ownership. They agreed to have the corporation redeem Mrs. Arnes’ stock for cash and a note (personally guaranteed by her husband).
In Arnes I, ( Arnes v. U.S., 981 F. 2d 456, 1992), the Ninth Circuit Court of Appeals upheld a district court ruling that section 1041 applied to Mrs. Arnes and ruled the transfer was on behalf of her husband because he had received a benefit. The Ninth Circuit ruled he received a benefit because the transfer was part of the property settlement resolving any future claims by Mrs. Arnes. Mr. Arnes also had benefited because the transfer relieved him of an obligation. The court held that section 1041 applied and Mrs. Arnes received nonrecognition treatment.
In Arnes II, a case brought by Mr. Arnes, ( Arnes v. Comm., 102 T.C. 522, 1994), the Tax Court held that Mr. Arnes received no constructive dividend from the transfer because he had not had a primary and unconditional obligation to purchase his wife’s stock. Under constructive dividend decisional law, the rule is limited to situations when the remaining shareholder has both a primary and unconditional obligation to purchase the stock. Mr. Arnes had only a secondary obligation by personally guaranteeing the note. The result was neither spouse was taxed on the transaction and the government was whipsawed.
In Hayes v. Comm., 101 T.C. 593, 1993, the government consolidated the cases to prevent the whipsaw that had resulted in Arnes I and II. As in those two cases, the husband and wife owned a corporation that operated a McDonald’s franchise. Their divorce agreement provided for Mr. Hayes to buy his wife’s stock. However, instead of Mr. Hayes buying the stock from Mrs. Hayes, the corporation redeemed her stock. After the redemption, the divorce agreement was modified to require the company to redeem the stock.
The court determined that Mr. Hayes had a primary and unconditional obligation to buy the stock. Therefore, the transfer resulted in a constructive dividend to him. The IRS conceded that if Mr. Hayes were taxed on the transaction, then his wife would receive nonrecognition treatment. So the court did not decide the section 1041 issue.
In Blatt v. Comm., 102 T.C. 77, 1994, both spouses were sole shareholders of a corporation. The divorce decree provided for the corporation to redeem Mrs. Blatt’s stock for cash. The court ruled that section 1041 did not apply to her redemption because the transfer was not on her husband’s behalf. The court used the Webster’s dictionary definition of “on behalf of” as meaning “in the interest of” or “as a representative of.” It ruled the transfer was not on Mr. Blatt’s behalf because he had no obligation to buy the stock, nor was he a guarantor of the corporation’s obligation to buy the stock. Therefore, the redemption was taxable to Mrs. Blatt in the year of the redemption.
These four cases all have facts in common: both spouses owned a corporation as sole shareholders. In a divorce, the corporation redeemed the wife’s stock for cash or other assets from the company. The husband might or might not have had an obligation to purchase his wife’s shares. The question then becomes should the wife be taxed on a corporate redemption or should the husband be taxed on a constructive dividend?
The temporary regulations state expressly that section 1041 does not apply to the second deemed transfer. In cases involving spouses and their corporations, the “on behalf of” standard in Q&A 9 applies to the deemed transfer between spouses, while the primary and unconditional obligation standard under the constructive dividend rules applies to the deemed transfer between the husband and the corporation. If the nontransferring spouse has a primary and unconditional obligation, “on behalf of” always will be met—not because that’s the standard to apply under section 1041 but, rather, because the husband clearly benefited from the transfer. But meeting the standard does not necessarily mean the husband has a primary and unconditional obligation under the constructive dividend rules. Without the temporary regulation, both spouses could be taxed; by applying two different standards, the government could be whipsawed (as in Arnes I and Arnes II).
In Read, a husband and wife owned all the stock in a corporation at the time of their 1986 divorce. The settlement provided that the wife sell and convey all her stock to her husband or, at his election, to the corporation or its ESOP. Mr. Read or, at his option, the corporation or its ESOP would transfer cash and a promissory note to Mrs. Read for the fair value of her shares.
Mr. Read elected to have his wife transfer her stock to the corporation, which then transferred cash and the promissory note (personally guaranteed by Mr. Read) to Mrs. Read. She reported no gain from the transfer but did report the interest payments received in subsequent years as taxable income. Mr. Read reported no income with respect to the transfer or later payments by the corporation, which deducted the interest payments in each subsequent year.
The IRS issued notices to Mrs. Read for 1989 and 1990 indicating that the principal payments were long-term capital gain. The IRS issued notices for 1988, 1989 and 1990 to Mr. Read and the corporation indicating the principal and interest were constructive dividends to Mr. Read and denying the corporation’s interest deductions.
Relying on Arnes II, the taxpayers argued the transaction was tax-free under section 1041 and that the legal standard to apply was the primary and unconditional obligation standard established by the constructive dividend decisional law. Under that law, a payment to a shareholder in redemption of stock is a constructive dividend to the remaining stockholder if the nonredeeming shareholder had a primary and unconditional obligation to buy the stock. For reasons not stated in the case, the husband and the corporation indicated in their motions that if the court had held that section 1041 applied to Mrs. Read, then the determinations in their respective notices should be sustained.
The court held that the primary and unconditional obligation standard is not appropriate to determine whether Mrs. Read’s transfer of stock to the corporation was on behalf of Mr. Read within the meaning of Q&A 9. The court applied the Webster’s dictionary meaning of “on behalf of” and held that Mrs. Read’s transfer of property to the company qualified for nonrecognition under the temporary regulations because the transfer was in Mr. Read’s interest.
The court sustained the IRS determinations to Mr. Read and the company. Thus it did not decide the constructive dividend issue. A dissenting opinion noted the motions from the two parties were taken out of context because Mr. Read and the company argued that the primary and unconditional obligation standard applies to section 1041. The two parties agreed that if section 1041 was found to apply to Mrs. Read under that standard, the determinations against Mr. Read and the company should be sustained. But the court did not apply the primary and unconditional obligation standard, instead using the Webster’s dictionary meaning of “on behalf of.” By not ruling on these determinations, the court missed an opportunity to clarify the issue.
AN IDEAL SOLUTION
In divorce-related property transfers, the ideal solution is to avoid involving third-parties. But when the third party is a closely held corporation, it is often necessary to include it. The corporation may be the major marital asset and perhaps the only party with sufficient assets to effect an equitable division of property. This opens the door to undesirable tax effects.
If the divorcing couple cannot avoid involving a third-party, they should try to structure the transaction to avoid section 1041 treatment. This can be accomplished by making sure the property settlement stipulates that the corporation will redeem the transferring spouse’s stock and that the transfer is not on the nontransferring spouse’s behalf. The nontransferring spouse also should not guarantee any debt related to the redemption.
Congress enacted section 1041 to treat the spouses as one economic unit. The Treasury Department could accomplish this same result administratively by amending the temporary regulations to add a safe harbor as follows:
“In transfers to a third-party corporation that leaves the nontransferring spouse in control of the corporation, the transfer will be treated as a stock redemption subject to capital gain treatment provided:
The divorce agreement stipulates which party will report the sale and remit the tax; and
A declaration to that effect is filed with the IRS within 30 days of the final divorce decree.”
This safe harbor would tax the economic unit instead of pitting the spouses against each other. The taxpayers could decide between themselves who will be responsible—they may even decide to split the tax, with one party filing the return and sending the money to the IRS. This could end the unpredictability and controversy surrounding third-party transfers. Until changes are made, however, CPAs should help clients plan carefully to minimize the tax consequences of third-party transfers if it is not possible to avoid them altogether.