Planning for Divorce-Related Stock Redemptions

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

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

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

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

Taxing a Redemption That Is Not a Constructive Distribution

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

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

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

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

Example 2. Handling a redemption that is not a constructive distribution: H and W, a married couple, each own 500 shares of O Inc. Their ownership represents 100% of the outstanding shares of the corporation. H and W have agreed to a divorce. The property settlement in the divorce decree does not contain any specific requirements about the ownership of O Inc. W and H decide that W will continue to operate O, and H will be paid $100,000 for his 500 shares of O stock. As a result, H tenders his shares to O shortly after the divorce is final and receives a check from O for $100,000.

W is not required or obligated to purchase H’s shares. So the redemption of H’s shares by O is not made on W’s behalf, and it therefore falls under the normal redemption rules. The $100,000 payment to H will be considered a nonliquidating corporate distribution received by him. Assuming that O has E&P in excess of $100,000, the entire payment will be a taxable dividend unless one of the exceptions under Sec. 302(b) permits stock sale treatment.

Since all of H’s shares are redeemed, the redemption will qualify for sale treatment under the complete termination exception. The family stock ownership attribution rules do not come into play because H and W are no longer married (and H has no attributed stock ownership under any other provision of Sec. 318(a)). Therefore, H will have a capital gain or loss equal to the difference between the $100,000 redemption proceeds and his basis in the stock. The redemption of H’s shares has no tax consequences for W (the nontransferor spouse).

Taxing a Redemption That Is a Constructive Distribution

The rules are different when the redemption is considered a constructive distribution to the other spouse. This occurs when one spouse has a primary and unconditional obligation under the divorce agreement to buy some or all of the other spouse’s shares, but the corporation fulfills that obligation by redeeming the shares in question (Berger, T.C. Memo. 1974-172).

The regulations provide that the following series of events occurs when a redemption creates a constructive distribution to the nontransferor spouse (Regs. Sec. 1.1041-2(a)(2)):

• First, the nontransferor spouse (the party who did not actually tender shares to the corporation for redemption) is treated as acquiring the shares from the transferor spouse (the party who actually did tender shares to the corporation) in a tax-free Sec. 1041 transfer.
• Next, those shares are treated as transferred by the nontransferor spouse to the corporation in exchange for a distribution equal to the redemption proceeds actually received by the transferor spouse. This transaction is taxable to the nontransferor under the Sec. 302 redemption rules.
• Finally, the nontransferor spouse is deemed to transfer the redemption proceeds to the transferor spouse in exchange for that person’s shares (the shares that were actually redeemed), again in a tax-free Sec. 1041 transfer.

The nontransferor spouse will recognize dividend income to the extent of the corporation’s E&P, unless one of the exceptions under Sec. 302(b) applies.

Observation: In this case, the nontransferor spouse often will be unable to meet any of the Sec. 302(b) exceptions that allow a redemption to be taxed as a sale of the shareholder’s stock because he or she actually owns stock in the corporation after the redemption. Thus, the redemption fails the complete termination of a shareholder’s interest test. It will also usually fail the substantially disproportionate distribution test, which requires that the redeemed shareholder’s post-redemption percentage decrease to less than 80% of the pre-redemption ownership percentage. In fact, the nontransferor spouse’s ownership percentage generally increases when the transferor’s stock is redeemed.

The transferor spouse is not taxed in this scenario. Under Sec. 1041(a), property transfers between spouses while they are still married, including transfers of cash, are generally free of any federal income tax consequences. They are considered tax-free gifts. The same is true for post-divorce transfers between ex-spouses that are incident to the divorce. In other words, when the Sec. 1041(a) general rule applies, transfers between the parties are treated as part of the nontaxable division of marital property, rather than as a taxable purchase/sale transaction. In this case, the transferor spouse is deemed to receive tax-free cash from the nontransferor spouse in exchange for the transferor spouse’s shares.

Example 3. Handling a redemption that is a constructive distribution: A and B, a married couple, each own 500 shares of Y Inc. Their ownership represents 100% of the outstanding shares of the corporation. A and B have agreed to a divorce. Under the divorce decree, B has a primary and unconditional obligation to purchase all of A’s shares, and A is required to sell the shares to B for $100,000. B does not have the funds to make this purchase, so Y redeems A’s 500 shares for $100,000. Y has $250,000 of E&P.

Under the divorce decree, B is required to purchase A’s shares. Therefore, the redemption of A’s stock by Y is considered to be made by Y on behalf of B under the rules previously explained. As a result, A is deemed to have transferred his shares to B, who in turn had those shares redeemed for $100,000. B is then deemed to have transferred the $100,000 to A as part of a tax-free marital division of property under Sec. 1041. The deemed stock redemption proceeds from Y constitute a nonliquidating corporate distribution and, based on E&P of $250,000, result in a $100,000 taxable dividend forB.

There are no tax consequences for A (the transferor spouse).

Electing to Apply an Alternative Set of Rules

The regulations allow divorcing couples to elect the tax treatment they want (Regs. Secs. 1.1041-2(c)(1) and (2)), which effectively permits taxpayers to choose how divorce-related stock redemptions will be taxed when they are uncertain about how they would be treated under applicable tax law.

