by Bob Rywick
If spouses who are planning to divorce both own shares of stock in a closely held corporation, they may desire to have the corporation redeem the shares of one of them at the lowest possible tax cost.
This can be accomplished if the corporation has substantial liquid assets on hand (cash or securities readily convertible into cash) or is in a position to borrow the extra funds needed to pay for the redemption.
Alternatively, the corporation may agree to pay part of the redemption price in installments over a period of years. The tax effects of the redemption distribution will depend in part on whether the distribution to one spouse is treated as a constructive distribution to the other, and whether the distribution qualifies for capital gain treatment.
Redemptions not treated as constructive distribution to the non-redeeming spouse.If a corporation redeems stock owned by a spouse or former spouse (the “redeeming spouse”), and the redeeming spouse’s receipt of property in respect of the redeemed stock isn’t treated, under applicable tax law, as resulting in a constructive distribution to the other spouse or former spouse (the “non-redeeming spouse”), then the form of the stock redemption will be respected for income tax purposes.
Accordingly, the redeeming spouse is treated as having received a distribution from the corporation in redemption of her shares of stock. This means that the tax treatment of the redemption is determined under the rules of Internal Revenue Code §302 and the rules of IRC §1041 (no recognition of gain or loss on transfers of property from one spouse to another or to a former spouse in connection with a divorce) don’t apply.
If a redemption of stock qualifies for sale-or-exchange treatment under IRC §302(a), then the redeeming spouse has capital gain or loss treatment on the redemption. If it doesn’t qualify as a sale or exchange, then he has a taxable dividend to the extent of the corporation’s earnings and profits.
Example 1: Your client and her husband, who are planning to divorce, each own 40,000 of the 100,000 outstanding shares of the only class of stock of Moonbliss Inc.
Your client wants Moonbliss to redeem all of her husband’s shares in Moonbliss so that, after the divorce, she will be the majority shareholder in the corporation (owning 40,000 of the 60,000 shares that will then be outstanding). She proposes to have Moonbliss redeem her husband’s shares for $1 million, with $200,000 to be paid when the shares are surrendered, and the $800,000 balance paid in four equal installments of $200,000 each over the next four years. She will guarantee Moonbliss’ obligation to make the installment payments.
Your client’s guarantee should not cause the redemption to be treated as a constructive distribution to her since she doesn’t have a primary and unconditional obligation to purchase her husband’s stock. Thus, the tax consequences of the redemption will be determined according to its form as a redemption of her husband’s shares of Moonbliss stock.
Redemptions treated as a constructive distribution to the redeeming spouse. If a corporation redeems stock owned by the redeeming spouse, and the redeeming spouse’s receipt of property in respect of that stock is treated, under applicable tax law, as resulting in a constructive distribution to the non-redeeming spouse, then the redeemed stock is deemed first to be transferred by the redeeming spouse to the non-redeeming spouse and then transferred by the non-redeeming spouse to the redeeming corporation.
Each of the deemed transfers is taxed as if the transfer had actually occurred. Under IRC §1041, no gain or loss is recognized on the deemed transfer of the stock from the redeeming spouse to the non-redeeming spouse.
Any property actually received by the redeeming spouse from the redeeming corporation in respect of the redeemed stock is deemed first to be transferred by the corporation to the non-redeeming spouse in redemption of that spouse’s stock. The non-recognition rules of IRC §1041 don’t apply to that redemption. The property is then deemed to be transferred by the non-redeeming spouse to the redeeming spouse, in a transaction to which the non-recognition rules of IRC §1041 do apply.
Example 2: The same facts apply as in Example 1, except that the divorce instrument will require your client to buy her husband’s shares in Moonbliss for $1 million. Instead, Moonbliss redeems his shares. This is treated as a constructive dividend to your client with the following tax consequences:
● Your client’s husband is treated as transferring his shares of stock in Moonbliss to your client in a transaction in which no gain or loss is recognized under IRC §1041.
● Your client is treated as transferring the Moonbliss stock she is deemed to have received from her husband to Moonbliss in exchange for $200,000 in cash and an installment note for $800,000 payable in four equal annual installments of $200,000 each. The non-recognition rules of IRC §1041 do not apply to this exchange. Instead, your client is treated as receiving a distribution from Moonbliss that is treated as a dividend to her to the extent of Moonbliss’ earnings and profits. This is so because the distribution doesn’t meet the requirements of IRC §302(a) for treatment as a sale or exchange, since your client owns two-thirds of Moonbliss’ outstanding stock after the redemption distribution.
