Under IRC section 1041, taxpayers recognize no gain or loss on property transfers between spouses during marriage or related to a divorce. The section’s intent is to treat spouses as a single economic unit and defer (but not eliminate) any tax on appreciation until property is transferred to a third party outside the marital unit.
Temporary regulations section 1041-1T(c), Q&A 9, describes three situations in which a transfer to a third party on a spouse’s behalf may qualify for nonrecognition of gain under section 1041. This “on behalf of” standard creates much confusion and litigation when the transferred property is stock the transferor spouse redeemed incident to a divorce. In such redemptions the transferor spouse receives the proceeds, but the nontransferor spouse may be liable for the tax on any appreciation due to the constructive dividend rules. For example a spouse not involved in the business may get stock in a divorce and redeem those shares. He or she gets the proceeds and the nontransferor spouse gets the taxable income.
On January 13, 2003, the Treasury Department issued regulations section 1.1041-2 addressing stock redemptions during marriage or incident to a divorce. The new regulations are limited to stock redemptions; other third-party transfers continue to fall under Q&A 9.
Under the new regulations
Stock redemptions not resulting in a constructive dividend to the nontransferor spouse (under applicable tax law) will be treated as redemptions by the transferor spouse, who will be liable for any tax consequences.
Stock redemptions that do result in a constructive dividend to the nontransferor spouse will be treated as such, and that spouse will be liable for any tax consequences.
The new regulations put third-party transfers under the constructive dividend rules and remove stock redemptions from Q&A 9 and the troublesome “on behalf of” standard. This assures only one spouse will be taxed, preventing the “whipsaw” that occurred in Arnes. There, neither spouse was taxed when different courts heard the two cases (see “ Avoiding Third-Party Transfers in a Divorce ,” JofA , Jan.01, page 24).
A special rule in regulations section 1.1041-2(c) gives spouses the option of treating the redemption as a constructive dividend to the nontransferor spouse or as a corporate redemption to the transferor spouse, thus allowing a couple to choose which spouse will be responsible for the tax consequences. The taxpayers can elect the special rule by stating in a divorce, separation or other written agreement how both spouses intend for the IRS to treat the redemption. This agreement must supersede any other that applies to the stock redemption. Both spouses must execute the agreement before the date on which the spouse responsible for the tax files his or her federal income tax return for the year of the redemption, but no later than the due date of the return (including extensions).
The new regulation applies to stock redemptions on or after January 13, 2003, under agreements in effect after that date. It also applies to redemptions before that date if the spouses had executed a written agreement on or after August 3, 2001, that meets the requirements of regulations section 1.1041-2(c)(1) or (2).
Observation. The new rules appear to have removed the uncertainty of the tax consequences of stock redemptions during marriage or in a divorce. If the spouses can’t agree which one will be responsible for the taxes, the constructive dividend rules will apply. However, if they can reach an agreement and comply with the requirements of section 1.1041-2(c), they are free to choose which spouse will bear the tax burden.
Prepared by Tina Quinn, CPA, PhD, associate professor of accountancy, Arkansas State University, State University, and Rebecca Carr, CPA, instructor of accountancy and real estate, Arkansas State University.