income doctrine can apply to transfers between spouses that are not incident to 301 (b) Examples. The following examples illustrate this paragraph. Example 1. H is a lawyer who uses the cash method of accounting and who is 301 The assignment-of-income doctrine should continue to apply to transfers between spouses who are not in the process of divorce but who nevertheless file separate tax returns under I.R.C. § 1(d). The proposed regulation assumes that I.R.C. § 1041 will continue to apply both to transfers during marriage as well as transfers incident to divorce. An equally justifiable approach, however, would be to amend I.R.C. § 1041 to repeal its applicability to transfers during marriage that are not incident to divorce. If that were done, this second sentence of the proposed regulation would not be necessary. Amending I.R.C. § 1041 in this manner would make sense for two reasons. First, nonrecognition of gain is not justifiable in the case of sales for valuable consideration. For example, assume that John owns a business that supplies other businesses with office supplies. Mary, his wife, opens a new business as a sole proprietor and purchases office supplies from her husband's business. There is no good reason why John's gain on the sale of office supplies to Mary should garner nonrecognition treatment, but it does under current I.R.C. § 1041. Spouses attempting to recognize built-in losses without selling the property to a third party, but rather to each other, would be prevented from doing so by I.R.C. § 267. Second, other transfers between spouses, i.e., gifts, do not need I.R.C. § 1041 to garner nonrecognition treatment, since gifts are not generally realization events. Indeed, having I.R.C. § 1041 apply to transfers that are gifts injects a discontinuity between spousal gifts and gifts among others, since the basis rules are different if the gifted property has a built-in loss. Under I.R.C. § 1041, the transferee spouse takes a carryover basis in all cases, even when the gifted property has a built-in loss at the time of the gift. Gifts of loss property between others, in contrast, are saddled with the basis rule in I.R.C. § 1015(a), which provides that the transferee, for purposes of calculating later gain or loss on a transfer of the gifted property, uses the lower of carryover basis or the fair market value at the time of the gift. This lower-of-basis-or-value rule prevents the shifting of built-in losses to someone (presumably a family member) who is in a higher tax bracket and can thus enjoy more value from the loss deduction. Allowing spouses to take a carryover basis in all cases, even with loss property, allows just such a shifting for spouses who file separate returns. It thus would make sense to consider amending I.R.C. § 1041 so that it applies only to transfers incident to divorce. See Gabinet, supra note 77, at 43-46. This paper does not press that issue only because its focus is on simplifying the tax consequences of transfers in divorce. Example 2. W, who uses the cash method of accounting, enters into a Example 3. W, who uses the cash method of accounting, enters into a Example 4. H receives from his employer nonqualified stock options that do not B. Divorce Redemptions of Stock in Closely Held Corporations The issue of how to treat redemptions of stock in closely held corporations that occur pursuant to the terms of a divorce settlement or decree has given courts some pause since the enactment of I.R.C. § 1041. To put the issue in perspective, I shall first describe the normal 302 302 See, e.g., Craven v. U.S., 2000-2 U.S.T.C. (CCH) ¶ 50,541 (11th Cir. 2000); Arnes v. U.S., 981 F.2d 456 (9th Cir. 1992); Read v. Comm'r, 114 T.C. 14 (2000); Arnes v. Comm'r, 102 T.C. 522 (1994); Blatt v. Comm'r, 102 T.C. 77 (1994); Hayes v. Comm'r, 101 T.C. 593 (1993). "background rules" that dictate the tax treatment of stock redemptions in closely held corporations outside the divorce context. I'll then turn to the issue within the context of divorce. Assume, for example, that Ann and John, who are siblings, each own 50% of the stock in a corporation through which they operate the family business begun by their father and handed down to them. Further assume that the corporation has $50,000 in cash as well as $50,000 in operating assets when Ann retires, and the corporation redeems Ann's stock (which has a basis to her of $10,000) by distributing to her the $50,000 in cash in exchange for all of her stock in the corporation. The redemption leaves sole ownership of the corporation, now worth $50,000 (instead