● Your client is treated as transferring $200,000 plus the $800,000 installment note to her husband in a transaction to which the non-recognition rules of IRC §1041 apply, so that he will not be taxed on the transaction. Only your client will have tax to pay as a result of the transaction.
How to make sure a redemption distribution in connection with a divorce has the desired tax consequences. Treasury regulations provide two rules that allow divorcing spouses to specify how they want redemption distributions to be treated for tax purposes.
Under one rule, a redemption distribution of property in exchange for stock is treated as a distribution to the redeeming spouse, and not a constructive distribution to the non-redeeming spouse in these circumstances. A divorce or separation instrument, or a valid written agreement between the transferor spouse and the non-transferor spouse, must expressly provide that:
● Both spouses or former spouses intend for the redemption to be treated, for income tax purposes, as a redemption distribution to the redeeming 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 3: The same facts apply as in Example 2, except that the divorce instrument specifically provides that the redemption will be treated for federal income tax purposes as a redemption distribution to your client’s husband. The divorce instrument also provides that it supersedes all other instruments or agreements concerning the purchase, sale, redemption or other disposition of the stock that is the subject of the redemption.
Accordingly, the tax consequences of the redemption are determined according to its form as a redemption of your client’s husband’s shares by Moonbliss, and not as resulting in a constructive distribution to your client.
Under the other rule, the spouses can provide that the stock redemption distribution should be treated as a constructive distribution to the non-redeeming spouse. This is done by having a divorce or separation instrument, or a valid written agreement between the transferor spouse and the non-transferor spouse, 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 non-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.
Example 4: The same facts apply as in Example 1, except that the divorce instrument provides that the redemption shall be treated, for federal income tax purposes, as resulting in a constructive distribution to your client. The divorce instrument also provides that it supersedes any other instrument or agreement concerning the purchase, sale, redemption or other disposition of the stock that is the subject of the redemption.
Accordingly, the redemption is treated as resulting in a constructive distribution to your client. Your client’s husband is treated as having transferred his stock in Moonbliss to your client in a transfer to which the non-recognition rules of IRC §1041 apply. Your client is treated as having transferred the Moonbliss stock she is deemed to have received from her husband to Moonbliss in exchange for $200,000 and an $800,000 note with the redemption distribution taxable to her as a dividend to the extent of Moonbliss’ earnings and profits. Your client is then treated as transferring the note to her husband in a transfer to which the non-recognition rules of IRC §1041 do apply.
Observation: Generally, the best way to structure a redemption distribution in connection with a divorce is to prevent the redemption distribution from being treated as a constructive distribution to the non-redeeming spouse. If the distribution is treated as having been made to the non-redeeming spouse, it will almost always be treated as a dividend to the extent of the corporation’s earnings and profits. This is because the non-redeeming spouse will continue to hold a substantial amount of stock in the corporation after the redemption. Thus, the distribution will not be treated as a sale or exchange eligible for capital gain treatment.
If all of the shares of the redeeming spouse are redeemed, she will usually be eligible for capital gain treatment on the redemption. Thus, gain will be recognized only to the extent of the excess of the amount received over the redeeming spouse’s basis in the redeemed shares.
If the distribution is not treated as a sale or exchange, the entire amount would be taxable as a dividend if the distributing corporation’s earnings and profits are sufficient.
Observation: The new rules taxing qualified dividends at the same maximum rate as long-term capital gains make it less important than before to have the redemption distribution treated as a sale or exchange instead of a dividend.
Nevertheless, to the extent of the redeeming shareholder’s basis in the redeemed shares, the taxable amount of the redemption distribution will be less, at least where the entire amount would be taxed as a dividend if sale-or-exchange treatment were not available.
Observation: Part of the tax savings that would be available to the redeeming spouse if capital gain treatment is available could be passed on in negotiations to the non-redeeming spouse. For example, the amount that the non-redeeming spouse would otherwise have to pay the redeeming spouse in the divorce settlement could be reduced.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
