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Stock Redemptions in Marital
Separation Agreements: Unsteady
Steps for the Unprepared
PAUL J. BUSER* and THOMAS R. WHITE**
More and more, today's family lawyer is faced with dividing a family estate
which includes a substantial interest in a closely held corporation. The
attorney must thread through a thicket of preliminary problems, such as
whether both spouses should retain ownership, who will have "control"
of the company, what other assets owned by the couple can be used for a
trade-off, and whether one spouse is able to purchase the other's interests
from some source outside the family estate. Often, the only practical alternative may be corporate redemption, the purchase of one spouse's stock interest directly by the company itself.'
Recent cases involving the redemption of stock in corporations make it clear
that even though section 1041 has brought greater ability to specify the tax
consequences of divorce, it has not put to rest all uncertainty. Tax practitioners still face a grey area when they are trying to predict when a stock
redemption from one spouse will be held to be made "on behalf of' the
other spouse. In that context, there are opportunities to take aggressive
* Paul J. Buser is a partner in the Cleveland, Ohio law firm of Skirbunt & Skirbunt
Co., L.P.A. and co-chairs the Marital Property Committee of the ABA Family Law
Section.
** Thomas R. White is Professor of Law at the University of Virginia School
of Law, Charlottesville, Virginia. He is currently vice-chair of the Domestic Relations
Committee of the ABA Tax Section, and a frequent lecturer on domestic relations tax
problems.
1. Lawrence H. Stotter, Redemption Is Also an EconomicIssue-The Redemption
of CorporateStock Requires Sophisticated Handling by the Attorney, 3 FAM. ADVOC.
6 (1981). Mr. Stotter's analysis of the tax treatment of redemptions in marital property
settlements is the leading articleprior to revision of the domestic relations tax provisions
in the Simplification Title of the Tax Reform Act of 1984, enacted in Division A, Deficit
Reduction Act of 1984 [hereinafter TRA 1984], Pub. L. No. 98-369, §§421-426, 1984
U.S.C.C.A.N. 494, 793-805. Section 1041, providing for nonrecognition of gain or
loss on transfers of marital property between spouses, was enacted in that Act.
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42
Family Law Quarterly, Volume 30, Number 1, Spring 1996
filing positions-and, in a planning context, to document the divorce transac-
tions to either dictate a specific tax result or create ambiguity.2
I. Introduction
In the autumn of 1995 the authors sent a letter to seventy-five family
law practitioners suggesting that the ABA Family Law Section host a
continuing legal education program on the subject of stock redemptions
in the settlement of divorce cases. One respondent objected that the
subject matter was too esoteric.
Legal practitioners and the judiciary cannot afford to ignore developments in the tax law governing marital property settlements and conflicting decisions on the tax treatment of corporate withdrawals in marital
planning. The reality is that corporations, large and small, play significant roles in the accumulation of family wealth. In settling the allocation
of that wealth in dissolution of marriage, the disposition of corporate
stock will frequently be the principal issue. Inevitably tax questions
will be present when corporate stock is transferred in marital property
settlements. The tax liabilities involved may be substantial, therefore
marital property settlements will require careful attention to determining when and by which spouse the tax cost of the settlement is to be
paid.
In most cases where business interests are present, they are centrally
important to the wealth of the family, and the assets owned by the
business, including its ability to generate income in the future, will
provide most of the resources available to fund a settlement. Generally,
only one of the spouses operates the business and the principal objective
of the other spouse is to be paid value for his or her marital property
2. William L. Raby, Raby Revisits Stock Redemptions Incident to Divorce, 62
TAX NOTES 1031 (Feb. 21, 1994), quoted in Ames v. Commissioner, 102 T.C. 522,
541 (1994) (Beghe, J., concurring). Raby has commented on this problems at other
times. William L. Raby, Braking Up May Be Taxing: Divorce Redemptions, 64 TAX
NOTES 365 (1994); William L. Raby, If He Gets the Big Mac, Does She Pay the Tax?,
62 TAX NOTES 347 (1994). By now, the literature is full of discussions about the stock
redemption problem. We think the following are the most useful: Michael Asimow,
When MarriagesDissolve: Transfers of Stock and PartnershipInterests under Section
1041, 47 S. CAL. TAX INST. 10.00 (1995); Jerald D. August, The Divorce of WallHolsey Doctrine-Transfers of Property Incident to Divorce, 53 N.Y.U. INST. ON
FED. TAX'N § 20.00 (1995); Donna Barwick, Right Up There with Death and Taxes;
EstatePlanning Techniques in the Context of Divorce, 29 HECKERLING INST. ON EST.
PLAN.
1700 (1995); Alan L. Feld, Divorce and Redemption, 64 TAX NOTES 651
(1994); Leandra Lederman Gassenheimer, Redemptions Incident to Divorce, 72 TAXES
651 (1994); Deborah A. Geir, Form, Substance, and Section 1041, 60 TAX NOTES
519 (1993); Robert J. Preston & Richard K. Hart, Spouse's Stock in Divorce Can Be
Redeemed Tax Free, 78 J. TAX'N 360 (1993).
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Stock Redemptions in Marital SeparationAgreements
43
interest. The source of payment for that value almost invariably is the
business itself. It is the use of the business assets to fund a settlement
over the continued ownership of the business which produces the tax
problem addressed by this article.
When the business is operated as a regular taxable corporation, distribution of corporate assets will necessarily, whether or not the distribution is part of a marital settlement, attract income tax at the individual
shareholder level. 3 This is a corporate tax problem which the recent
enactment of section 1041 did not solve. 4
The focus is on the following transaction:
Spouses B (business spouse) and N (nonbusiness spouse) own all of the
stock of corporation A, through which B conducts the business. The stock
of A Corp. is marital property and is the principal asset of the marriage.
B, who will end up owning all of the stock of A, does not have independent
assets sufficient to compensate N for the marital property interest in A.
Therefore, the parties agree that the corporation will make the agreed upon
payments to N in exchange for N's stock. In the end B will own all of the
stock of A, which has less net worth because of the payments to N, and
N will have received the value of the interest in cash.
The payments by the corporation to N will be immediately taxable
to one of the spouses, because the tax on N will be a capital gain,
3. A taxable or "C" corporation will pay income tax under IRC § 11 on its
profits. Corporate profits, when distributed to shareholders, will again be taxed to the
shareholders as "dividends" or as amounts realized in a redemption. This two level
or "tiered" tax system, frequently referred to as the "classical" corporate tax system,
may be illustrated by a simple example: Assume that Acme Corp. has $100 of income,
and the tax on this income is 25%. Acme will then have $100 - $25 = $75 of after
tax profit, which it can distribute to shareholders. If it does so as a dividend, the
shareholder distributee will receive $75 of ordinary dividend income. Assuming a
marginal rate of tax on the shareholder of $40, the shareholder will get to keep $75
- $30 = $45, after tax, for an aggregate tax rate of 55 %. On the other hand, if the
distribution was made in redemption and the shareholder's tax basis for his or her
stock is disregarded, the tax rate will be less. Assume that it is 20 %-a distinct possibility
should pending tax legislation be enacted. The shareholder will then keep $75 - $15
= $60 after tax. This illustrates why redemptions are important strategies, because
using a redemption has the effect of reducing the aggregate tax paid in the settlement.
This article addresses the problem of redemptions involving taxable "C" corporations. Most of the principles discussed here may also apply to redemptions of interests
in other, "pass-through" type entities, but the discussion of planning for these entities
is beyond the scope of this article. Such entities include corporations which have elected
subchapter S ("S" corporations), partnerships and the fashionably new type of entity,
the limited liability company.
4. Cf Temp. Reg. § 1.1041-IT(a) Q&A #2 Example (2) (sale of property by
one spouse to a sole proprietorship operated by other subject to nonrecognition), with
id. Example (3) (sale of same property to a corporation, the stock of which is wholly
owned by the other, is taxable).
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
the parties would in a planned transaction prefer that it be imposed
on N.5
The second-tier or shareholder level tax6 must be paid by one of the
spouses. The problem is to determine with an acceptable degree of
certainty which one will pay the tax in a divorce-related stock redemption transaction. Some years ago practitioners had grown accustomed
to the idea that a corporate redemption could be used to allocate the
tax cost to the nonbusiness spouse, who received cash and/or notes
directly from the corporation in a carefully structured transaction. In
Ames v. United States,7 the case which piqued the current interest in
redemptions used in marital settlements, the Ames entered into this
type of transaction, which seemed to touch the corporate tax bases
necessary to assure that N, who was paid cash and notes, would pay the
tax. N paid the tax, but then brought a refund action which culminated in
the favorable Ninth Circuit decision.
This decision challenged a lot of long held assumptions and injected
a large dose of uncertainty into these transactions. Subsequently the
Tax Court in a series of cases involving the same problem,' including
the Ames' situation, 9 made clear its view that the corporate requisites,
as it viewed them, would qualify the transaction as a redemption. Appeal
from Mr. Ames' case in the Tax Court would have been to the Ninth
Circuit, which having just decided in Mrs. Ames' favor might have
been expected to reverse routinely,'° but the Service allowed the time for
appeal to expire without taking action. It then announced a regulations
5. See infra note 15. Moreover, the parties may use some of the tax basis for
their stock to offset the payments from the corporation. If incidence of the tax is known,
of course, the marital settlement can be negotiated to account for the amount of the
tax cost, the party who bears it, and the time when it is to be paid.
6. The "tiers" refer to the level at which the tax is paid. The "first tier" tax
is the regular corporate income tax on corporate taxable income. The "second-tier"
tax is personal income tax imposed on the shareholder when the corporation makes
a distribution. It is the second-tier or shareholderlevel tax which is the focus of our
concern here.
7. Ames v. United States, 981 F.2d 456 (9th Cir.1992), aff'g 91-1 USTC
50,207 (W.D. Wash. 1991) (Ames 1) (payment to wife not redemption); Ames v.
Commissioner, 102 T.C. 522, 541 (1994) (reviewed by the court) (Ames II) (corporate
payments in redemption of stock owned by wife not constructive dividends to husband).
See infra text following note 108 for discussion of court of appeals decision.
8. Hayes v. Commissioner, 101 T.C. 593 (1993) (business spouse taxable); Blatt
v. Commissioner, 102 T.C. 77 (1994) (reviewed by the court) (nonbusiness spouse
taxable); Ames v. Commissioner, supra note 7 (business spouse not taxable).
9. In the Tax Court decision in Ames II, John was held not taxable on corporate
payments made to Joann in the redemption. This case is discussed at infra note 131.
10. This fact created a jurisprudential issue in the Tax Court on which it split
down the middle. See infra note 132.
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Stock Redemptions in Marital Separation Agreements
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project under sections 1041 and 302 to deal explicitly with the problems
presented by these cases. 1
Typically, marital property is divided between the parties consistent
with their objectives in owning the property. The business is usually
allocated in toto to the spouse who will operate it (B). The value of
the stock of B's operating the corporation can be expected to exceed
B's share of the value of the property. To equalize the division of
property, B will usually be required to compensate the nonbusiness
spouse (N) for the value of N's share of the stock which has been
allocated to B. Often B will be personally obligated to pay money to
N for this reason.' 2 Under current law, B's payment to N will not be
taxable to N, even if made in a transaction structured as a sale.' 3 B
will have to make these payments out of income on which B has paid
income tax, usually from income received as compensation or dividends
from the corporation. 4 In this transaction, B will bear all of the tax
on business income used for this purpose and N will receive tax-free
cash.
Either B or N must pay tax on the corporate distributions. The parties
will be faced with a decision as to which of them should bear the tax
burden. In considering this question, divorcing spouses may want to
shift the tax burden to N. There are several reasons for this, not least
of which is the advantage of having the distribution from the corporation
11. IA-REG-0 11-95, Chief Counsel's Report on Regulations Projects, at 63 (6/
30/95). The project was opened in February 1995. Tax Notes Today (3/27/95).
12. See, e.g., N.Y. DOM. REL. LAW § 236, part B.l(b) ("distributive award");
-.5(e) (authorized when division "impractical or burdensome") (Consol. 1995); OHIo
REv.CODE ANN. § 3105.171(A)(1) (defining "distributive award"); -(E)( 1) ("impractical or burdensome") (Baldwin 1995). In Virginia, the court is not authorized to
divide marital property which is titled in the name of one spouse but may make a
"monetary award" instead, which may, in turn, be satisfied with the approval of the
court by the conveyance of property. VA. CODE ANN. § 20.107.3(D) (Michie 1995).
In some states, a monetary or distributive award is not explicitly defined by statute,
but the courts are almost always authorized to make such an award in order to distribute
property equitably. See MICH. COMP. LAWS ANN. §§ 552.19; 554.01 (1995) ("awarding to either party the value [of that party's equitable share of the marital property],
to be paid by either in money. "); WASH. REV. CODE § 26.09.080 (West 1995) (equitable
distribution); In re Marriage of Barnett, 818 P.2d 1382 (Wash. Ct. App. 1991) (lien
on business, with payment deferred to "encourage" husband to sell).
13. I.R.C. § 1041; Temp. Reg. § 1.1041-1T(a) Q&A #2; Balding v. Commissioner, 98 T.C. 368 (1992) (cash payment in exchange for wife's share of husband's
military pension); Godlewski v. Commissioner, 90 T.C. 200 (1988).
14. B will make the payments personally to N. Since these payments are made
for personal reasons, B cannot claim a deduction or other tax advantage, such as an
increase in the tax basis of the property acquired from N, for having made the payments.
Temp. Reg. § 1.1041-IT(d) Q&A #11. As a result, the payments are made by B out
of B's after-tax income.
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
taxed as a capital gain.' 5 A redemption of corporate stock is the classic
way to accomplish this objective. The corporation will agree to redeem
stock either owned by or allocated to N for a stated price. N will receive
the funds in exchange for N's stock. Properly executed, this transaction
results in a capital gain to N 16 payable as the funds are received with
no taxable income to B. The corporation will have to make the payments
to N from its after-tax income, and the burden of this tax liability will
normally fall on B as the sole stockholder. 7 This results in the parties
having a shared tax burden.
There is a problem in the corporate tax law which potentially places
B at the risk of being charged with a dividend, "constructive" because
the cash was actually paid, not to B, but to N. This problem, the cause
of the difficulty inArnesI, is discussed at some length later in the article.
Note what happens to the tax consequences if B is actually charged with
having received a constructive dividend because of the payments to N.
The cash payments from the corporation are treated as having been made
to B, because of the benefit B is said to have received from the payments
to N. N, in turn, is treated as having transferred the stock to the corporation for B's benefit. B is deemed to have received the stock and then transferred it to the corporation. 8 A consequence of the revision of the deal
negotiated by the parties is that the transaction now becomes a sale of
the stock between the individual spouses. The transaction is not taxable
to N under current law.' 9 B made the payments to N out of the dividend
15. For individuals, at the time this is being written, the maximum rate of tax is
28%. I.R.C. § 1(h). Pending legislation would reduce this rate further by allowing
a 50% deduction from adjusted gross income for "net capital gain" (net long term
gain in excess of short term loss) and repealing section 1(h). The maximum rate on
capital gain under this provision would be 19.8%, although for many taxpayers it
would be less. H.R. 6301, 104th Cong., 1st Sess. § 6301 (1995); S. 1357, 104th
Cong., 1st Sess. § 12141 (1995). In passage of the Revenue Reconciliation measures,
the Senate substituted its amendment, but on this point, the language of the two is
identical.
16. I.R.C. § 302(a). Gain on a redemption may be reported on the installment
basis under section 453 if a deferred payout is provided.
17. Income accumulated at the corporate level may have been taxed while the
parties were married. The after-tax nature of these funds will, presumably, be reflected
in the value of the stock for purposes of the marital property settlement.