of $100,000) in John's hands. Thus, while his ownership interest increases from 50% to 100% because of the redemption, the value of his interest remains unchanged at $50,000, since prior to the redemption he owned 50% of the stock of a corporation worth $100,000, and after the redemption he owns 100% of the stock of a corporation worth $50,000. While the sale of appreciated stock held by nondealers normally triggers capital gain (after the tax-free recovery of basis), Congress enacted I.R.C. § 302 in order to ensure that this treatment will apply when shareholders sell their stock back to the corporation itself only if the sale sufficiently resembles a sale to a third party and is not a ruse to extract earnings from the corporation without dividend treatment. If a redemption results in little or no diminution in the redeemed shareholder's interest in the corporation, then the transaction will not be respected as a sale but rather will be treated as the distribution of a cash dividend-ordinary income to the recipient with no tax-free basis recovery. 303 Since Ann is completely redeemed in our hypothetical, she has clearly reduced her interest in the corporation, and thus her sale will be respected as a true sale rather than a disguised dividend distribution.304 She thus will realize a $40,000 capital gain ($50,000 amount realized less her $10,000 stock basis). John might also realize tax consequences on Ann's redemption. Even though the value of his economic interest in the corporation remains unchanged before and after the redemption, he would nevertheless be treated as realizing a dividend of $50,000 if John had actually had the "primary and unconditional obligation" to purchase Ann's stock upon her retirement, and the corporation satisfied that obligation in John's stead. The transaction would be treated, in that case, as if John had received a $50,000 cash distribution (a dividend306 to him), which he then used to purchase Ann's stock interest (resulting in $40,000 of capital gain for her, as before). If 303 304 See I.R.C. § 302(d). 305 See I.R.C. § 302(b)(3), (a). While I.R.C. § 302(c) provides that the attribution rules of I.R.C. § 318 apply in determining the extent to which a shareholder's interest has actually decreased, the family attribution rules do not operate to attribute John's stock to Ann. See I.R.C. § 318(a)(1) (failing to mention sibling attribution). 305 306 See, e.g., Rev. Rul. 69-608, 1969-2 C.B. 43. I am assuming, of course, that the corporation has sufficient earnings and profits so that the entire cash distribution qualifies as a dividend. See I.R.C. §§ 301(a) & (c), 316. John did not have the primary and unconditional obligation to purchase Ann's interest, then he would realize no tax consequences on Ann's stock redemption. Notice that Ann's treatment is not affected by John's tax treatment. She realizes $40,000 of capital gain, whether she is deemed to transfer the stock to the corporation or to John. 307 John's tax treatment, revolving around whether he had the "primary and unconditional obligation" to purchase Ann's stock at the time of the redemption, was developed in a series of litigated cases that resulted in the issuance of Revenue Ruling 69-608, which summarized them and provided guidance regarding the tax consequences of common buyback agreements among shareholders when a closely held corporation redeems stock. The ruling makes clear that form will govern in this context. If, for example, John and Ann had entered into an agreement under which either would purchase the stock of the other upon the other's death or retirement, and that agreement remained outstanding at the time of Ann's retirement and redemption of her stock by the corporation, then John would realize a dividend.308 If, in contrast, John and Ann had amended such an agreement prior to her retirement to provide that the corporation would assume the obligation to redeem her stock upon her retirement, then John would avoid dividend treatment, so long as the amendment did, indeed, occur prior to Ann's retirement (when John's obligation would have ripened). If the buyback agreement between John and Ann had provided that the corporation would have the primary obligation to redeem the stock interest of each upon death or retirement, with a secondary obligation imposed on the remaining shareholder to purchase the stock if the corporation is unable to fulfill its obligation, then John would avoid dividend treatment, since his obligation would not be "primary" but only "secondary. Because form controls in this context, the parties