As explained earlier, the transferor spouse bears the tax consequences when the redemption does not result in a constructive distribution to the nontransferor, while the nontransferor spouse bears the tax consequences when the redemption does create a constructive distribution. The ability to effectively choose which set of rules will apply gives the divorcing couple great flexibility to tailor the tax outcome to their specific circumstances with IRS approval.

Electing to Tax Transferor Spouse

When a redemption would result in a constructive distribution to the nontransferor, the couple can elect to have the transferor spouse taxed on the redemption proceeds (Regs. Sec. 1.1041-2(c)(1)). To make this election, the divorce or separation instrument or other valid written agreement must expressly provide that:

• Both spouses or former spouses intend for the redemption to be treated for federal income tax purposes as a redemption distribution to the transferor spouse; and
• The instrument or agreement supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other disposition of the stock that is the subject of the redemption.

Electing to Tax Nontransferor Spouse

When the redemption would not result in a constructive distribution to the nontransferor, the couple can elect to have the nontransferor spouse taxed on the redemption proceeds (Regs. Sec. 1.1041-2(c)(2)). To make this election, the divorce or separation instrument or other valid written agreement must expressly provide that:

• Both spouses or former spouses intend for the redemption to be treated for federal income tax purposes as resulting in a constructive distribution to the nontransferor spouse; and
• The instrument or agreement supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other disposition of the stock that is the subject of the redemption.

   

  Example 4. Electing to reverse the tax impact: H and W each own 500 shares of Z Inc. They have agreed to a divorce. Under the divorce decree, W has a primary and unconditional obligation to purchase all of H’s shares, and H is required to sell the shares to W for $100,000. W does not have the funds to make this purchase, so Z redeems H’s 500 shares for $100,000. Z has $250,000 of E&P.

Under the divorce decree, W is required to purchase H’s shares. Therefore, the redemption of H’s stock by Z would be considered to be made by Z on behalf of W under the rules previously explained. As a result, H would be deemed to have transferred his shares to W, who in turn had those shares redeemed for $100,000. Then, W would be deemed to have transferred the $100,000 to H as part of a tax-free marital division of property under Sec. 1041. The deemed stock redemption proceeds from Z constitute a nonliquidating corporate distribution and would result in a $100,000 taxable dividend for W. There would be no tax consequences forH.

However, the couple can elect to have H taxed on the redemption. The $100,000 payment to H will be considered a nonliquidating corporate distribution received by him. Since Z has E&P in excess of $100,000, the entire payment will be a taxable dividend unless one of the Sec. 302(b) exceptions permits stock sale treatment.

Since all of H’s shares are redeemed, the redemption will qualify for sale treatment under the complete termination exception. The family stock ownership attribution rules do not come into play because H and W are no longer married (and H has no attributed stock ownership under any other provision of Sec. 318(a)). Therefore, H will have a capital gain or loss equal to the difference between the $100,000 of redemption proceeds and the basis of his Z shares. In this situation, the redemption of H’s shares has no tax consequences forW.

Timing Requirement for Election

To make either election, the divorce or separation agreement must be effective, or the valid written agreement must be executed by both spouses or former spouses, before the date on which the spouse who will be taxed on the transaction files his or her initial federal return for the year of the stock redemption. However, the effective date or execution date (whichever applies) cannot be later than the due date, including extensions, for that return (see Regs. Sec. 1.1041-2(c)(3)).

Deciding Whether to Make an Election

When deciding whether these elections will be beneficial, one must consider the tax treatment of the redemption for both spouses (i.e., whether the transaction qualifies for sale treatment, allowing basis to offset proceeds), each spouse’s tax rate (i.e., taxpayers in the lower ordinary income tax brackets pay a reduced rate on capital gains and dividends), and the extent of corporate E&P. Also, the degree of animosity between the parties cannot be overlooked. Sometimes, regardless of the potential tax savings, the level of mistrust is so high that the couple cannot work together to make either of these elections.

Planning Considerations Relating to Stock Options and Deferred Compensation

Rev. Rul. 2004-60 reiterated the holding in Rev. Rul. 2002-22 that divorce-related transfers of interests in nonstatutory (or nonqualified) employer stock options and nonqualified deferred compensation to a former spouse do not have to be included in gross income of either spouse at the time of transfer. The transferee ex-spouse will recognize the income at the time the stock options are exercised or when the deferred compensation is paid or made available.

Rev. Rul. 2004-60 also provided that a transfer of stock options and/or an interest in a nonqualified deferred compensation plan from the employee to a spouse in connection with a divorce does not result in wages for Federal Insurance Contributions Act (FICA) or Federal Unemployment Tax Act (FUTA) purposes. The stock options will be subject to FICA and FUTA taxes when the nonemployee ex-spouse exercises them. The nonqualified deferred compensation will be subject to FICA and FUTA taxes at the time it is paid or made available to the ex-spouse. The wages subject to FICA and FUTA taxes are considered the wages of the employee but are withheld from the payments made to the nonemployee ex-spouse.

Both the income recognized by the nonemployee ex-spouse from the exercise of stock options and the amounts of deferred compensation distributed to the ex-spouse are subject to income tax withholding. The amount withheld is deducted from the ex-spouse’s payments, and the ex-spouse can take a credit for the amount withheld on his or her income tax return.  

This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 28th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).