Page 79 - Family Law Services

• Such instrument or agreement supersedes any other instrument or agreement concerning the pur-
chase, sale, redemption, or other disposition of the stock that is subject to the redemption.

IRC Section 1.1041-2(a)(2) relates to situations in which the nontransferor spouse will be taxable, in-
cluding circumstances under which the nontransferor spouse will be deemed to have received a con-
structive distribution from the corporation followed by the deemed transfer of cash to the transferor
spouse in redemption of his or her stock. If the divorce or separation agreement sets forth the following
agreements of the parties, the transfer will be treated as a constructive distribution to the nontransferor
spouse:

• 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.

• Such instrument or agreement supersedes any other instrument or agreement concerning the pur-
chase, sale, redemption, or other distribution of the stock that is the subject of the redemption.

The final IRS regulations include examples of various possible tax outcomes under scenarios contem-
plated by the regulations. Further, absent adherence to the special rules in the case of agreements be-
tween spouses or former spouses in divorces identified previously (transactions in which a spouse is re-
lieved of his or her primary or unconditional obligation to acquire the other spouse’s stock by the corpo-
ration) will result in a constructive distribution to the nontransferor spouse. Thereafter, the redemption
proceeds will be deemed to have been transferred to the transferor spouse in a nontaxable transaction
under IRC Section 1041. The taxable result of this transaction is such that the nontransferor spouse (the
spouse deemed to have received a constructive distribution as the result of his or her relief from his or
her primary or unconditional obligation to purchase the other spouse’s stock) will likely be unable to
avail themselves of IRC Section 302(b). In this case, the taxpayer will be subject to ordinary income tax
treatment under IRC Section 301.

In cases in which divorced or divorcing spouses avail themselves of IRC Section 1.1041.1-2(c), the tax
treatment of the transaction will be as specified in the agreement and respected by the IRS. If the rela-
tively straightforward requirements of the regulations are adhered to, the spouses will be able to deter-
mine whether the transferor or the transferee spouse will be taxable on the transaction. An election by
the transferor spouse to be taxable on redemption will generally result in capital gain treatment on the
redemption under IRC Section 302(b). Thus, the new regulations provide the taxpayers with great lati-
tude in determining which spouse will be taxed on a transaction and the taxable nature of the transaction
when the corporation is buying the stock.

Carryover basis and holding period rules apply to transferred shares when determining the gain on re-
demption.

IRC Section 1041 is generally straightforward and easy to understand. Transfers between spouses (or
ex-spouses if incident to a divorce) are effectively treated as gifts with carryover basis, and the holding
period is also transferred to the recipient spouse. These transactions are treated as transfers, not sales, for
tax purposes even if the transaction is structured as a sale.

Although it is beyond the scope of this practice aid, the history of the tax case law and IRS Private Let-
ter Rulings in the area of stock redemptions pursuant to divorce reflects conflicting results among the
cases and, more often than the government would have liked, neither spouse paid any tax on a stock re-
demption by a corporation. The following is a list of the tax cases, IRS Private Letter Rulings, and the

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