Category: Individuals, Corporations, Nontaxable Exchanges Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayers are getting divorced. Included in the marital assets is stock in various closely-held corporations. Under the terms of the property settlement, the wife gets one-half of all assets including the stock. The husband wants sole ownership of the stock. The husband does not have sufficient liquid assets to purchase the wife's stock interests. The parties are considering a redemption of the wife's stock. Normally, assets can be transferred between spouses on a tax-free basis under Section 1041. The husband could buy the wife's stock interest, either prior to the divorce or afterwards but pursuant to the divorce decree, and the transaction would be tax-free to the wife under Section 1041. See Regs. Section 1.1041-1T(a), Q & A-2; Regs. Section 1.1041-1T(d), Q & A-11. If the divorce decree requires the wife to transfer her stock to the husband and the corporation redeems the wife's stock at the behest of the husband, then the transaction is tax-free to the wife under Section 1041 and treated as a constructive dividend to the husband. On the other hand, if the there is no obligation under the divorce decree for the wife to transfer stock to the husband, then a subsequent redemption of the wife's stock is not covered under Section 1041 but rather tested under the redemption rules of Section 302. Obviously, this creates real tax tension between the divorcing parties. As I understand it, you have been hired to give a second opinion on the property settlement from the wife's perspective. It is not entirely clear exactly what has been proposed, but I infer from the material you sent there will be an agreement outside of the divorce decree for redemption of the wife's stock at the price and under the terms stated in your correspondence. If the purchase price of the stock is its fair market value, then I think the wife is giving up too much under this arrangement. The hard-line approach for the wife is as follows. She has a right to one-half of this stock. It is possible for her to sell the stock to the husband on a tax-free basis pursuant to the divorce decree. If the husband wants the stock, it is his problem how he gets the money. He could borrow the money from a bank, borrow the money from the corporation, cause the corporation to redeem the stock and take the dividend hit, or draw additional salary from the corporation to purchase the stock. Otherwise, the husband has to deal with her presence in corporate affairs. It is unfair for the wife to "eat" the tax on the redemption and have the husband avoid any negative tax impact caused by something he wants (complete control of the company) in the first instance. The softer approach is as follows. As a practical matter, the only source of liquidity in this deal is the corporation. The husband obviously wants the wife out of corporate affairs. Chances are, the wife wants out too. Plus, the wife undoubtedly would prefer to have cash instead of stock. If the corporation is the source of the funds to cash-out the wife, then someone will have to pay tax somehow, someday as a result of taking the money from the corporation. The avenue to what both parties want that has the least tax cost seems to be through a redemption outside the divorce decree. The only question is who should bear the tax cost. Since using the corporation to redeem the stock serves the interests of both parties, then perhaps both parties should share the tax burden. I think the fair end position is for the parties to share the wife's tax burden on the redemption 50-50. Depending on the circumstances between the parties, obviously it may be necessary to start with the hard-line approach in order to end up here. If this approach seems appealing, then the various advisors should give very careful attention to structuring the agreements to accomplish the desired result. This area of law is very much in flux and requires very careful draftsmanship. I stand ready to assist you in this if desired. I look forward to discussing this with you. |