18. Literally, this is the reconstruction of the transaction seemingly authorized by
Temp. Reg. § 1.1041-1T(c) Q&A #9, infra note 112. According to IRS officers who
drafted the regulation, which was done quickly after enactment of section 1041 because
of the need for guidance, this provision was not intended to be applied in a case like
Ames I. See Blatt v. Commissioner, 102 T.C. 77, 81 (1994) (transfer to satisfy debt
owed to unrelated third party). As applied by the court of appeals in Ames I, it raises
a classic "chicken or egg" problem: should the transaction there be reconstructed
because of the benefit to B? . . . or should a benefit be imputed to B because the
regulation authorizes the reconstruction by its terms (the agreement or decree provides
for the redemption)? The court of appeals was not clear as to which view it adopted.
19. I.R.C. § 1041(a), and supra note 13.
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Stock Redemptions in Marital Separation Agreements
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B is treated as having received, so N is relieved of the tax liability which
N purported to have accepted in the settlement. That liability is placed
on B instead. Moreover N's capital gain has become B's ordinary income. As one might well imagine, this turn of events completely upsets
the economics of the settlement.
The IRS' goal, to collect tax from one of the spouses on the corporate
distribution, puts it in the place of a stakeholder. Presently the Service
appears to be somewhat unsure of its position. The business spouse,
who sought to have to reduce the tax cost of the divorce settlement
through a negotiated stock redemption, incurs the additional cost of
uncertainty as the nonbusiness spouse may try to shift the tax burden
back to the business side. This does not mean that the redemption plan
must be avoided, rather it must be approached with care. 2°
This article explores answers to this difficult problem through review
and close analysis of tax law history and recent corporate redemption
decisions which directly impact the settlement of divorce cases. Because
it is not possible to predict all of the elements involved in negotiating
different stock redemption agreements, this article is not meant to be
an exhaustive treatment. Each factual case stands on its own. Instead
the article is intended to provide a thoughtful foundation to attorneys
and judges who must address the challenge of stock redemptions in
the settlement of divorce cases.
The article is divided into four parts: The first section discusses the
rules that govern corporate tax on stock redemptions, highlighting the
importance of the stock redemption agreement in planning for divorcing
20. The commentators have not been in complete agreement on the impact of
section 1041 transfers on section 302 stock redemptions. For example:
The redemption of shares by the corporation, though it may be intended as a
device for the settlement of property rights, is not a Section 1041 transfer and
its consequences are governed by the usual Code provisions relating to redemptions. The elimination of the capital gains preference has reduced the importance
of compliance with the provisions of Section 302, which prescribe the rules for
obtaining capital gain treatment on the redemption of shares.
WREN, GABINET AND CARRAD, TAX ASPECTS OF MARITAL DISSOLUTION § 12:08.60, 11
"Problems in Division of Corporate Business Interests," at 300.32 (Clark, Boardman
Callaghan, 1993).
A more optimistic view, emphasizing the importance of section 1041 in a divorcerelated stock redemption, is taken by the authors in this article, albeit with some
reservation because of the apparent uncertainty that current developments have injected
into the subject:
Since I.R.C. Section 1041 now permits the nontaxable transfer of assets, the use
of stock redemptions will become a much more viable planning technique in
dividing the type of property interests than was formerly the case under the preDRTR rules.
MAHONEY, KORITZINSKY & FORKIN, TAX STRATEGIES IN DIVORCE § 4, "Closely Held
Corporate Stock," at 29 (1987). See also the discussions cited supra note 2.
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
couples. This section will specifically identify the circumstances under
which a redemption of stock held by the nonbusiness spouse may become a constructive dividend to the business spouse.
Second, there is a review of the tax treatment of marital property transfers and how this treatment affects the corporate tax consequences of
marital redemptions after enactment of Section 1041 by the Domestic
Relations Tax Reform Act of 1984 (DRTRA). 21 The primary difficulty
is reconciling traditional stock redemption rules, under which redemptions
are taxable events, with the new "tax free" treatment of marital property
transfers.
Next, there is a review and analysis of the present state of case law
governing the tax treatment of marital redemptions. The fourth part
covers recommendations and guidelines for structuring redemptions in
divorce settlements, including methods for reducing the uncertainty
injected by the recent Ames I decision.
II. Tax Treatment of Stock Redemptions
A distribution by a corporation "out of its earnings and profits" is
generally a dividend,2 2 taxed to the stockholder who receives it as ordinary income. When the corporation makes payments which benefit a
stockholder, the payments may also be taxed as constructive dividends
to that stockholder .23 A common type of constructive dividend is the
payment of the stockholder's personal debt. The funds represented by
the debt may have been used for purposes which require the use of
after-tax income, so when the debt is paid by the corporation the stockholder is treated as having received income. 24 This debt may have been
21. Congress enacted Section 1041 of the Internal Revenue Code "to minimize
the intrusion of the tax laws into marital relationships." As noted in the House Committee report, "(t)he committee believes that, in general, it is inappropriate to tax transfers
between spouses. This policy is already reflected in the Code rule that exempts marital
gifts from the gift tax and reflects the fact that a husband and wife are a single economic
unit." H. REP. No. 98-482 (1984), at 1491.
22. I.R.C. § 316(a).
23. The payment of personal expenses, such as legal fees, Dolese v. United States,
605 F.2d 1146 (10th Cir. 1979), cert. denied, 445 U.S. 961 (1979) (corporation ordered
in divorce case to pay counsel fees for nonbusiness spouse) or travel expenses, Ireland
v. United States, 621 F.2d 731 (5th Cir. 1980), are classic illustrations of this problem.
Often the expenses are so clearly personal that the payment is disguised as a "loan"
from the corporation, and many of the constructive dividend cases address this factual
question and are often contrary to the position of the stockholder. See, e.g., Crowley
v. Commissioner, 962 F.2d 1077 (1st Cir. 1992) (citing many cases); Epps v. Comnmissioner, 70 T.C.M. (CCH) 1 (1995) (a recent example).
24. The case universally cited for this proposition is Old Colony Trust Co. v.
Commissioner, 279 U.S. 716 (1929), in which an employer paid the income tax liability
of the employee on the employee's compensation. Payment of the tax liability was
held to be additional compensation. A similar result occurs when the corporation pays
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incurred to purchase stock of the corporation itself, in which case the
purchasing stockholder will be taxed on the funds used to pay the
obligation.25
When the corporation redeems the stock of one stockholder (seller)
the remaining stockholder (buyer) may appear to have received a benefit. The buyer does end up owning a larger percentage of the corporation
than he or she owned before the redemption. This increase in control
over the business is an advantage gained through the use of corporate
funds. However, the corporation is now less valuable by the amount of
its funds used to redeem the seller's stock. If the redemption accurately
reflects the value of the business, then the buyer is economically no
better off than before. Since the corporate payments were not made to
the buyer, most courts have concluded that the fact that the redemption
occurred is not sufficient to charge the buyer with a constructive dividend.26 Generally the buyer can plan to avoid the potential constructive
dividend, but before exploring the nature of that problem, it is necessary
to consider the transaction from the selling stockholder's perspective.
The seller will require gain from the disposition of his or her stock
to be taxed as capital gain. To achieve this result, a distribution by the
corporation in exchange for the seller's stock must meet the requirements of one of four statutory categories.27 If the redemption does
the personal debt of its stockholder. Cf. DeNiro's Estate v. Commissioner, 795 F.2d
582 (6th Cir. 1986), on remand, 60 T.C.M. (CCH) 300 (1990) (dividend from corporate
payment of estate tax to release tax lien).
25. Wall v. United States, 164 F.2d 462 (4th Cir. 1947), is the classic statement
of this question:
It cannot be questioned that the payment of a taxpayer's indebtedness by a third
party pursuant to an agreement between them is income to the taxpayer. . . . The
transaction is regarded as the same as if the money had been paid to the taxpayer
and transmitted by him to the creditor; and so if a corporation, instead of paying
a dividend to a stockholder, pays a debt for him out of its surplus, it is the same
for tax purposes as if the corporation pays a dividend to a stockholder, and the
stockholder then utilizes it to pay his debt.
26. Holsey v. Commissioner, 258 F.2d 865 (3d Cir. 1958), rev'g, 28 T.C. 962
(1957), acq. Rev. Rul. 58-614, 1958-2 C.B. 920. In Holsey, the "buyer" assigned
an option which he held to purchase 50% of the stock of Corporation to the Corporation,
which promptly exercised the option. The striking price was conceded to be less than
the value of the stock, so the value of the buyer's stock increased because of the
purchase. Nonetheless, that was not enough to result in a constructive dividend to the
buyer.
27. I.R.C. § 302(a). Note that a sale of stock in one corporation to another,
commonly controlled corporation may be treated as a distribution in redemption of
the stock of the purchasing corporation, which would then have to fit within one of
these categories for it to be taxed as an exchange. I.R.C. § 304(a)(1).
When stock of a deceased shareholder is redeemed from his or her estate in
order to pay death taxes and funeral expenses, the corporate payment will be
treated as a redemption if the value of all of the stock owned by the estate exceeds
35 % of the value of the gross estate for federal estate tax purposes less expenses
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
satisfy one of these categories, then the corporate payment is treated
as having been received by the seller in exchange for the stock. This
means that the payment is treated as an amount realized by the seller
in a sale of a capital asset. Gain is determined by subtracting the seller's
tax basis for the stock and is generally taxed as capital gain. 28
A. Redemptions Not Essentially Equivalent to a Dividend
A stock redemption will receive capital gain treatment if the redemption is not "essentially equivalent" to a dividend with respect to the
shareholder, i.e., if it results in a meaningful reduction in a shareholder's proportionate interest in the corporation, taking into account the
constructive ownership rules .29 Whether a distribution is "not essentially equivalent to a dividend" is a question of fact which is made on
a shareholder by shareholder basis. 30 However, after United States v.
Davis,3' the business purpose for the redemption is irrelevant, so a
redemption undertaken for sound business reasons must nonetheless
be tested under the numerical rules if it is to qualify as an exchange.
B. Substantially DisproportionateRedemption of Stock
A redemption will be taxed as an exchange when it meets one of two
statutory safe harbors. The first is a "substantially disproportionate"
redemption. The percentage of stock owned by the seller after the
and charitable contributions. I.R.C. §§ 303(a) and (b)(2). Because the estate has
obtained an increase in the tax basis of the stock to its fair market value, presumably
the value at which the redemption occurs, the estate will not realize gain or loss
on the redemption. See I.R.C. § 1014. Effectively, this special rule permits the
constructive ownership rules to be disregarded when the redemption is made
within the limited parameters of this carefully designed provision. While it may
be regarded as limited special tax relief for decedents, the policy it represents
does have some resonance with the policy supporting nonrecognition for marital
property transfers.
28. See generally RIA TAx ACTION COORDINATOR, "Tax Planning," Vol. 1, §
108-M-Stock redemptions," at 128 (1994). This assumes that the stock is a capital
asset in the hands of the selling stockholder, which is almost universally true.
29. I.R.C. § 318.
30. I.R.C. § 302(b)(1).
31. 397 U.S. 301 (1970). Davis, the sole stockholder of his corporation, had a
class of preferred stock, issued for the business purpose of temporarily increasing the
corporation's working capital, redeemed by the corporation. Because his proportionate
interest in the corporation was unchanged, the Court agreed with the Commissioner
that the distribution was a dividend, regardless of the Davis' bona fide business purpose
in issuing and then redeeming the class of preferred. This Davis case, coincidentally
bearing the same name as United States v. Davis, infra note 56, which imposed tax
on the transferor of property in a martial property settlement, is viewed as having
established an automatic dividend rule which has virtually read section 302(b)(1) out
of the Code. It is important for our purposes because of its effect on the interpretation
of the tax rules governing the tax treatment of corporate distributions.
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redemption must be less than 80 percent of the seller's pre-redemption
percentage ownership in both the outstanding voting stock (common
or preferred) and the pre-redemption outstanding common stock (voting
or nonvoting); and the seller must own less than 50 percent of the
outstanding voting power immediately after the redemption. Constructive ownership
rules apply in determining the percentage of the seller's
32
ownership.
C. Complete Termination of the Stockholder's Interest
The second safeharbor is a complete termination of interest. When
all of the stock (common and preferred) actually owned by a stockholder
is redeemed, the redemption may qualify as an exchange, provided the
constructive ownership rules do not treat the seller as the owner of
stock actually owned by some other person.33 In this case, a special
rule permits the seller to waive the family attribution rules, so the
complete termination of the interest of a family member in the corporation can qualify, even though other family members own stock.34 In
divorce settlements the sole purpose of the redemption is to buy out
the interest of the selling spouse, so complete terminations are standard
in divorce settlements. After the redemption, the spouses will be divorced, and stock owned by one cannot be attributed to the other. 35
D. PartialLiquidation Redemption of Noncorporate Stockholder
A redemption from a noncorporate stockholder in partial liquidation
of the corporation will qualify as an exchange.36 The distribution is a
partial liquidation, when it is "not essentially equivalent to a dividend"
(determined at the corporate level), usually resulting from a contraction
of the corporation's business. Here, another statutory safe harbor protects a distribution which results from the termination of a qualified
trade or business when it continues to conduct another qualified trade
or business thereafter.37
32. I.R.C. §§ 302(b)(2); 302(c); 318.
33. I.R.C. § 302(b)(3).
34. I.R.C. § 302(c)(2).
35. The situation may not be that simple. Adult children, or trusts for minor
children, may also own stock in the corporation. Thus, waiver of attribution may be
important or, if the waiver is not available, see section 302(c)(2)(B)(I), then the redemption may have to qualify as a "disproportionate redemption."
36. I.R.C. § 302(b)(4).
37. I.R.C. § 302(e). The term "qualified trade or business" refers to the active
conduct of a trade or business and generally requires the corporation to have terminated
one such trade or business while continuing to conduct the other. This requirement
is similar to the active trade or business requirement for qualifying nontaxable divisive
reorganizations under section 355. Although partial liquidations would be rare in divorce settings, a split-off and split-up under section 355 conceivably could be planned
in a marital settlement.
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
Although stock redemptions generally involve difficult technical issues,38 this article focuses on the narrower questions raised by these
transactions for the participants. More complex corporate tax subjects
are beyond the scope of this article and are discussed extensively elsewhere.39
In nonmarital situations, redemptions occur frequently when the principal source of funding for a buy-out is the corporation itself. Under these
circumstances, the buyer may acquire stock of the seller by a combination
of redemption and direct purchase by the buyer, who thus acquires stock
necessary for his or her acquisition at a more affordable price. The net
effect of the combined transaction is a sale, or if one thinks of the order
of events as a purchase followed by redemption, a complete termination
of the seller's interest in the corporation. Redemptions in combined or
"bootstrap" purchases were blessed on the seller's side many years ago
in Zenz v. Quinlivan.40 The court employed an end-result test, under
which the integrated buy-out transaction was analyzed after all of its parts
had been completed. Subsequently, the Service has applied the Zenz principle to conclude that the order of events is immaterial, so long as the
purchase and redemption are related. 4' The seller's capital gain is assured, regardless of the order of events.
On the buyer's side, matters are not as straightforward. As noted
earlier, corporate payment of the stockholder's debt results in a constructive dividend to the shareholder. This principle applies to debt
incurred by the stockholder in purchasing stock in the corporation.42
Later, in Sullivan v. United States,4 3 this idea was extended to include
38. Many of the questions raised again by these divorce redemption cases implicate
the repeal of the so-called General Utilities rule by the Tax Reform Act of 1986.
These provisions now require the corporation to recognize gain on any distribution
of appreciated property, particularly including distributions in liquidation. This is not
inconsistent with allowing the stockholder to treat gain recognized in a redemption as
capital gain, but it does make redemptions appear somewhat incongruous.
39. See generally, BORIS I. BITTKER & JAMES S. EusTICE, FEDERAL INCOME TAXATION OF CORPORATIONS & SHAREHOLDERS, ch. 9 (6th ed. 1987); 7 CCH FED. TAX
SERV. "Corporations," CH. 1:8 "Stock Redemptions and Partial Liquidations," at
1:8-1 et seq.; RIA TAX ACTION COORDINATOR, supra note 28, at 130 et seq.; Tax
Mgmt. Portfolios No. 343-2nd, "Corporate Stock Redemptions-Definitions; Basic
Categories" (Supp. July 1995).