are given absolute power to determine what the tax consequences will be through their choice of form. ,,310 309 It's not my purpose to analyze whether this form-sensitive approach makes sense as the general background rule. Rather, my job is to note that it has been well accepted for more than three decades and then to consider how it ought to affect the tax treatment of redemptions in divorce. Now assume the same facts as above, except that Ann and John are married, and Ann's 50% stock interest in the corporation is required to be redeemed for $50,000 in their divorce agreement. Suppose instead that the divorce decree actually required John, not the corporation, to purchase Ann's stock, but the corporation nevertheless redeems the stock. How should Ann and John be treated for tax purposes in these situations? 307 See, e.g., Sullivan v. U.S., 363 F.2d 724 (8th Cir. 1966); Holsey v. Comm'r, 258 F.2d 865 (3d Cir. 1958); Wall v. U.S., 164 F.2d 462 (4th Cir. 1947); S.K. Ames, Inc. v. Comm'r, 46 B.T.A. 1020 (1942), acq., 1942-1 C.B. 1; Kobacker v. Comm'r, 37 T.C. 882 (1962), acq., 19642 C.B. 6. There are two possibilities. Ann's stock transfer could be respected as a direct transfer to the corporation. Under this view, Ann would realize a $40,000 capital gain when she receives the $50,000 cash, and John would have no tax consequences. In the second situation, in particular, however, John may be considered to have had the "primary and unconditional obligation" to purchase Ann's stock but instead caused the corporation to redeem it. Should we deem the $50,000 cash to have gone first to John (dividend to John), which John used to purchase Ann's stock, as we do outside the divorce context? Or, to put the steps in a different order (though it makes no difference in end result), should we deem Ann to have transferred to John her stock since he was, in fact, required to purchase it, which was then redeemed (dividend to John311), followed by the payment by John to Ann of the redemption proceeds? Ann's deemed transfer to John in that case would be nontaxable under I.R.C. § 1041. This would be the one big difference in tax consequences, as compared to the same transaction occurring outside the divorce context, where Ann would realize capital gain in any event (either on the transfer to the corporation or on the transfer to her fellow shareholder), since no nonrecognition provision would be available for the redeemed shareholder outside the divorce context. 311 312 Is that the proper approach? Would it make sense to deviate from the current practice outside the divorce context (i.e., essentially allowing the parties to designate to whom the corporate distribution should be taxed by their choice of form) if the redemption happens to occur pursuant to divorce? Might not the divorce context actually provide the more persuasive context for maximum flexibility for the parties to decide to whom the distribution should be taxed? Before addressing these questions, consider another possibility. Another common fact pattern in divorce is that only one spouse, say John, actually owns 100% of the couple's interest in the corporation, but Ann is entitled to a $50,000 cash payment representing her marital property interest in the stock. In the simplest case, John can pay Ann cash directly from other resources, and the tax consequences of that cash payment would be analyzed under I.R.C. § 71, described in Part II. But suppose John has his wholly owned corporation redeem one-half of his stock for $50,000, which he then transfers to Ann? Because the redemption would not reduce his percentage interest in the corporation (since John would own 100% both before and after the redemption), John would be treated as receiving a $50,000 dividend. The cash transfer to Ann would again be analyzed under I.R.C. § 71. 313 311 See U.S. v. Davis, 397 U.S. 301 (1970) (holding that when one person owns 100% of the stock of a corporation, actually or constructively, any redemption distribution is taxable as dividend unless the transaction qualifies as a partial liquidation under I.R.C. § 302(e)). 312 Ann's receipt of the cash, which would then be deemed to come from John instead of the corporation, would be tax-free to her as well as "not alimony" (under current law, at least), except in the extremely unlikely event that her estate's right to receive the cash would disappear if Ann died prior to receipt. Under the proposals advanced in Part II, John and Ann could decide whether the cash transfer from John to Ann would be includable/deductible or excludable/nondeductible. |