40. 213 F.2d 914 (6th Cir. 1954), acq., Rev. Rul. 55-745, 1955-2 C.B. 223 (as
to transaction governed by the 1954 Code).
41. Rev. Rul. 75-447, 1975-2 C.B. 113. See Rev. Rul. 81-186, 1981-2 C.B. 85;
Rev. Rul. 79-273, 1979-2 C.B. 125; Rev. Rul. 77-226, 1977-2 C.B. 90.
42. Wall v. United States, supra note 25. See, e.g., Schroeder v. Commissioner,
831 F.2d 856 (9th Cir. 1987); Adams v. Commissioner, 594 F.2d 657 (8th Cir. 1979);
Jacobs v. Commissioner, 41 T.C.M. (CCH) 951 (1981), aff'd per curiam, 698 F.2d
850 (6th Cir. 1983).
43. 363 F.2d 724 (8th Cir. 1966), cert. denied, 387 U.S. 905 (1967).
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personal obligations under an executory agreement to buy stock. In
Sullivan, the taxpayer agreed to sell some of his personally owned
stock in the corporation to the managing employee, subject to the
taxpayer's personal contractual commitment to repurchase the stock
when requested by the employee to do so. Eight years later, the
employee requested the taxpayer to repurchase the stock. The taxpayer arranged to have the corporation satisfy the repurchase
agreement. The corporation's payments were held to be constructive
dividends to the taxpayer because they relieved him from the binding
contractual commitment. The court's reasoning implied that any relief from a legal liability personally to acquire the seller's stock
might result in a constructive dividend to the buyer, but until now,
that principle had not been expansively applied.
Shortly after Sullivan, the IRS issued Revenue Ruling 69-608,"
in which it concluded that a constructive dividend would not result
unless the purchasing stockholder's contractual obligation was "primary and unconditional." The ruling sets forth examples which make
clear that guarantees by the buyer, assignable obligations to purchase, and modification before the triggering event has occurred
will not result in constructive dividend treatment to the buyer.45 The
ruling was essential for corporate planners. Buy-sell agreements are
common in the commercial world, where they perform an essential
function. Often these agreements are made many years before the
events occur which might require performance. If the buying stock44. 1969-2 C.B. 43.
45. Rev. Rul. 69-608, supra note 44, "situations" 5-7, respectively. Situation 5
is the most relevant example for purposes of our discussion:
A and B owned all of the outstanding stock of X corporation. An agreement
between A and B provided that upon the death of either, X will redeem all of
the X stock owned by the decedent at the time of his death. In the event that X
does not redeem the shares from the estate, the agreement provided that the
surviving shareholder would purchase the unredeemed shares from the decedent's
estate. B died and, in accordance with the agreement, X redeemed all of the shares
owned by his estate.
In this case A was only secondarily liable under the agreement between A and
B. Since A was not primarily obligated to purchase the X stock from the estate
of B, he received no constructive distribution when X redeemed the stock.
If one were to substitute "divorce" for "death" and B for B's estate, the marital
redemption cases, and in particular, Ames, seem to fit this example to a "T". In the
other situations, the ruling adopts the holdings in Sullivan (situation 1); a buy-sell
agreement with both parties bound on the death of the first to die (situation 2); Schalk
Chemical Co., 32 T.C. 879 (1959), aff'd, 304 F.2d 48 (9th Cir. 1962) (corporate
payment of shareholder obligations after "bootstrap" acquisition) (situation 3); and
S.K. Ames, Inc., 46 B.T.A. 1020 (1942), acq., 1942-1 C.B. 1 (only the buyer bound
by contract: no dividend to buyer) (situation 4).
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
holder in a cross-purchase arrangement has incurred personal contractual liability to buy the seller's stock, then the buyer may be
unable to avoid the potential constructive dividend should the corporation execute the contract and redeem the seller's stock.46
The distinction is essentially formal and totally dependent on contract
drafting. The ruling makes planning possible because it specifies how
to plan buy-out arrangements. At least, it clarifies the Internal Revenue
Service's position, a position which the Service has at times vigorously
litigated. Recent cases interpreting and applying the Service's argument
seemed to have accepted the "primary and unconditional" test, and
have made clear that both parties must be bound by the contract to buy
and sell the specific stock.47 A provision permitting assignment of the
obligation will avoid constructive dividend treatment when the buying
stockholder assigns the contract to the corporation to redeem the seller's
stock.48
In the nonmarital setting, failure to avoid the "primary and unconditional obligation" which can cause the constructive dividend problem
is an expensive foot fault, which no properly advised buyer should be
allowed to make. When it happens in the commercial world, the seller's
tax treatment is not affected, so the buyer incurs an unnecessary additional tax on money paid and taxed to the seller. Only the IRS and the
buyer are interested in this additional tax, which might explain why
Revenue Ruling 69-608 has played such an important role in the development of the law.
The early marital redemption cases, 49 House of Carpets, Nichols,
46. See Smith v. Commissioner, 70 T.C. 651 (1978). Taxpayer entered into
a cross purchase agreement with his father that the survivor would purchase the
stock of first to die from the decedent's estate and, further, would purchase the
stock of taxpayer's sibling or her estate if she requested him to do so. When both
taxpayer's sister and his father died later, settlement of the purchase obligation by
a corporate redemption resulted in a constructive dividend with respect to the purchase of father's stock because taxpayer was obligated to buy and his father's estate
to sell. However, no constructive dividend resulted with respect to the purchase
of his sister's stock because only the taxpayer was obligated to buy. In making this
insubstantial distinction, Smith shows what is wrong with the test adopted in the
ruling.
47. Smith, 70 T.C. at 651; Rev. Rul. 69-608, supra note 44, situation 4.
48. Kobacker v. Commissioner, 37 T.C. 882 (1962), acq., 1964-2 C.B. 6, which
is cited for this proposition in situation 6, Rev. Rul. 69-608, supra note 44; Buchholz
Mortuaries, Inc. v. Commissioner, 59 T.C.M. (CCH) 746 (1990); Bunney v. Commissioner, 55 T.C.M. (CCH) 394 (1988).
49. By "early," we mean transactions planned and carried out before the effective
date of section 1041, which was enacted on July 18, 1984.
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and Edler, among others, ° were decided under this test. In each, the
selling spouse owned the stock in question, although in some of the
cases, "ownership" for this purpose resulted from an allocation of
marital property and the transfer of ownership to the selling spouse."1
In each of these early marital redemption cases, the buyer initially
incurred a personal obligation in the settlement agreement or under
the divorce decree to purchase the interest of the selling spouse in the
corporation. Unless the buying spouse was able to remove the obligation, he or she was held to have received a constructive dividend when
the corporation made the purchase and satisfied the personal liability.
In each case, the selling spouse would be taxed on gain realized in the
sale (if the purchase was made individually)5 2 or in the redemption of
the stock.53 Taxation of the buyer on a constructive dividend should
not have mattered to this result, and would therefore have resulted in
the unnecessary "additional tax" referred to above. So, these cases
may not tell much about constructive dividends emanating from marital
settlements. Before examining the recent cases and rulings which reflect
the uncertainty which may always have been present in marital redemp50. Edler v. Commissioner, 727 F.2d 857 (9th Cir. 1984), aff'g, 43 T.C.M.
(CCH) 508 (1982); Gordon v. Commissioner, 34 T.C.M. (CCH) 437 (1975); Berger
v. Commissioner 33 T.C.M. (CCH) 737 (1974), aff'd mem., 538 F.2d 334 (9th Cir.
1976); House of Carpets, Inc. v. Commissioner, 32 T.C.M. (CCH) 1239 (1973);
Nichols v. Commissioner, 32 T.C.M. (CCH) 507 (1973). In Gordon, Berger, and
House of Carpets, the divorce decree clearly imposed a personal obligation on husband
to buy stock owned by wife, and in all three cases, the courts sustained the Commissioner's assertion of a constructive dividend. In Edler and Nichols, the divorce court
subsequently altered the language of the decree to make the obligation to be that of
the corporation.
51. See Serianni v. Commissioner, 765 F.2d 1051 (1lth Cir. 1985), aff'g, 80
T.C. 1090 (1985) (Florida "special equity") (proceeds of sale of corporate assets
under former section 337); Laird v. United States, 16 Cl. Ct. 441 (1989) (Oregon
equitable distribution) (redemption following award of 50% of stock in corporation
in nonconsensual divorce decree); Harrah v. Commissioner, 70 T.C. 735 (1978)
(Nevada community property) (redemption following allocation under marital settlement agreement approved by divorce court). This, of course, is also what happened in Edler, when the nonbusiness spouse was allocated stock in the corporation
as her share of community property under California law. See supra text at note
50.
52. Community property: Harrington v. Commissioner, 67 T.C.M. (CCH) 3060
(1994); Siewert v. Commissioner, 72 T.C. 326 (1979). Jointly owned property in
noncommunity states: Pennington v. Commissioner, 60 T.C.M. (CCH) 559 (1990);
Angst v. United States, 60 A.F.T.R. 2d 87-6013 (E.D. Wis. 1987); cf. Gerlach v.
Commissioner, 55 T.C. 156 (1970), app. dis. (6th Cir. 1971), acq., 1971-2 C.B. 2
(taxing wife on installment payments received for corporate stock even though this
point had not been asserted by the Commissioner).
53. See supra cases cited at note 51.
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
tions, a brief description of the impact of Section 1041 on marital
transfers follows.
E. Taxation of Marital Transfers
Before 1984, the division of community property, 54 or of marital property in noncommunity states which had ownership attributes,5 5 was not
taxable. In 1962, the Court held in United States v. Davis56 that a transfer
of appreciated property by one spouse in satisfaction of marital property
claims asserted by the other was a taxable transaction resulting in the
recognition of gain by the transferorand a tax basis equal to value for
the transferee.5 7 Appreciation in the value of the property at the time was
charged to the spouse who held title. Application of a Davis tax to property transfers meant that the transferor had to pay an additional tax, even
though the transferor's net wealth was depleted by the transfer to the
transferee as her share of the spouse's marital property, and the transferee received the benefit of that payment through a stepped up tax basis.
Within a few years, the Court had relegated the determination when
such transfers were taxable to state law, under which the property rights
of the spouses were determined. 58 Lower courts accepted this notion
wholeheartedly, and found co-ownership elements which justified not
applying the Davis tax on transparent linguistic formulations. By 1984,
with the almost universal implementation of equitable distribution statutes, very little remained of the Davis rule, although there was enough
uncertainty to cause serious concern to the government about "whipsaw." In a whipsaw, the transferee would assert an increase in adjusted
basis for property received under a divorce settlement many years earlier, which was then found to have been a taxable exchange under Davis.
The transferor, who would otherwise have paid the Davis tax, had not
reported the transaction, and the statute of limitations had since run.59
54. Estate of Frances R. Walz v. Commissioner, 32 B.T.A. 718 (1935) is the
leading case cited for this proposition, which seems to have been accepted as the rule
in later cases. See, e.g., Gaughan v. Commissioner, 75 AFTR 2d 1231 (5th Cir. 1995)
(unpublished opinion), rev'g, 66 T.C.M. (CCH) 168 (1993); Davis v. Commissioner,
88 T.C. 1460 (1987); Siewert v. Commissioner, 72 T.C. 326 (1979).
55. Pokusa v. Commissioner, 37 T.C.M. (CCH) 434 (1978); see Rev. Rul. 81-292,
1981-2 C.B. 158.
56. 370 U.S. 65 (1962).
57. Rev. Rul. 67-221, 1967-2 C.B. 63.
58. Collins v. Commissioner, 393 U.S. 215 (1968), on remand, 412 F.2d 211
(10th Cir. 1969); Imel v. United States, 523 F.2d 853 (10th Cir. 1975). See Rev.
Rul. 81-292, 1981-2 C.B. 158.
59. Compare Cook v. Commissioner, 80 T.C. 512 (1983), aff'd mem., 745 F.2d
1431 (2d Cir. 1984) (husband's transfer of family properties to wife in divorce settlement under Connecticut law not taxable to husband), with Cook v. United States, 904
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In 1984 Congress intervened. To eliminate the potential whipsaw
(which the government desired) and the apparent harsh consequences
from imposing tax on a transferor whose wealth had been depleted,
and for other reasons, 6° section 104161 was enacted. It provides that
no gain or loss shall be recognized (by either transferor, as in Davis,
or transferee, as in a sale) on a transfer of property between spouses,
or between ex-spouses when incident to divorce. The transferee takes
a carryover basis. These provisions seem straightforward, but they
F.2d 107 (1st Cir. 1990) (wife entitled to basis equal to value at the time of divorce
for the same properties because the transfer was not a nontaxable division of co-owned
properties). The whipsaw potential was very much on the Tax Court's mind in Ames
11, where the court was very critical of the Service's efforts to prevent litigation of
both wife's and husband's tax cases together in the Ninth Circuit.
60. The Congress believes that, in general, it is inappropriate to tax transfers
between the spouses. This policy is already reflected in the Code rule that exempts
marital gifts from the gift tax [the unlimited marital deduction], and reflects the
fact that a husband and wife are a single economic unit.
The current rules governing transfers of property between spouses or between
former spouses incident to divorce have not worked well and have led to much
controversy and litigation. Often the rules have proved a trap for the unwary
.. . [because of an unexpected imposition of the Davis tax].
Furthermore, in divorce cases, the government often gets whipsawed ...
The Congress believes that to correct these problems, and make the tax laws
as unintrusive as possible with respect to relations between the spouses, the tax
laws governing transfers between spouses and former spouses should be changed
[by enactment of Section 1041]. [Emphasis supplied.]
STAFF OF JOINT COMM. ON TAX., GENERAL EXPLANATION OF THE REVENUE PROVI-
SIONS OF THE DEFICIT REDUCTION ACT OF 1984, 98th Cong., 2d Sess. 710-11 (1984)
("DEFRA Blue Book"). Although the legislative history refers to the Davis tax (presumably) as "inappropriate," the result of imposition of the Davis tax was often
described as "harsh" in the hearings. See, e.g., Tax Law Simplification and Improvement Act of 1983: Hearingson H.R. 3475 before the House Comm. on Ways & Means,
98th Cong., 1st Sess. 151-52 (Assistant Secretary Pearlman's statement). It should
also be noted that this provision was included in a "simplification" measure. This
must have meant the substitution of a uniform rule (nonrecognition) for a rule which
depended upon the particularities of state law, and especially on the presence of precise
legislative language.
61. Section 1041 of the Internal Revenue Code provides in part:
(a) GENERAL RULE.-No gain or loss shall be recognized on a transfer of
property from an individual to (or in trust for the benefit of)(1) a spouse, or
(2) a former spouse, but only if the transfer is incident to the divorce.
(b) TRANSFER TREATED As GIFr; TRANSFEREE HAS TRANSFEROR'S BASI.-In
the case of any transfer of property described in subsection (a)(1) for purposes of this subtitle, the property shall be treated as acquired
by the transferee by gift, and
(2) the basis of the transferee in the property shall be the adjusted basis of
the transferor.
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
conceal a wide range of problems, most of which are beyond the scope
of this article. 6 2 It is vital to recognize several important features.
First, the statute is much broader than necessary to solve the narrow
problem caused by United States v. Davis. Its application is not limited
to transfers or divisions of marital or community property; rather it applies to any property transferred between spouses. Moreover, the manner of transfer is immaterial. An exchange between spouses which is
structured explicitly as a sale is nonetheless governed by the nonrecognition rule: the selling spouse does not recognize gain, and the buying
spouse takes the property with a carryover basis, thus receiving no basis
adjustment for consideration paid by the buyer in the sale.63 The cash
payments in this kind of exchange must be analyzed separately for their
tax effect. When the exchange is part of a divorce settlement, it is possible
to bring such payments, even when secured and interest-bearing, within
the definition of alimony. 64 Although alimony questions are also beyond
the scope of this article, the professional who plans divorce settlements
must be aware that an alimony-structured property settlement is possible
and in some ways a superior alternative to the redemption. 65
Second, this nonrecognition statute has very real tax effects. Gain
on appreciated property (or loss on depreciated property) is shifted to the
transferee. Because carryover basis is assigned property by property,
62. Section 1041 applies to transfers between former spouses when "incident
to the divorce." The Temporary Regulations provide that any transfer which (1) is
"pursuant to" a divorce instrument and (2) occurs within six years is presumed to
be "incident to divorce," while transfers not meeting these conditions are presumed
not "incident to divorce." The "presumption" may be rebutted only by showing that
the transfer was made to "effect the division of property owned at the time of [divorce]."
Temp. Reg. § 1.1041-IT(b) Q&A #7. None of this is provided in the statute, and the
specificity raises some serious application problems, which we do not address. However, in general, every economic rearrangement related to a property settlement involves transfers which are, in same way, "incident to the divorce," even though the
difficulties may stem from circumstances which arise after the divorce. Such transfers
include the stock redemptions we discuss in this article, or obligations to make payments
for stock, even though, technically, a stock redemption is between stockholder and
corporation. Difficulties like these may contribute as much to uncertainty in the application of section 1041 as does the unarticulated decision in Ames I. There are also much
broader questions which one of us (Professor White) has dealt with at length elsewhere.
"Stock Redemption in Matrimonial Settlements" (work in progress). These include
the definition of the term "property" as it is used in the statute, that is, whether the
assignment of income doctrine will prevent the transfer of ordinary income assets
(receivables for services) under section 1041. See Kochansky v. Commissioner, 67
T.C.M. (CCH) 2665 (1994), app. pending (3d Cir.).
63. See supra note 13; Balding v. Commissioner, 98 T.C. 368 (1992).
64. I.R.C. § 71(b)(l).
65. See Joseph Du Canto, Tax Aspects of Dissolution and Separation, §§ 17.4717.48 (1II. Property Settlements and Transfers Under the New Domestic Relations
Tax System), at 17-73 (Illinois Family Law, Ill, Inst. for CLE, 1984, Supp. 1985).
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low-basis property in a marital property settlement can be allocated to
one spouse while high-basis property is assigned to the other. A cash
buy-out is the classic illustration of this problem. Assume that spouses
B and N each own 50 percent of the stock of Acme Corp. for which
they have very little tax basis. Pursuant to divorce settlement with N,
B "acquires" N's 50 percent interest in Acme for $500,000.
This "acquisition," a taxable sale when done by persons not married
to each other, is not taxable to N, the seller. 66 N will take the cash
paid by B with a tax basis equal to face value and B will obtain 100
percent of the stock of Acme with its original low basis. So, N has
received high-basis assets, the cash, and B low-basis assets, the stock.
B, however, will have to pay tax on the cash used to pay N, 6 7 immediately on payment to N or later, if the cash was borrowed from a third
party. B may also have to pay tax on any gain realized when stock in
Acme is sold, 68 but the liability for this tax may be long deferred, and
thus the present value of the tax cost of the low basis allocated to B
may be lower than it may appear. 69
Third, section 1041 does not directly prescribe how the internal tax
consequences of property transfers should be determined, although the
legislative history does state that the nonrecognition rule recognizes
that B and N are "a single economic unit.' 70 Viewed in this light,
property transfers simply rearrange the ownership of property within
66. See supra note 13.
67. B might have agreed to pay N in installments. The cash to make the payments
required by the contract must come from somewhere, and, in this context, the source
is usually the corporation. So, B might have received compensation or dividends from
Acme, on which B will pay tax before making the payments to N. This is not a
remarkable result as payments on the principal of any debt are not deductible by the
payor. The point, of course, is that the transaction described in the text, which looks
like a classic illustration of a marital transaction that is "not taxable" under section
1041, is a direct allocation of the tax effects to one of the parties.
68. B intends to operate the business for the indefinite future, so the actual tax
liability which B may ultimately have to pay is not determined. If B owns the stock
of Acme until death, her heirs will obtain stepped up basis under section 1014, and
the gain will be exempt. See supra note 27. B may also dispose of the Acme stock
in nontaxable corporate reorganization, which would defer taxation of the gain to a
time later than the disposition.
69. State courts have been reluctant to hold that this tax cost must be taken into
account in valuing the corporation, or in determining the amount to be paid to the
departing spouse, because the tax is said to be "speculative." For classic examples
of the problem, see Adams v. Adams, 854 P.2d 501 (Or. Ct. App. 1993) (potential
tax on distributions from DISC ("Domestic International Sales Corporation," see IRC
§ 992(a)) to pay ex-spouse for her interest disregarded); DeHaan v. DeHaan, 572
N.E.2d 1315 (Ind. Ct. App. 1991) (tax on the buyer disregarded in personal cash
buyout of the seller).
70. See supra note 60.
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Family Law Quarterly, Volume 30, Number 1, Spring 1996
that unit, as if each spouse had been an owner of the property from
the time either or both spouses first acquired it. One can argue that a
distribution from a corporation should be taxed appropriately to whichever spouse is the nominal stockholder who receives it and should not
be attributed to the other. This position seems to be supported by hold71
which
ings in cases under pre-1984 law like Serianni and Harrah,
hold that the assignee spouse should bear the tax consequences of redemptions or liquidations of the interests assigned to him or her in a
marital property settlement, thus reaching tax results consistent with
the single economic unit theory.
Enactment of section 1041 has changed the tax incidence of divorce
transfers. Under prior law, the nontaxable transfer of property to one
spouse 72 followed by a disposition of that property for cash would result
in gain taxable to the transferee, even when the cash was paid by the other
spouse. That is not true anymore, as section 1041 has eliminated tax when
the purchase is made by the other spouse. Now when the corporation
makes the payment, and the business spouse ends up owning all of the
stock of the corporation, relieving the nonbusiness spouse from tax on the
transaction arguably seems more consistent with the apparent purpose of
section 1041, to lift the tax liability from the transfer. 73 At least, a purported redemption which is left unclear7 4 allows both sides to make the
arguments rehearsed here 75 and potentially may give rise to the whipsaw
experienced by the government in the Ames cases.
71. See supra note 51.
72. Transfers of property under pre-1984 law, contrary to widely held views,
were generally not taxable either as a division of jointly owned or community property
or because of statutory marital property rights. See supra text at notes 54-58. Once
the transfer had been made, the tax consequences flowing from a taxable disposition
of the property, even a sale to the other spouse, were the responsibility of the transferee.
This is what Serianni holds. Section 1041 could be viewed as implementing the preenactment conclusion, and, initially at least, the Service held that view. See infra text
at note 100. On the other hand, section 104 1, as discussed in the text, could be interpreted
as implementing a different view, one which looks at the end result of the settlement
rather than the intervening steps by which the settlement was attained. That view
potentially would treat the redemption as part of the personal settlement between the
parties, and not an independent transaction between the corporation and a shareholder.
73. See infra note 80.
74. Although we are inclined to believe that a guarantee should not disqualify
an otherwise well structured redemption transaction, the apparent importance of the
guarantee to the reasoning of the court of appeals inAmesImay mean that the inclusion
of a guarantee by the business spouse in the settlement agreement will, by itself,
produce the ambiguity necessary to permit both arguments to be made.
75. The ambiguity, as suggested by Raby, may be deliberately created by one or
both sides in the negotiation. See supra note 2. It may also result from the difficulty
of negotiating a clear agreement on the allocation of the tax cost. As Raby also notes,
the IRS is not likely to be interested in any such case as long as the transaction conforms
to the divorce documents, and one of the spouses reports taxable income from the
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In the last analysis, section 1041 does not apply to transfers between
persons who are not spouses or ex-spouses in divorce. In particular,
it will not protect a shareholder from the tax effect of a distribution
from his or her corporation.7 6 Congress might have been persuaded to
provide tax relief for corporate withdrawals in divorce settlements, but
it did not reach corporate transactions in enacting section 1041. In
marital redemption cases, funds are distributed from the corporation.
That distribution inevitably will produce an immediate tax effect at the
shareholder level to one of the spouses. Which one is a question that
section 1041 does not directly address, and it is this question with which
the recent decisions are concerned.
F. Taxing Marital Redemptions: The Post-1984 Law
1.
THE STAKES: How CONSTRUCTIVE DIVIDENDS CHANGE THE RESULT
With this background, the stakes in marital redemptions can be understood. It may be too facile to write off the Ames I decision as an
anomaly. Instead, there is an arguable substantive basis for the decision,
although we make clear our disagreement with that result. The Service,
in its pending regulations project, should definitively reject that theory
and specify the conditions, consistent with the single economic unit
theory on which section 1041 is grounded, for taxation of corporate
distributions in marital settlements as redemptions.
It is generally true that stock owned by B or N or both, during a marriage, unless the source of the original shares can be traced to separate
property, will be, at least in part, marital property. 7 Divorce courts are
required to determine the value of marital assets and the appropriate percentage to be awarded to the nonbusiness spouse (N), at least in terms of
value, 78 and to make a compensating award when the business is allocated
transaction. Because of the uncertainty raised by the decision in Ames II, however,
the parties may take aggressive reporting positions. The nonbusiness transferor spouse,
who is the nominal owner of the stock being redeemed, is almost required to use refund
procedures as the Tax Court's expressed view of these transactions seems to favor
the business spouse in any transaction which meets the formal conditions of the corporate
tax constructive dividend test. See supra text at note 45.
76. Temp. Reg. § 1.104 1-IT(a) A-2 Example (3) (section does not apply to sale
of property between one spouse and corporation solely owned by the other).
77. The marital property law of most states presumes that property owned by
either or both spouses at divorce is marital property and subject to division. A spouse
who contends otherwise must bear the burden of proving that the property is separate.
Also, even when business interests were originally separate, enhancement of value
during marriage may convert at least part of the value of those interests to marital or
community property.
78. See e.g., Rutland vs. Rutland, 652 So. 2d 404, at 405-06 (Fla. Ct. App. 1995).
All of the stock in a family corporation solely owned by husband was held to be
marital property after husband, who had originally owned 50% of the stock, caused
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solely to the business spouse (B) .79 This compensating award is frequently made in the form of an installment obligation imposed on B to
pay money to N. For tax purposes, this structure allocates the high basis
cash to N and all of the tax consequences to B as illustrated earlier. While
this appears to be the best tax solution for N, presumably the parties have
negotiated their settlement anticipating how the tax costs will be borne
and have set the price accordingly. In fact, one can generalize about this
situation to point out that any negotiated settlement should have been
reached with the tax allocation in mind, and only a vague or uncertain
rule which prevents a clear determination of the tax allocation in the settlement would be objectionable.
In a properly structured redemption, N will sell N's stock to the
corporation for a negotiated price, anticipating that a tax will be paid on
the exchange. As noted, the tax is imposed because funds are withdrawn
from the corporation, whether incident to a marital settlement or not.
Suppose, however, that a court could plausibly decide that B did incur
a personal, contractual obligation8° to pay money to N in order to buy
N's stock in the corporation, but the corporation redeemed N's stock.
The distribution in redemption of N's stock might then be treated as
a constructive dividend to B. To be a dividend to B the distribution
would be treated as having been made to B, followed by B's purchase
of N's shares. Unlike the nonmarital situation, the tax consequences
to N of this reconstructed transaction are dramatically different from
the original plan. Under section 1041, B's purchase of N's shares is
not taxable to N and B will not be allowed any basis adjustment for
B's constructive payment. B, on the other hand, must then pay tax on
the amount paid to N as a dividend to B. This not only shifts the tax
the corporation to redeem his brother's 50% interest. Compare In re Marriage of
Bepple, 683 P.2d 1131, 1133 (Wash. Ct. App. 1984) (corporate redemption of shares
owned by third party was a corporate acquisition which did not convert husband's
shares into community property to any extent).
79. See supra note 12. Allocating all of the business to the spouse interested in
the business might be a common expectation when that spouse is the principal operating
officer of the corporation, but it is far from universal. In a contested divorce, the court
may simply divide the assets which forces the business spouse to negotiate a buy-out
after the fact. See Laird, supra note 51, for an example of the potential tax issue in
this situation. One might expect this circumstance to provide the nonbusiness spouse
with some bargaining leverage in negotiating a buy-out as part of the settlement, but
if that is so, it is not discernable from the case law.
80. The Sullivan rule has from time to time required courts to interpret ambiguous
circumstances to determine whether the buyer did incur a contractual obligation at all,
and if so, whether that obligation was "primary and unconditional." See Apschnikat
v. United States, 421 F.2d 910 (6th Cir. 1970) (exchange of letters); Enoch v. Commissioner, 57 T.C. 781 (1972), acq. on this issue, 1974-1 C.B. 1 (loan documents); State
Pipe &Nipple Corp. v. Commissioner, 46 T.C.M. (CCH) 415 (1983) (oral assurances).
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burden from N to B, but also may increase it, as the tax on capital
gains will generally be less than the tax on ordinary dividend income.
Such a drastic change in the economics of the settlement, caused by
procedural or technical defects in the structure of the redemption, is
unlikely to have been anticipated by the parties in negotiating the settlement. 81
As pointed out earlier, the Service, the interested party in distributing
the tax effects of the typical redemption, had declared what has seemed
to be a straightforward test for distinguishing effective redemption arrangements from constructive dividends and has enforced its view of
the law. But, now, in the marital redemption at least, N has a direct and
compelling interest in expanding the reach of the Sullivan constructive
dividend rule to attack carefully structured redemption arrangements
in marital settlements, like the one in Ames, which the Service would
never have attempted to upset. Existing case law defined the meaning
of "primary and unconditional" obligation, as the Service has sought
to enforce it, but this history does not preclude a broader view of the
personal obligation which might cause a constructive dividend to occur.
Ames I indicates that this view should not simply be dismissed. 2
The personal benefit in marital redemptions may stem from the underlying marital property law, particularly for a court concerned with more
substance than the existing test contains. Marital or community property
is universally defined as property acquired during marriage by either
spouse individually or by both acting together.8 3 Title is not relevant
81. One party may have been aware of the tax uncertainty and intentionally took
advantage of the other party's apparent lack of awareness, attempting to exploit the
ambiguity in decisions. That seems to us to be a risky strategy to employ deliberately,
particularly if it means giving up some of the economics. In any event, given the
publicity which the present dispute has generated, professional advisors are chargeable
with knowledge that the rule is uncertain. Professor White believes that a rule which
causes such an enormous change in the economics of marital settlements, which are
difficult to make under the best of circumstances because of technical defects in drafting
documents, cannot be justified on any serious policy ground.
82. "The tendency of a principle [is] to expand itself to the limit of its logic."
BENJAMIN CARDOZO, NATURE OF THE JUDICIAL PROCEss 51 (1921). The Service was
undoubtably aware of the difficulty which expansive application of the Sullivan holding,
see supra text at note 43, might cause for common types of corporate transactions,
so it was careful in Rev. Rul. 69-608 to set out the limits of the test which it would
enforce. After all, the tax on a constructive dividend in a nonmarital redemption is,
as we have pointed out, an additional and quite unnecessary tax. Therefore, unlike most,
the application of this principle of law has been restrained basically to the parameters set
forth in that ruling 25 years ago.
83. Each state has its own definition, of course, and all distinguish "separate" property from marital or community property. In general, separate property is property
owned before marriage or received during marriage by gift or inheritance, although there
are many exceptions to this generalization. The variation in state property laws does not
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for this purpose. This view is strongly expressed in the community
property tradition, which in the wave of reform following the institution
of no-fault divorce, has become the dominant influence in the development of equitable distribution of marital property as the norm. This
aspect of marital property sharing is present in Ames I, involving Washington, a community property jurisdiction, 84 but does not seem to have
influenced the decision in the court of appeals.
The divorce court is charged with determining what property is community, valuing it, and dividing the property between the spouses, often
in the discretion of the court, viz., in such proportions as the court
determines to be equitable or just. This concept of property, unlike
the tax law concept, views each spouse as owning rights to the aggregate
and specifies those rights in terms of value. Particular assets may be
allocated as the court (or the parties, in a privately negotiated settlement)
sees fit, and if business assets are entirely allocated to one spouse, then
compensating or offsetting assets must be allocated to the other. When
the marital property is not sufficient to do this, as in the case of a
business which cannot effectively be divided between the spouses, the
business spouse will have incurred a personal obligation to pay money
to the nonbusiness spouse.
2.
CONSTRUCTIVE DIVIDENDS IN THE LAW OF MARITAL REDEMPTIONS
Argument on this point, not well articulated in Ames I, is not found
in the early cases,
5
which followed the Sullivan distinction as it had
been set out in the 1969 ruling. It is useful briefly to review some
before moving to the current situation, because they tell a story that
is different in important respects and fully justify some pronouncement
by the Service to clear the air. Finally, some planning steps to be
taken for making effective redemptions in a divorce settlement will be
suggested.
House of Carpets, Inc. v. Commissioner$6 is a useful illustration
of a failed redemption under the pre-1984 law .87 Carpets' stock was
detract from the essential point we make here, that in divorce a definition of property
which looks only to title in determining who is to be taxed is simply not adequate to understand the economics of marital settlements under modem divorce law.
84. In divorce, both the community property and the separate property of the parties
are subject to equitable distribution: -[The divorce court] ... shall such dispos(e) of
the property. . . of the parties, either community or separate, as shall appear just and
equitable after considering all relevant factors .
REV. CODE OF WASH. § 26.09.080
(West 1995).
85. See supra cases cited note 50.
86. 32 T.C.M. 1239 (1973).
87. Indeed, like some of the other early cases, this transaction was planned and
carried out before Sullivan was decided and Rev. Rul. 69-608 was issued. Without
the guidance provided by these authorities, it is not surprising that the parties failed
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community property which was allocated to B by the marital property
settlement agreement. In the agreement and under the provisions of
the divorce decree to equalize the division of community property, B
was ordered to pay N approximately $60,000 in installments for her
community share of the entire marital estate. B then personally executed
a promissory note to N, but the payments on this note were made
directly by Carpets.88 None of the stock was redeemed. All payments
made to N were found to be taxable dividends to B.
This case can be characterized as a "slam-dunk" for the Commissioner, even under the state of the law as it existed when the transaction
was planned. 9 Since B had few assets other than the corporation's, it
was clear from the beginning that equalizing payments had to come
from Carpets, and some curious language in the documents made clear
that this was in fact intended. So, it is hard to understand why so little
attention was paid to some basic corporate tax issues. One commentator
catalogued the following improper procedures in this stock redemption
case9°:
" The parties did not sign any stock redemption documents until
after the divorce, when the obligation to pay was set. Instead, the
promissory note was secured by a pledge of 200 shares of stock
in Carpets after the divorce.
* No actual transfer of stock certificates ever took place or was
reflected in the corporate books, although bylaws of the corporation required this to be done.
* The only stock ever issued to the couple was issued solely to B.
None was ever placed in N's name, so that stock could have been
redeemed from her. 9'
" Both the promissory note and the stock transfer were between the
couple. Carpets was not a party to either.
to get it right. One should note that apart from Edler, which may involve a slightly
different problem, there is a distinct gap in the litigated tax cases between the early
group of cases and the more recent series leading from Ames I.
88. The corporation in Carpetswas involved in the tax proceeding because it (and
a sister corporation) had claimed deductions for interest paid on the note, which were
disallowed on the ground that the payments were dividends.
89. The parties were rather informal in their rearrangement of corporate assets
in the marital settlement. Some real estate assets owned by Carpets were allocated to
Betty in the agreement and were simply deeded to her in the settlement. Although the
Commissioner did not make any determination about these transactions, it seems clear
that they were taxable distributions to either Betty or William, or perhaps both.
90. Stotter, supra note 1, at 7-8.
91. If she had never actually had title to any Carpets stock, it is unlikely that she
would have paid tax on the sale of her community property interest to William, although
actually holding title is not necessary for the principle expressed in cases like Siewert,
supra note 50, to apply.
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* Carpets' records failed to disclose any resolution by the directors
authorizing a redemption, any transfer of stock to or from N, or
any reduction in capital stock as reflected on the corporate balance
sheets.
The same problem was encountered in Nichols v. Commissioner.92
But there the parties had agreed that the corporation would redeem N's
stock, and the board of directors had actually met and taken formal
action to that effect the day before B and N executed their separation
agreement. The problem for Nichols arose because this agreement,
drafted by his wife's attorney and incorporated in the divorce decree
one week later, had required that B, not the corporation, purchase N's
interest. After the Service had begun an audit of his tax return for that
year, B was able to obtain a nunc pro tunc order correcting the entry
of the decree, so that he was obligated to purchase N's interest as
"agent" for the corporation. 93 In Nichols, the formal steps to make
the redemption were actually taken and the evidence was clear that a
redemption was intended. B failed to read the separation agreement
carefully enough before signing. While B's procedural error was corrected in Nichols, reliance on post-decree correcting motions to remedy
such mistakes is perilous. 94
92. 32 T.C.M. 507 (1973). Of the other cases decided against the taxpayer, see
supranote 50. Gordon involved a redemption of wife's 49 %minority interest pursuant
to a marital settlement agreement, incorporated in the divorce decree, which provided
that "Husband shall pay Wife the sum of $xxx in cash for all Wife's stock.... This
obligation may be discharged by Husband by the corporation redeeming Wife's stock
for the sum of $xxx .... "The corporation was one of a family of corporations engaged
in the trucking business, and without any corporate formalities, it simply cut the check
and paid Wife. This case was lost on bad draftsmanship, a mistake quite clearly not
made in later cases. In Berger, the parties negotiated over a redemption of wife's
community property interest (she held title to 40% of the stock) by the corporation,
but in the decree this obligation was stated as follows: "[Wife] shall sell and [Husband]
shall purchase, for ... $xxx, . . . [Wife's] one-half of book value of [corporation]."
Wife's shares were placed in escrow, and a variety of restrictions were placed on the
rate at which the stock could be purchased ("redeemed") by Husband. About a month
later, the board of directors for corporation met and adopted a resolution authorizing
redemption of Wife's stock, and it thereafter made all the payments on Husband's
obligation under the divorce decree. As in Gordon, this transaction had been thought
of as a redemption from the beginning, and was negotiated as such, although the
settlement agreement or stipulation was poorly drafted to accomplish this result. In
neither case, did the taxpayer attempt to correct the difficulty which the draftsmanship
had created for them, but in fairness, both divorce settlements had been planned before
Sullivan, so it might not have occurred to the lawyers (although it should have) that
an unexecuted contractual commitment would have been sufficient to attract the constructive dividend taint.
93. This is a plausible approach, later endorsed by some constructive dividend
cases like Bennett v. Commissioner, 58 T.C. 381 (1972), acq., 1972-2 C.B. 1.
94. See Stotter, supra note 1, at 9. Hayes v. Commissioner, 101 T.C. 593 (1993),
also involved a nunc pro tunc correction of an Ohio divorce decree incorporating a
settlement agreement personally obligating the husband to purchase shares belonging
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The last of the early cases, Edler v. Commissioner,95 also involved
an effort to correct a seriously defective decree, although the problem
this time stemmed from the divorce court's resolution of a contested
divorce. The couple owned all of the stock of the corporation as community property. In the divorce decree, the divorce court awarded all of
the stock to B and required him to make an interest bearing promissory
note to N for $269,000. He executed the note, made a few payments
(approximately $7,750) and six months after entry of the divorce decree
defaulted. After N had obtained a Writ of Execution, she agreed to
give it up when the corporation paid $283,500 in cash 96 in redemption
of shares which were allocated to her for this purpose in a modified
settlement agreement. The parties went back to the divorce court and
obtained a nunc pro tunc blessing on their renegotiated deal.
The Commissioner argued that the substitution of the modified arrangement, under which a minority interest was allocated to N and
then immediately redeemed by the corporation, for B's personal liability
under the promissory note had discharged his personal obligation within
the meaning of Sullivan. The result would have been a constructive
dividend to B. 97
Both the Tax Court and the court of appeals decided that B's personal
obligation had been eliminated by the nunc pro tunc decree, which the
Commissioner failed to challenge in timely fashion.98 B's agreement
to obligate his corporation to redeem the minority stock interest alloto the wife. There was no evidence in Hayes that the parties had actually planned a
redemption until it was too late, although there was evidence that both knew that only
the corporation could make the payments. Nichols was distinguished on this basis.
The Tax Court held that the divorce court's nuncpro tunc modification was not effective
to eliminate husband's personal obligation, which, under Sullivan, charged him with
a constructive dividend. In a lengthy footnote, the Tax Court pointed out that only an
effective nunc pro tunc order under state law could have relieved husband from the
obligation imposed by the decree, as distinguished from satisfying that obligation.
95. 727 F.2d 857 (9th Cir. 1984).
96. The amount seems to be slightly more than the she was originally entitled to
receive, taking into account the accrual of interest. In cases like this, it is difficult to
assess the relative bargaining positions of the parties, as Annette may have been concerned that Vernon could not raise any more money, and foreclosure would have wiped
out what value existed. The payment to her had been borrowed by the corporation.
97. Annette's tax situation is not discussed. Vernon, however, was obligated to
purchase her community property interest in the corporation out of future income,
which probably would have been viewed as his separate property. Annette, therefore,
should have been taxed on the sale of her interest to Vernon, just as she would have
been taxed on the redemption which the parties later completed. See Harrington v.
Commissioner, 67 T.C.M. (CCH) 3060 (1994) (California divorce); Carri6res v.
Commissioner, 64 T.C. 959 (1975), aff'd per curiam, 552 F.2d 1350 (9th Cir. 1977)
(same).
98. The Commissioner, of course, would not make the same mistake again. See
Hayes, supra note 94. It seems unlikely that the nunc pro tunc order which basically
restructured the parties' deal would be accepted as an effective modification.
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cated to N was held to have been effective to avoid constructive dividend
treatment, a tax disaster which the divorce court might inadvertently
have forced upon him. 99
After Edler, there is a gap before the redemption issue surfaces again
after the effective date of section 1041. First, the IRS weighed in on
the meaning of the provision for the attribution of tax consequences
in divorce property transfers.
3. SECTION 1041
AS A TAX ALLOCATION RULE
This interpretation of section 1041 was expressed in a 1990 Technical
Advice Memorandum.'0° In the memorandum, B owned most of the
stock of a family corporation. Pursuant to the divorce decree between
B and N, B transferred 39 percent of the stock of Corp. to N, and
Corp. promptly redeemed N's stock in return for Corp.'s promissory
note. As provided in the decree, B assigned personal assets to N as
collateral and guaranteed payment of the note. After the redemption,
B owned 83.6 percent of Corp.'s outstanding stock, which he then sold
to an unidentified party.
The IRS concluded that under section 1041 Congress had provided
the parties with a "mechanism" for determining which spouse would
pay the tax on the redemption. If the transaction was structured as a
transfer to one followed by the redemption, then he or she would be
taxed on the redemption with no dividend consequence to the other.
On the other hand, if the stock had been redeemed before any transfer
and the proceeds paid directly to the redeeming spouse, the payment
would have been treated as a dividend distribution to the other, followed
by his or her nontaxable cash transfer to the redeeming spouse. In the
Tech. Memo. the redemption passed muster, and the redeeming spouse
was held taxable.
For the Service, the difficult issue seemed to be whether the stock
had been effectively transferred, so there could be a redemption of
stock attributed to her.1 0 ' For this point, the memo cites authority dealing
with gifts of corporate stock to charity, followed by redemptions.'l°
A binding obligation on the charitable donee to surrender the stock in
redemption will cause a constructive distribution to the donor followed
99. 727 F.2d 857, at 860.
100. Tech. Adv. Mem. 90-46-004 (Nov. 16, 1990).
101. This is a recurring theme in the later private letter ruling, to which we return
to enabling discussion on how marital redemptions should be planned.
102. Compare Grove v. Commissioner, 490 F.2d 241 (2d Cir. 1973), and Palmer
v. Commissioner, 62 T.C. 684 (1974), aff'd without discussion of this point, 523
F.2d 1308 (8th Cir. 1975), acq., Rev. Rul. 78-197, 1978-1 C.B. 83, with Blake v.
Commissioner, 697 F.2d 473 (2d Cir. 1982).
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by a gift of the cash to the charity. 103 The Tech. Memo. concluded that
section 1041 overrides this authority and provides redemption treatment
to the transferee, even when the transferee was committed to the redemption before the transfer occurred, so that the form of the transaction
absolutely controls the tax result. 04There was no mention of the substantial corporate tax authority on constructive dividends discussed earlier in this article. 105
This is a clear statement that the IRS viewed section 1041 as intending
to function as a tax allocation statute. It permits the divorcing parties
to determine the order in which the transactions are to occur, thereby
controlling the tax result, even though the transferor may have personally guaranteed that the corporation would make the payments as
agreed.' ° The tech memo could then have functioned as a road map
for designing similar transactions, but this interesting view of how
section 1041 should be applied was not to survive for long. The decisions
in Ames I, decided the following year, and the other recent cases raise
the following unsettling questions.
4.
THE CURRENT CASES
Before proceeding into these cases, 07 note that the Ames transaction
was a transaction carefully planned to fit within the corporate tax rules
on redemptions. The redemption agreement was between the corporation (Moriah) and the nonbusiness spouse, although the business spouse
was obligated, both by the redemption agreement and the marital settlement agreement, to see that it was carried out. All the proper documents
103. See Rev. Rul. 78-197, 1978-1 C.B. 83.
104. In a strange twist, considering subsequent developments, the Tech. Advice
noted that the temporary regulations specifically apply section 1041 to transfers to
third parties (the corporation) on behalf of the transferee (W), Temp. Reg. § 1.1041IT(c), Q&A #9, thus treating W as the owner because of the exercise of her authority
to cause her interest in the corporation to be redeemed. This rather different slant on
the meaning of the Q&A #9 might have caused the Ninth Circuit to pause in Ames I
before writing the opinion it did.
105. See text at supra notes 40-48.
106. Note that H in the Technical Advice Memo sold his remaining stock in the
corporation shortly after the marital settlement was implemented. Although the Tech
Memo does not refer to the sale, the tax effect of the marital settlement in the ruling
is to allocate the tax consequences of a final sale of that property between the parties
as the proceeds of the sale were shared. The text of the ruling does not advert to this
aspect of the transaction, but it is interesting to speculate on the relevance of the sale
to the Service's conclusions as to the tax effect of section 1041.
107. Ames v. United States, 981 F.2d 456 (9th Cir. 1992), aff'g, 91-1 USTC
50,207 (W.D. Wash. 1991); Ames v. Commissioner, 102 T.C. 522, 541 (1994). The
time for appeal in Ames H was allowed to expire in late 1994. See also Pozzi v. United
States, 1993 WL 405422 (W.D. Or. 1993) (similar to Ames 1).
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were executed in the right order. Yet, despite this planning, and its
apparent acceptance by the Service, there was a problem.
The Ames formed Moriah to operate a McDonald's franchise. Moriah
issued 5,000 shares of stock to the couple jointly, all of it being community property. The McDonald's franchise agreement precluded joint
ownership of Moriah after the divorce because McDonald's required the
equity and profits to be held by the owner/operator. 108 The couple entered
into an agreement that they would cause Moriah to redeem N' s 50 percent
interest in the outstanding stock for $450,000,'09 payable by (1) forgiving a debt of approximately $110,000 to Moriah which N had incurred
by withdrawing that money from the corporation earlier in the same
year," (2) making two $25,000 payments shortly after divorce, and
(3) issuing a ten-year installment note calling for monthly payments.
Ten days later, in late December 1987, the parties and the corporation
entered into a separate agreement governing the redemption of N's stock
by Moriah on the same terms. The divorce decree, incorporating the parties' separation agreement, was issued in January 1988. Moriah then redeemed N's stock, canceling the note, making the $25,000 payments,
and issuing its installment note to N for $289,000 plus interest at 9 per108. The position of McDonald's on owner/operators is typical. Failure of the
franchisee to obtain approval from McDonald's for the restructured ownership of the
franchise would have resulted in an auction of the franchise to others. However, because
of this position of McDonald's on the acquisition of franchises by new owners, the
price may have been kept somewhat below its then market value. Anyway, it is not
clear what relevance the position of McDonald's has to the tax issue in these cases.
In the usual approach in divorce cases, the result is that all of the business interests
must be allocated to the business spouse because the business is viewed as "nondivisible." The restrictions imposed by the franchise agreement merely emphasize what is
commonly viewed as essential in divorces.
109. The parties did not explicitly agree on a value for Moriah. Of course, one
might infer that they thought it was worth $900,000, but this does not take into account
the tax liabilities. If Joann were to pay tax on the redemption, as the parties clearly
anticipated, then she would have received less than half of a corporation worth
$900,000. From this, one could conclude that Moriah was worth somewhat less than
$900,000 because Joann had been given a slightly larger share of the proceeds to
compensate her for the tax liability. In the actual deal, John not only agreed to the
redemption but he also agreed to pay her $50,000 in addition to community property
allocated to her.
110. The parties played this one a bit loosely, but it seems to have been accepted
by the Service. Moriah's bank accounts were drained in the early part of the year on
Joann's behalf. In return, she executed an interest bearing promissory note payable
to Moriah. It seems clear in retrospect that she had no intention of repaying the money
to Moriah, so this transaction appeared to be a dividend to Joann. However, following
Zenz v. Quinlivan, supra note 40, the Service may have analyzed these transactions
as interrelated dispositions of Joann's interest in Moriah, so that they should be taxed
as a single transaction, reflecting its view that the redemption of Joann's stock was
effective.
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cent. N paid tax on the redemption in 1988, but then brought the refund
action that is at the center of this problem.
In a cryptic, poorly reasoned opinion, the district court found that
in the transaction, because it was required by the settlement agreement
between the parties, B had "benefitted" from the redemption. The
court concluded "as a matter of law" that, when N had transferred
stock to Moriah, N had done it on B's behalf, and the payments from
Moriah should have been treated as having been made first to B, and
then from B to N. As far as N was concerned, the transfer qualified
for nonrecognition under section 1041.111
On appeal, a panel of the Ninth Circuit thought that the case turned
on the question whether the redemption of N's stock could be construed
as having been made on "behalf of" B under a provision of the temporary treasury regulations.' 2 The court of appeals affirmed the district
court's conclusion that B did receive a benefit because the transfer
111. Ames v. United States, order on summary judgment, 91-1 USTC 50,207,
1991 WL 82830 (W.D. Wash. 1991). The district court did "find that John Ames
benefitted by the transaction because it was part of the marital property settlement
with wife. John Ames limited (any) future community property claims that his wife
might have brought against him by agreeing [to the] . . . redemption." (Emphasis
added.)
112. Temp. Reg. § 1.1041-1T, Q&A #9, provides that:
Q#9 May transfers of property to third parties on behalf of a spouse (or former
spouse) qualify under Section 1041?
A#9 Yes. There are three situations in which a transfer of property to a third
party on behalf of a spouse (or former spouse) will qualify under Section
1041, provided all other requirements of the section are satisfied. The first
situation is where the transfer to the third party is required by a divorce or
separation instrument. The second situation is where the transfer to the third
party is pursuant to the written request of the other spouse (or former spouse).
The third situation is where the transferor receives from the other spouse
(or former spouse) a written consent or ratification of the transfer to the
third party. . . . In the three situations described above, the 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 the third party. The deemed transfer from the
nontransferring spouse (or former spouse) to the third party is not a transaction that qualifies for nonrecognition of gain under Section 1041.
T.D. 7973,49 Fed. Reg. 34451 (Aug. 31, 1984), reprintedin1984-2 C.B. 170 (emphasis
supplied). These temporary regulations were issued six weeks after enactment of the
statutory provisions to which they relate (sections 71, 152, 215, and 104 1), so to say that
the regulations were drafted quickly is to state the obvious. We have been informed that
the language in the temporary regulation, which the court ofappeals treated as significant,
was actually intended to provide a little flexibility for those planning marital settlements
by analogy to similar provisions under the alimony rules. The IRS officials who drafted
the rule have been surprised and perhaps dismayed by the Ninth Circuit's interpretation
which had the effect of creating an indirect transfer rule to transform otherwise taxable
transactions into nontaxable marital property transfers.
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made by N was part of a marital property agreement which settled any
future community property claims that N could have asserted against
B. In other words, B had an obligation to N that was relieved by the
corporation's payment to N. This obligation was based in the divorce
property settlement, which called for the redemption of N's stock and
the cash payments which would equalize the division of the community
property. 113 Although B and N were the sole stockholders in Moriah, the
court concluded that the obligation to pay N was B's, not Moriah' S114
The Ninth Circuit rejected the government's interpretation of the
redemption arrangement and instead pegged its conclusion to the "on
behalf of" provision in the temporary regulations, which "demonstrates" that the statute is meant to apply to situations such as this one
where a transfer is made on behalf of one's former spouse." 5 There
113. See supra text following note 82.
114. 981 F.2d at 459. The court also commented, "a transfer is considered to have
been made on behalf someone if it satisfied an obligation or a liability of that person."
Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929), is often cited for
this proposition, though indiscriminately, as if all legal obligations have the same
characteristics. It seems as though payment by an employer of the income tax of his
employees should be income to the employee as compensation. However, this may
not be true if, for example, a stockholder has a binding contract to buy a parcel of
real property and assigns it to the corporation that completes the purchase. Afterwards,
the corporation has satisfied the stockholder's legal obligation but has also acquired
the property. We would not argue that the shareholder has received a dividend because
he transferred to the corporation an opportunity (and the accompanying obligation)
to buy property. Corporate assets were not reduced. The acquisition of its own stock
from another shareholder, however, may be different but only because the acquisition
of the stock caused corporate assets to be distributed in a way which benefitted the
remaining stockholder. Neither the benefit nor assumption of the obligation by itself
is enough to result in a constructive dividend. It is not clear, even in the clearest of
cases, why the two together should cause that result. In Ames I, the court of appeals
failed to explain why the principle that the satisfaction of a shareholder obligation
results in a constructive divided should apply there.
If a corporation assumes its shareholder's obligation on a note which the shareholder
had given in exchange for stock, the old cases held that the shareholder had received
a constructive dividend. Wall, supra note 25. In some recent constructive dividend
cases, such as Schroeder v. Commissioner, 831 F.2d, 856, 859 (9th Cir. 1987), a
bank loan incurred by the buyer of stock had been paid by the corporation in a redemption
from the buyer after the acquisition had been completed. Under existing principles,
that clearly is a dividend. Old Colony and Schroeder were cited by the court in Ames
I, supra note 7, at 459, however, both involved payment of a third-party debt (tax
liability owed to the government and an independent loan made by an unrelated bank)
and are therefore inapposite.
115. This argument may lead to the opposite result in situations where the nonbusiness spouse does not actually have title before the divorce settlement is made. Consider
the transaction analyzed in the 1990 Tech. Advice. Husband transferred shares of stock
to Wife, who was under a pre-transfer obligation to transfer them to the corporation in
redemption. In this example, Wife may be viewed as the "nontransferring spouse"
with the result that the transfer becomes a transfer on her "behalf' within the meaning
of the temporary regulation. If so, taxation of that transaction as a redemption would
be assured, even though that result would seem to be less consistent with the corporate
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is a competing view, under which the spouse holding the property at
the time of the redemption is viewed as if he or she had always been
a co-owner of that property. In Ames this was true, and N should
bear the tax consequences which an owner would incur on the same
transaction. N's interest has been retired in the redemption, N received
cash from the corporation, not from anyone else, and so, despite the
obvious indirect benefits to B, N should pay the tax on the redemption.
The Tax Court's position in this dispute has been established in three
decisions issued after Ames I. The first, Hays v. Commissioner,116 is
another McDonald's case which is a throwback to the early cases. In
the separation agreement, executed by the parties in the presence of
counsel, B was personally obligated to buy N's stock in the corporation
for $128,000, $100,000 within thirty days of the date of the agreement
and two additional installments of $14,000 each in later years. The
money to pay N had to come from the corporation. Two days after
signing the separation agreement B's attorney proposed that the corporation redeem N's stock, for that reason and because the tax liability
incurred on the redemption would be less than B's tax liability on money
withdrawn by him from the corporation to pay N.
It seems that the referee in the divorce action pressured the parties
to complete the divorce process, and two months after the separation
agreement was executed, a decree was issued which incorporated the
original separation agreement. Parallel negotiations resulted in a redemption agreement on the same terms, which was signed on the date
that the decree was issued, but there was no mention in the separation
agreement of the redemption. Nor did the redemption agreement refer
to the separation agreement or to the pending divorce action. The corporation paid N under the redemption agreement. Ten months later, presumably at the time tax returns were being prepared, the divorce court
entered its nunc pro tunc order conforming the terms of the original
decree to reflect the redemption agreement. 1 7 The Commissioner issued inconsistent deficiency notices to the parties on the ground that
one of them was taxable on the corporate distribution.
tax theory. On the other hand, the court's reasoning supports the conclusion that the
transfer to the corporation, however it is made, is always on behalf of the surviving
stockholder, so that an effective redemption in a marital dissolution is not possible.
This is not only an extraordinary conclusion in itself but seems to produce the kind
of tax result which Congress rejected in enacting section 1041. That result being the
surviving stockholder, whose wealth has been depleted by the redemption, is called
upon to pay a tax without having received any cash, and the selling stockholder takes
that cash, free of tax, with the step-up in basis earned by the other's tax liability.
116. 101 T.C. 593 (1993). See supra note 94.
117. This shaggy dog story is difficult to understand. Under the original decree,
it seems clear from the early cases that Husband would be taxed on the corporate
payment as a constructive dividend. The tax impact of changing the deal from a direct
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The Tax Court concluded that the parties intended the separation
agreement to effect the division of their property and the release of
marital property claims. Further, the agreement was incorporated in
the divorce decree and was therefore considered merged under Ohio
law. 18 The Tax Court analyzed the divorce court's nunc pro tunc order
and determined that it was significant that the order did not indicate
the reason for change as required under Ohio law." 9 Consequently, the
Tax Court held that the order was a retroactive change in the substantive
rights of the parties under the settlement agreement rather than the
correction of an error in the original judgment, so "[the change] should
not be given effect for federal tax purposes. ",' 20 Burdened by his "primary and unconditional obligation" to purchase N's stock, B was taxable on the payments to N as constructive dividends.
Blatt v. Commissioner 2 1 is important because it marks the other side
of the constructive dividend issue. The facts in this case are sparsely
stated, which leaves some potentially interesting aspects of the case
unexamined. B and N, residents of Michigan at the time of their divorce,
each owned 50 percent of the corporation since its formation under
Washington State law. 122 Pursuant to the divorce decree, which required
personal purchase by Husband to a redemption by the corporation would result in a
significant shift in the economics of the settlement, detrimental to Wife. Yet she seemed
to have accepted the request for a modification without additional compensation to
which she, in our view, would be entitled. There is nothing in the record to explain
why she agreed to the modification. All parties may have assumed that regardless of
the impact on Husband, Wife would simply not be taxable. The case may also be a
warning to marital practitioners who venture into deep tax waters and deal with taxable
corporations that professional tax advice is essential before the deal is made. The IRS
Field Service officers have made their view very plain that an executed marital settlement agreement creates an obligation which cannot be modified away to avoid the
Sullivan constructive dividend rule.
118. This is another point of difficulty with these kinds of agreements. It is routine
in most states to have the agreement "incorporated," or undergo some similar procedure, in the divorce decree for purposes of enforcement. Although the doctrine of
"merger," which is now obsolete in many states, is technically different, in cases
like Hayes, supra note 94, it serves the same purpose. It is true that the occurrence
of divorce, with or without incorporation or merger, may be viewed as the "triggering
event" for the purchase obligation in the agreement which fixes it in stone for tax
purposes. However, we find this to be too restrictive for practical purposes and likely
to lead to harsh results. Tax rules should not depend on the details of state law divorce
procedure.
119. See Cherry v. Figart, 620 N.E.2d 174 (Ohio App. 1993).
120. Hayes v. Commissioner, 101 T.C. 605, citing Graham v. Commissioner, 79
T.C. 415, 420 (1982) (nunc pro tunc decree ineffective to change designation for
alimony purposes retroactively).
121. 102 T.C. 77 (1994) (reviewed by the court).
122. The divorce apparently was governed by Michigan law. Washington, on the
other hand, is a community property state. The significance of incorporation under
the law of Washington is not even remarked upon in the opinion. If the parties were
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that the parties "shall cause [corporation] to redeem [N's] stock," N's
stock was redeemed for approximately $45,000 cash. 123 There was no
obligation placed on B other than the requirement that he join in causing
the corporation to make the redemption. The only issue for decision
was whether the payment by the corporation was a redemption taxable
to N as an exchange under section 302 or was not taxable to her as a
purchase by B under section 1041.
In the Tax Court, N argued that her case was governed by Ames I and,
therefore, by the Ninth Circuit's interpretation of the temporary regulation. 124 The Tax Court could find nothing in the record which indicated
that N had acted on B's "behalf' in agreeing to the redemption, at least
not in the sense that the redemption satisfied any obligation of B. The
court expressly stated disagreement with Ames I, refused to follow
it and
25
then lamely explained why the cases were distinguishable. 1
The lack of an evidentiary record showing that the redemption did
satisfy an obligation of B provides a sound enough reason for the court's
holding. 26 However, the majority opinion stated disagreement with
residents of Washington at the time the corporation was formed, the stock would have
been community property. Michigan is an equitable distribution state, see supra note
12, and under Michigan law the stock was almost surely marital property. In any case,
the status of the corporate stock for state marital property law purposes was not even
mentioned by the court, despite the obvious importance of that fact in Ames I. Other
provisions of the marital settlement also were not considered in the court's opinion
to determine the relationship of the redemption to the overall settlement. We examine
the possible relevance of state marital property law concepts in the text beginning at
note 81, supra. This is a different approach from that taken in Ames I, which may
explain the Tax Court's "disagreement" with Ames I. See infra note 125.
123. The stated facts in the case were brief. Although the corporation was required
to redeem Wife's stock for the stated price that was set out in the decree, there were
other provisions which make it clear that it was a negotiated settlement. See Blatt v.
Commissioner, 66 T.C.M. (CCH) 1409 (1993).
124. Temp. Reg. § 1.104-1-IT Q&A #9. See supra note 112.
125. Four reasons were given for distinguishing the cases. Two of the reasons relate
to the requirement of the McDonald's franchise agreement that permitted only operators
to own stock, thus forcing Husband in Ames I to arrange for the elimination of Wife's
stock if he wished to retain the franchise. The third was Husband's guarantee of
the corporation's installment obligation which was unnecessary in Blatt because the
corporation paid cash. The fourth was that the governing law was community property
(Washington State), though the corporation in Blan may itself have been community
property. See supra note 123 (discussing the relevance of state law in Blatt). In our
view, the only distinction which makes any sense is the presence of the guarantee.
Moreover, ascribing that much importance to the guarantee goes far beyond the corporate tax rules for determining whether the redemption resulted in a constructive dividend. See Preston & Hart, supra note 2, at page 363 (suggesting that the guarantee
was determinative). Something more must be involved, but it is not clear what that
something might be.
126. Blatt, supra note 8, at 82-83; see also id. at 86 (concurring opinion of Judge
Chiechi).
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the result in Ames I, as well as attempting to distinguish that case, but
was taken to task in a concurring opinion by Judges Halpern and Beghe
for not stating how or why the majority disagreed. 2 7 Although the
redemption in Blatt was part of a negotiated divorce settlement, one
can assume that the corporation, the stock of which was owned equally
by the Blatts, had been equally divided; Mrs. Blatt simply received
the share to which she was entitled as an owner in a taxable transaction
with a third party, the corporation. This conclusion marks the outer
limit of the constructive dividend idea in divorce settlements; marital
redemptions taxable as exchanges can occur under these circumstances. 21 8 Ames I in the Tax Court pushed the line further in, although
the Tax Court majority was careful to limit the scope of its conclusion.
In Ames v. Commissioner (Ames II), 29 the Tax Court held that Mr.
Arnes had not received a constructive dividend in the redemption of
Mrs. Ames' stock, because the payment by Moriah did not meet the
test under corporate tax law-that is, B did not have a "primary and
unconditional" contractual obligation to purchase N's stock. In its opinion, the court rejected the reasoning in Ames I, following instead the
reasoning in Edler.130 This decision staked out the position of a majority
of the Tax Court judges on this issue. It also spawned more opinions
than normal in Tax Court decisions, with two dissenting opinions on
the application of the Golsen rule.' 3 ' Because the dispute over Golsen
127. The Tax Court must have been aware of its pending decision in Ames H at
the time Blatt was decided. The disagreements there foreshadowed the majority's
position in the later case where the formal legal obligation of the transferee spouse
was required before constructive dividend treatment would be visited on the transferee.
Nonetheless, while holding that Mrs. Blatt had failed to satisfy her burden of proof
would explain the decision in Blatt, it does not distinguish Ames I satisfactorily. The
majority was probably aware of this problem and felt compelled to state its disagreement
with the nature of the proof required by the holding of the Ninth Circuit in Ames L
The distinguishing features cited by the court all relate to the transferee's obligations
flowing from an unequal division of marital or community property. This aspect of
the underlying divorce settlement was probably also present in Blatt, even though Mrs.
Blatt failed to argue the point.
128. See infra text at note 134, which discusses a private letter ruling issued after
the Tax Court's decision in Blatt. The Service's reasoning in the ruling is based on
Blatt but was issued before the Service was aware of the Tax Court's subsequent
decision in Ames H.
129. 102 T.C. 522 (1994). The time for appeal expired without notice of appeal
having been filed. The facts of the case are discussed in the text, supra note 7.
130. Edler is discussed in the text, supra note 95.
131. Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff'd, 445 F.2d 985 (10th
Cir. 1971), expresses a principle of judicial economy under which the Tax Court has
bound itself to follow the decisions of the circuit to which the taxpayer's appeal will
lie. In Ames II, the appeal would be made to the Ninth Circuit, which had decided
the other side of the dispute less than two years earlier. A fair reading of the cases
leads to the conclusion that the Ninth Circuit, had it been called upon to decide Ames
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complicates matters, therefore it is difficult to determinejust how firmly
that court's position on the substantive holding has been fixed.
The conflicting decisions in the two Ames cases produce a whipsaw:
neither former spouse will incur any tax liability as a result of the
$450,000 stock redemption. It is tempting to argue that this result can
be justified by the policy underlying section 1041. While neither section
1041 nor the temporary regulations resolve this issue, the result would
be an exemption from tax for gain on corporate stock redeemed in a
marital settlement by allowing a tax-free basis step-up to the transferee
on the transfer of appreciated property (viz., Mrs. Arnes' cash). 132 This
result is so extraordinary that Congress would have clearly so provided
had it meant to do so.
The reasoning in the two Ames cases focus on different aspects of
the same transaction. The majority in Ames H argued that B's guarantee
was a secondary obligation to N, in that he was liable only if the
corporation failed to make the payments on the installment note. Revenue Ruling 69-608 specifically approves these arrangements under corporate tax law, which focuses on the formal contractual relationships
among the parties to the exclusion of broader, underlying obligations.
In the normal commercial world, this is fair enough, as those underlying
obligations are rarely if ever imposed by law. When the focus of analysis
shifts to B's obligations under marital property law, however, a different argument can be made. All of the stock of Moriah was allocated
to B; he was then obligated to compensate N in order to equalize the
division of property, whether this was done by him personally or indirectly, by the redemption of her stock. It appears that this argument
11, would either have reversed (which most dissenters believed would be the case) or
would have been compelled to overrule the earlier decision by one of its panels. Because
this meant that the issue was likely to be raised in the court of appeals, no matter how
the Tax Court decided, a majority concluded that it was not inhibited by its Golsen
rule. See Ames 11, 102 T.C. 522, 532-34 (Beghe, J., concurring); 542 (Chiechi, J.,
concurring); 548-9 (Ruwe, J., dissenting); 549 (Halpern, J., dissenting). Since all
dissents rested on this ground, it is difficult to determine how the court would have
split in the absence of the Golsen issue, although on this point, the three dissenting
votes in Blatt are instructive, and one of those judges (Parr, J.) concurred in the result
in Ames I.
132. Exemption, as it used here, would mean that both spouses would receive the
advantage of the tax basis of the assets involved. The transferor spouse, who received
cash, would have a tax basis for the cash equal to face value. The transferee would
receive the entire tax basis of the stock, the basis attributable to his or her shares and
the basis attributable to the shares of the transferor. So, this policy would not be merely
deferral; it would be exemption. Section 1041, which provides for carryover basis,
did not go this far. Earlier we suggested that a similar exemption policy allowing
transmission of property on death under I.R.C. § 1014 might be appropriate in this
case. See supra note 27.
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underlies the decisions in Ames I, even though the courts did not articulate it well. When followed to its logical extreme, however, this argument may prove too much because for tax purposes it could preclude
any effective redemption in marital settlements in community property
and certain equitable distribution states. This would recreate a situation
where federal tax results varied according to the law of the state in
which the divorce occurred, a problem which section 1041 was meant
to eliminate. That goes too far, so the question remains, where to draw
the line, a question which may appear to have been solved for nonmarital
redemptions by Sullivan.'33
5.
THE MOST RECENT RULING: ANOTHER ROAD MAP?
In a private letter rulingTM issued concurrently with the decision in
Ames II, the Service held that a planned redemption of a minority stock
position allocated to N in a negotiated settlement could be an effective
redemption for tax purposes. At the time of divorce, N asserted a
community property interest in B's 52x shares of common stock in the
corporation (of which B is a director and former chief executive officer).
Immediately prior to the divorce, the corporation had 105x shares of
common stock outstanding, 48x shares owned by B's children from a
former marriage.
The couple entered into a marital settlement agreement (MSA) under
which B agreed to transfer 12x of the 52x shares of stock to N. The
MSA provided that N may negotiate a separate redemption agreement
with the corporation under which N would redeem the 12x shares for
$3y. B would not be liable in any way should the corporation fail to
do so. In the redemption, the corporation was authorized under the
MSA to withhold 39 percent of the proceeds, otherwise payable to N
and to retain the funds in escrow to pay "any tax liability related to the
redemption." The MSA stated that B was not a party to the redemption
agreement and had no obligation to pay N $3y if the corporation failed
35
to redeem the stock.
133. See supra text beginning at note 45.
134. Priv. Ltr. Rul.94-27-009 (Apr. 6, 1994). The ruling was released for publication, July 8, 1994. 20 Fam. L. Rep. (BNA) 1424 (1994). The IRS cautions that private
letter rulings are directed to the taxpayers who request them, and they may not be
cited as precedent. See I.R.C. § 61100)(3). Nonetheless, private letter rulings are
useful in that they indicate the current position of the Service on many such issues.
In this case, a comparison of the instant letter ruling with the earlier Tech. Advice
shows a marked retreat in the IRS view of marital redemptions.
135. We were reliably informed that both parties were represented by the same
attorney for the purpose of negotiating a most favorable letter ruling with the Service.
The representations contained in the MSA and made by the parties in their ruling
request were required by the Service as a condition of issuing a favorable ruling.
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The ruling held that the redemption of N's shares would be taxed
as an exchange, including the amount withheld in the escrow for taxes,
and B would not incur a constructive dividend on this transaction. The
text of the ruling stressed that the redemption was a separate transaction
between N and the corporation, which neither was obligated to complete, at the time B transferred stock to N. The Service said this fact
brought the transaction in the ruling within the holding of Blatt and
distinguished it from Ames I.
First, note that this transaction had been fully negotiated, including
the price, before the ruling request was submitted. Although neither
the corporation nor N was legally obligated to follow through on the
redemption, and either could have abandoned the redemption after B's
transfer to N, it is inconceivable that either would have done so. N
received the cash price which had been carefully negotiated, presumably
taking the tax liability into account, and B (and the rest of the family)
settled what could have become a nettlesome problem. 136 It may seem
discouraging that the IRS would bless such a transparent arrangement
solely on the representation that the subsequently executed redemption
was independent, but there is a point to it. Most divorcing parties prefer
to have all loose ends tied before going ahead with the divorce. When
a redemption is planned, the actual redemption must be carefully structured so that both sides have strong incentives to follow through and
complete the settlement as planned. Without that aspect to the deal,
one or the other might be tempted to jettison the settlement at the
redemption phase. If uncertainty as to the tax result is to be avoided,
the approach taken in the ruling will require more explicit bargaining
over the economics of the settlement and the role that the party incurring
the tax liability will play in it than may have occurred in other cases.
Otherwise, the ambiguity highlighted by the decisions in Ames I will
persist.
Second, the transaction in the ruling may have been a bit too easy.
The corporation had cash, or could raise the necessary cash, to complete
136. The idea of using an escrow arrangement to assure payment of Wife's tax on
the redemption, at least at the first cut, is an interesting twist. Because the negotiation
of the private letter ruling seems to have been essential to the parties, it does provide
the opportunity to extend the business spouse's control over this aspect of the economics
of the deal. Failure of Wife to report the redemption as a taxable exchange would
have permitted application of the escrowed funds to Husband's potential tax liability
on a constructive dividend. Should wife file a claim for refund after she originally
reported the exchange on her return, one can assume that the terms of the escrow
would have imposed liability on her to pay any tax refund back to the escrow, or
perhaps, to agree to apply it against husband's tax liability which might result from
her refund. We recommend this technique as one way to protect against the temptation
by the nonbusiness spouse to sabotage the economics of the settlement.
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the redemption on closing. Many transactions are not so easily accomplished. Cash might not be available from third-party lenders on acceptable terms and this necessitates financing by the business. That will
expose the nonbusiness spouse to the risk of nonpayment, perhaps
beyond an acceptable limit, and may seem to require the independent
guarantee by the business spouse that the payout will be completed
as projected. Alternative security arrangements, such as a pledge of
corporate assets to secure payments, are possible. It may also be possible to receive the guarantee of the business spouse qua corporate shareholder in the redemption, even though that guarantee was not required
by the settlement agreement. How far the terms of the redemption
agreement can be adjusted and yet come within the Service's view of
Blatt as controlling precedent remains to be seen.
Third, most authors have accepted this private letter ruling as the
new road map. It is recommended that the ruling be seriously considered
as an indication of how to proceed.
HI. The Care and Structure of
a Stock Redemption in Dissolution of
the Marriage of the Corporation's Stockholders
As can be seen from the cases and letter rulings, there is no clear
rule to resolve the underlying tax problem, some suggestions are made
here, at least to minimize uncertainty about the tax consequences in a
stock redemption agreement involving B, N, and their corporation. The
following suggestions are just that, guidelines. Moreover, the marital
property law and divorce procedure of each state will vary, which may
require alterations in approach. It is suggested that what the reader
chooses to do for his or her own client should be based upon a close
reading of the cases, particularly from the client's jurisdiction. That
reading, combined with these suggestions, should provide some confi37
dence that the tax consequences have been accurately anticipated. 1
A. Set Out the Steps to Be Taken
A plan which follows the steps outlined below has a reasonable chance
to be treated as an exchange, that is, as a taxable sale by the nonbusiness
spouse:
137. There are any number of publications which discuss this problem. We recommend MARJORIE A. O'CONNELL DIVORCE TAXATION
11,001-11,009, and particu-
larly 11,006 (Supp. Nov. 1995); Asimow, supra note 2; Gerald D. August & Mitchell
D. Schepps, Recent Cases Complicate Redemptions of Stock Incident to Divorce, 22
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1. The redeeming spouse must be the owner of the stock when the
redemption occurs. "Ownership" for this purpose may be derived from an allocation of marital property under the marital
settlement agreement, and whatever steps are necessary to transfer ownership should be completed before the redemption
agreement is made with the corporation and reflected on the corporate books, stock register, etc.
2. The negotiations about the redemption should include the corporation as a party from the beginning, so the remaining shareholder
is never personally obligated to buy the stock under any agreement
which the parties make. The redemption agreement may be negotiated before divorce, but should not be signed or executed until
after the divorce, so either the corporation or the redeeming
spouse may reject it without any legal obligation after the divorce
has occurred. 38 The price at which the redemption is expected
to occur may and usually will be negotiated in advance, but following the approach suggested in the most recent letter ruling, neither
the corporation nor the redeeming shareholder should be bound
to accept it. 139 Negotiation of the redemption would best be evidenced by correspondence between attorneys for the corporation
and the redeeming spouse's attorney with an offer to purchase
the shares and negotiate terms. (Preferably, the corporation's
attorneys are not the same who will have represented the nonredeeming spouse in the divorce.)
J. CORP. TAX. 112 (1995); Stotter, supra note 1. Some of these steps were described
by Stotter and outlined in the text following supra note 92, as having been omitted
in the failed redemption illustrated by House of Carpets, supra note 50.
138. In the most recent private letter ruling, the Service required the business spouse
to represent, both in fact and in the settlement agreement, that he had any legal obligation
to purchase the stock of the redeeming spouse in the event that the corporation did not
make the redemption. Such a representation in the settlement agreement would be useful,
although in a properly structured redemption there will not be any such liability. See
BARTH GOLDERG, VALUATION OF DIVORCE ASSETS § 7.13 at 192-193 ("Dealing with
Stock Issues-Particular Corporate Problems-Stock Redemption") (Supp. 1994).
139. See supratext following note 137. We were informed that the Service insisted
on the representations inserted in the settlement agreement between the parties as well
as made independently in the ruling request. They were made on advice of counsel
to assume prompt action on the request. The representations stated the nonbusiness
spouse was not under any obligation to offer the stock allocated to her in the settlement
for redemption by the corporation, nor was the business spouse obligated to buy his
or her stock if the corporation did not redeem it. If taken literally, this would mean
that once divorce occurred, either side could say the stock had been allocated to the
nonbusiness spouse, and he or she did not want to accept the price previously negotiated,
preferring instead to continue to own it. The ruling incorporates and to some extent
relies upon these representations, so it is not clear how important they might have
been to the result.
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3. If the stock is covered in a buy-sell agreement that gives the
shareholders first right to buy any stock offered for sale, that
agreement must be amended to make the corporation the party
with the first right.
4. The board of directors should be formally advised of the stockholder's pending divorce and the fact that the business spouse
does not wish to acquire the stock. The business spouse's financial
status and reasons why the other's stock should be acquired by
the corporation should be explained. The minutes of the board
should then formally authorize that steps be taken to have the
corporation purchase the selling spouse's shares. After terms of
sale have been agreed upon, the board should approve the sale
and have the approval reflected in its minutes. It is preferable
that these actions be taken without the participation of the business
spouse, who will remain a shareholder after the redemption.
5. The remaining shareholder-spouse may be required to exercise
his or her best efforts to have the redemption occur, but the
redemption should never be characterized as action by the corporation to satisfy or discharge that shareholder's obligation.
6. The stock being redeemed should be actually transferred to the
corporation in exchange for payment, execution of a promissory
note, etc., as the redeeming spouse and the corporation have
agreed. After transfer, the stock may be held by the corporation
as treasury stock.
B. Set Out the Anticipated Tax Effect of the Redemption
If the parties want to eliminate uncertainty in the tax result, it would
be important for the anticipated tax impact of the redemption to be
made very clear in the settlement agreement, and the effect of a variation
from the anticipated result, as the basis for the settlement, to be specified. One technique is the use of a corporate escrow account for the
purpose of paying the resulting tax liabilities. 140 Other devices should
be considered, including the imposition of an offsetting liability on
the spouse whose actions have prevented achieving the negotiated tax
consequence.
4
C. Effecting a Tax-Free Corporate "Split-Off" '
So far this article has proceeded under the assumption that a taxable
redemption is the desired objective because the nonbusiness spouse
140. See supra note 137.
141. See WREN ET AL., supra note 20, at 300.33-300.34.
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wishes to be paid in cash. When spouses are in business together,
however, both may want to end up with a part of the business and
when that is an objective there is an alternative, the nontaxable division.
Split-offs or split-ups are difficult transactions to accomplish successfully, and this article does not purport to examine all of the corporate
tax complexities. The IRS recently issued an elaborate procedural ruling42
explaining in detail the requirements for a successful ruling request. 1
It is included so that it will not be overlooked as an attractive planning
alternative.
With the elimination of the so-called "General Utilities" doctrine in
the Tax Reform Act of 1986' the distribution of appreciated property,
including intangibles such as goodwill, in a liquidation of a corporation
results in corporate level tax on the appreciation. Therefore, distribution
of assets to the shareholder-spouses will result in gain t, the corporation
in the amount of the difference between the net value of the assets
distributed and their adjusted basis. The shareholders will also pay tax
on the gain measured by the net value of the assets distributed from
the corporation over the tax basis for their shares. ,' Thus, liquidation
of the corporation as a means of dividing the assets is much costlier
than it was prior to 1987.
.
142. See Rev. Proc. 96-30, 1996-19 I.R.B. _
143. Under pre-1986 law, a corporation could distribute appreciated property in
liquidation without realizing gain at the corporate level. Int. Rev. Code of 1954 §
336, repealed by Tax Reform Act of 1986, Pub. L. No. 99-514, § 631(a), 100 Stat.
2085, 2269 (1986). The shareholders would realize gain measured by the value of the
property distributed in liquidation over their tax basis, and the distributed property
would take a basis in the hands of the shareholders equal to its fair market value.
I.R.C. §§ 331, 334. In effect, gain at the corporate level was exempt. Such gain
extended to certain redemptions: partial liquidations; redemptions to pay death taxes;
or redemptions which met operating business requirements similar to those imposed
on nontaxable divisions. The latter type of redemption may have played some role in
divorce settlements, but overall the GeneralUtilities rule was not particularly germane
to the marital side of corporate tax planning.
144. Consider a simple example. Corp. owns assets, including goodwill, having a
value of $1,000 and a tax basis of $200. Spouses B and N each own /2 of Corp.'s
stock, having a tax basis of $10 to each one. Corp. distributes all of its assets to B
and N in complete liquidation. For purposes of illustration, assume that the effective
corporate level tax on Corp.'s realized gain ($1,000 - $200 = $800) is 30%, taking
into account any limitation on tax applicable to capital gains. Corp. will pay tax of
$240 (.3 x $800 = $240), and will then distribute net assets of $760 ($1,000 - $240
= $760), $380 each to N and B. Assume further that the effective tax on shareholder
level gain, taking into account the maximum rate on capital gains, is 25%. N and B
will each pay tax on a gain of $370 ($380 - $10 = $370), or $92.30. The total tax
bill on this liquidation is then $184.60 + $240 = $424.60, for an effective rate of
roughly 42.5%. This is a relatively high tax bill which the parties would clearly want
to avoid if given the choice, particularly if each intended to continue to operate his
or her portion of the business.
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In view of this cost, it is generally anticipated that use of the divisive
reorganization provisions of section 355 will be attractive for shareholder spouses who wish to divide their business interests in a closely
held corporate enterprise. Planning would proceed by contributing the
assets of that part of the business to be distributed in the settlement to
one of the spouses (N) to a newly formed corporation (Newco), all
of the stock of which would be owned by the existing corporation
(Distribco). Under the marital settlement, Distribco would distribute
all of the Newco stock to N in exchange for all of N's stock in Distribco.
As a result, B would own all of the Distribco stock and N would own
all of the Newco stock.
There are two requirements of section 355,145 which are particularly
relevant for this plan to work in the marital situation:
1. The distributing corporation (Distribco) and the controlled corporation (Newco) must both be engaged in the active conduct of a
trade or business immediately after the distribution of Newco
stock. 146 The trade or business of each must have been conducted
throughout the five-year period immediately preceding the distribution of stock, although the two businesses need not have been
separately conducted for this to work. 147
2. The distribution of Newco stock must be supported by a corporate
business purpose. 148 The completion of a marital settlement is
not such a purpose because it is intended to further the individual
and personal objectives of the shareholders. However, management disagreement which is solved by dividing the business between the disagreeing factions may satisfy the corporate business
purpose requirement, even though division of the business coin145. Generally, a split-up will not qualify if it is used as a "device for the distribution
of the earnings and profits" of either of the 'resulting corporations. I.R.C. §
355(a)(1)(B); Reg. § 1.355-2(d) (spelling out "device" and "nondevice" factors). A
valid corporate business purpose, discussed below, may be evidence that the distribution
of Newco stock was not a device. Where the intent of the parties is to operate both
businesses after the division, the device requirement will usually be met. Problems
will arise if one party means to convert the retained or distributed stock to cash, in
whole or in part.
146. I.R.C. § 355(b)(1); Reg. § 1.355-3. The regulation specifies what is meant
by "trade or business" and "active conduct." It specifically rules out the holding of
investment property.
147. I.R.C. § 355(b)(2)(B). A set of rules is designed to prevent the acquisitipn
of the assets of a trade or business within the five-year period in order to qualify the,
distribution for section 355 purposes.
148. Reg. § 1.355-2(b). After 1986, greater emphasis has been placed on this
requirement as a means of limiting the ability of closely held businesses to escape the
corporate level tax which would otherwise result from the repeal of the General Utilities
rule; see Rev. Proc. 96-30, supra n. 142, at § 4.04.
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cides with the personal planning objectives of the shareholders.149
Indeed, one would expect that a business run by two parties who
are divorcing each other to suffer from just this sort of disagreement, but it is not a foregone conclusion.
When the requirements of section 355 have been met, the distribution
of Newco stock to N will not be taxed, either to Distribco or to N.
Instead, assets held by Newco after the distribution will have the same
tax basis as they had before the plan was implemented. N's basis for
the stock in Newco will be the same as the basis for the Distribco stock
which was exchanged. In this plan, N may have obtained ownership
of Distribco stock in the marital settlement. That transaction will also
be nontaxable and N will take an allocable share of B's tax basis before
the transfer of stock. It is not clear whether this feature would make
qualification difficult, but there should be some warning signs. Usually,
a spouse who is actively engaged in the business will already own stock;
if he or she does not, then the transaction may appear to be simply a
division of assets rather than a separation of incompatible business
interests as section 355 presupposes.
The tax risk in this type of transaction can be striking and can cause
a major disruption of the economic assumptions that support the settlement. Usually when the tax effect of the transaction plays a central
role in the settlement, the parties will seek a ruling that the tax effect
they anticipate will in fact be obtained. "0 The Service has set out elaborate ground rules for obtaining a ruling, mainly on the business purpose
element. 15' This procedure is recommended when substantial tax is at
stake.
IV. The "Social Compact" of Stock Redemption
Agreements: Where Do We Go from Here?
In a marital redemption, the tax treatment of the continuing shareholder is not prescribed by statute, but rather depends on interpretation
of principles developed in cases on constructive dividends. In general,
a nonredeeming shareholder (in our lexicon, the business spouse) will
not be treated as having received dividend income solely because all
or a portion of the stock of another shareholder (the nonbusiness spouse)
was redeemed, even though the effect of the redemption is to increase
149. Reg. §§ 1.355-2(b)(2); -2(b)(5) Example (2). Cf. Athanasiosv. Commissioner,
69 T.C.M. (CCH) 1902 (1995).
150. See supra note 134 (private letter ruling prescribing the tax effect of a marital
redemption).
151. Rev. Proc. 96-30, supra note 142, superseding Rev. Proc. 86-41, 1986-2 C.B.
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his or her percentage ownership in the corporation. When, however, the
business spouse inadvertently incurred a "primary and unconditional"
obligation, by contract or under a divorce decree, to purchase the nonbusiness spouse's stock, a belated attempt to have the corporation assume the obligation, as in Wall, 5 2 Sullivan,'53 and Schroeder v. Co.mmissioner,154 it will result in a dramatic shift of the tax burden to the
business spouse.
These long-standing rules amount to a "social compact" that contemplates
a pattern in which, when one shareholder or group of shareholders withdraws
from the corporation, wholly or partly, with a resulting increase in the
percentage ownership of the remaining shareholder, the remaining shareholder will not be taxed. The withdrawing shareholder is treated as having
sold or exchanged a capital asset, while the remaining shareholder is considered to have realized nothing that can be viewed as a taxable gain or dividend.
Although the withdrawal and shift in interest is financed out of the corporate
treasury rather than individual bank accounts, and may be viewed as conferring an indirect benefit on the remaining shareholder, the transaction is
considered no more than a sale to the corporation by the holder whose stock
interest is terminated or substantially reduced."'
This is the fundamental argument for maintaining continuity in the
tax law across different personal situations. The tax law of redemptions
is difficult enough without making it more difficult for the uninitiated
whose encounters with these problems is episodic. Whether the redemption occurs for personal estate planning purposes intended to assure
succession of family members in the business, in an acquisition by
newcomers who rely on corporate assets to buy out the departing shareholders, or in the personally stressful environment of divorce, the same
corporate tax rule should apply. This would permit the careful planning
which was present in the settlement in the Ames cases to achieve a stable
economic settlement and would support the consistency and certainty of
result which Judge Beghe has characterized as a "social compact."
Arguments such as the argument that would explain the Ninth Circuit's
departure from the corporate tax rules cause uncertainty by undermining
the formal distinctions, which have been accepted as the distinguishing
feature for redemptions, and have provided stability necessary for planning to undertake these relatively common transactions.
This does not mean that this article necessarily endorses the formal
'primary and unconditional" liability test, 156 presently used for testing
152.
153.
154.
155.
156.
See supra note 25.
See supra note 44.
831 F.2d 856 (9th Cir. 1987).
Arnes(II), 102 T.C. 522, 538-39 (Beghe, J., concurring).
See supra text at notes 45-46.
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redemptions in bootstrap acquisitions, as the best approach. The Service
in its consideration of the problem for the purpose of proposing regulatory changes might do well to abandon the Sullivan test, 57 and require
the presence of a more formal and distinct liability than the executory
contractual obligation involved there, such as the installment obligation
in Wall, before a tax effect planned for one party to the settlement is
shifted to the other. However this plays out in the regulatory milieu,
the type of transaction actually done in Ames should qualify as an
effective redemption, without the need to resort to fictional representations about the independence of the redemption from the property allocation.
The problems discussed in this article emphasize the Tax Court's
concern that cases involving inconsistent tax treatment of a transaction
as between the parties to it, particularly spouses, should somehow be
consolidated. 18 The tax litigation system, permitting one party to pursue
a refund in the federal district court, while the other defends against
a deficiency in the Tax Court, may make consolidation and consistent
treatment difficult to obtain while protecting each party's right to a
day in court. Neither the courts, nor the Service should make this
objective more difficult to obtain than it is already. It may be time for
Congress to permit a party who desires consolidation to slow down the
progress of one case in order to allow the other to catch up procedurally.
Finally, a legislative policy issue is raised. In the context of probate
estate planning, Congress recognized the difficulty in distributing
money out of a corporation in order to cover the decedent stockholder's
taxes and costs without a dividend consequence. It enacted section 303
to provide relief on the ground that this use of corporate funds had
none of the usual hallmarks of a dividend. 59 A similar type of relief
could be made available when distributions are required in divorce
157. See supra text following note 44.
158. Judge Beghe's comments on the importance of consolidation in these types
of proceedings are right on point:
Joann's and John's cases provide an instructive example of lost opportunities.
This Court missed the last clear chance in 1992 to put John's summary judgment
motion on a fast track, so that his case could catch up with Joann's case coming
up from the District Court, and both appeals considered on a consolidated basis
by the Court of Appeals for the Ninth Circuit. However, our mistake in agreeing
with respondent's arguments for postponement of John's case does not mean it
is too late for us to try to rectify the situation, insofar as John is concerned. In
view of respondent's successful efforts to prevent the appeals in the two cases
from being consolidated, the resulting whipsaw is of respondent's own making.
102 T.C. at 531-32. See also Cunningham v. Commissioner, 68 T.C.M. (CCH) 801
(1994) (consolidation in alimony cases).
159. See supra note 27.
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settlements. This would have to be consistent with the purpose of section
1041, to prevent imposition of inappropriate tax burdens on these distributions, even if complete exemption is not acceptable.
V. Thinking about the Future
This article has focused on the impact of one court of appeals decision,
Ames I, on the present state of the tax law governing corporate redemptions. The effect of that decision in the tax literature has been remarkable, which reveals some unresolved problems in interpreting and
applying both the corporate tax law on redemptions used in "bootstrap"
transactions and the tax law governing transfers of property between
spouses. The approach taken in this article has to deal with the issues
faced by marital law practitioners who must deal with these issues in
planning and negotiating settlements now. It is most unwise to project
the uncertainty about an important economic component of every marital settlement, at least those that involve corporate businesses, and
particularly to do it intentionally. Nonetheless, because of both bargaining strategy and the difficulty of resolving intractable economic
issues in the adverse circumstance of divorce, this happens more frequently than it should.
There is no legitimate tax policy objective to leaving the tax status
of redemptions uncertain, particularly in the marital context, so long
as section 302 remains in the Code. The IRS has opened a regulations
project for the specific purpose of changing the regulations under both
sections 302 and 1041 to clarify the tax treatment of marital redemptions. On a technical level, reconsideration of Q&A #9 of the temporary
section 1041 regulations'6° to remove the inference made by the Ninth
Circuit in Ames I would seem to be the minimum which such a project
could accomplish. Although that regulation was convenient for the
analysis in Ames I, it is not essential to the result, so consideration
should be broader. Prominent among the issues which should be exam16
ined is the status of the rule attributed to United States v. Sullivan 1
and stated in Revenue Ruling 69-608. 162 Under that rule, a "primary
and unconditional" personal obligation of the buying stockholder to
purchase stock of the seller can result in imputing a constructive dividend to the buyer.
Judging from the decided cases, the "primary and unconditional"
obligation test seems to have worked reasonably well in nonmarital
160. See supra note 112.
161. See supra note 44.
162. See supra text beginning at note 45.
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redemption cases,163 although the potential for the assertion of inappropriate tax results on an unsuspecting taxpayer exists, but the marital
situation casts that rule in a different light. The current situation justifies
reconsideration of the rule and supports regulatory revision to allow
effective redemptions in most bootstrap transactions. The project should
include cases like Schroeder,' 64 holding that a constructive dividend
resulted to the buying stockholder when the corporation paid a bank
loan which the buyer had personally made to purchase the seller's stock,
and on which the buyer was personally liable at the time of the corporate
payment.
There are also legislative possibilities, although the immediate prospects for this kind of legislation are not encouraging. There are some
suggestions, however. The marital redemption cases show how difficult
it is to administer a rule which determines the tax treatment of a corporate redemption according to the individual tax characteristics of the
shareholder. Present law works this way, sometimes identifying inappropriate marks for the imposition of unjustified tax, at least so long
as Congress leaves section 302 in its present form. For corporate distributions in marital property settlements, a separate tax could be imposed
on the distribution and made payable by one of the spouses, more
appropriately the spouse receiving the distribution. The proposed tax
could be at a predetermined rate, probably close to the capital gains
rate, and would be in lieu of income taxes. In contrast, a proposal to
exempt marital redemptions along the lines suggested by sections 303
and 1014 is unjustified and unwise. If the incidence and amount of tax
were made definite, the parties would be able to negotiate a stable
property settlement which appropriately allocates the tax cost of taking
funds from corporate solution and using them to settle the economics
of the marital division.
163. It is, after all, curable simply by inserting language permitting assignment to
the corporation of the contract to buy the seller's stock. See supra cases cited at note
48.
164. See supra note 154.
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