consideration that Joann received and her basis in the surrendered stock would produce capital gain or loss for her. The Ninth Circuit agreed with Joann, interpreting Treasury Regulations § 1.1041-1T(c), Q&A 9, to mean that the transfer made directly by Joann to the corporation should be deemed to have been made to John instead, since the transfer outside the marital unit was required by their settlement agreement. The court reasoned that the transfer by Joann to Moriah was made "on behalf of" John because the redemption was mandated by an agreement that was executed in settlement of any community property claims that Joann might otherwise have been able to assert against John. Since virtually any property transfer mandated by a divorce decree or settlement is part of an agreement that, by its nature, settles all claims between the parties that each can otherwise possibly assert against the other under state law, such an approach essentially means that any transfer of property that the divorce decree or agreement requires to be made to a third party outside the marital unit (for any reason, including franchise contract requirements) should first be deemed made to the other spouse before leaving the marital unit, regardless of whether the parties are aware of or intend such a deemed transfer at the time. The bizarre uncertainty and unintended tax surprises that such an approach creates for divorcing parties was made clear when Mr. Arnes, in a separate Tax Court case brought by the government against him after it lost the case against Joann, argued that the form of the transaction should be upheld, with the tax consequences of the redemption falling on Joann. The Tax Court agreed-a position that I think to be correct-with the result that neither party was held responsible for the tax consequences of the redemption. 324 322 323 The Tax Court also originally held that the law outside the divorce context that can impose a constructive dividend on the nonredeemed spouse should inform when transfers are made "on behalf of" the other spouse within the meaning of Treasury Regulations § 1.1041-1(c), Q&A 9. In Hayes v. Commissioner, for example, H was required to purchase W's stock under the terms of their divorce settlement. Instead, however, the corporation redeemed W's stock. Because H had the "primary and unconditional obligation" to purchase the stock under the divorce settlement at the time of the redemption, the Tax Court concluded that H should, as in the non-divorce context, be deemed to have received a constructive dividend under the cases summarized in Revenue Ruling 69-608. In other words, W was deemed to have transferred her stock to H, since H had a legal obligation to purchase it, before it was redeemed by the corporation. W's transfer would be a nonrecognition event under I.R.C. § 1041, H's deemed redemption would trigger a constructive dividend for him, and the deemed transfer of the redemption proceeds from H to W would likely not fall within the inclusion/deduction scheme of I.R.C. §§ 71 and 215. 322 See Arnes v. Comm'r, 102 T.C. 522 (1994); see also Blatt v. Comm'r, 102 T.C. 77 (1994) (also respecting the form of a transaction and taxing W on a direct redemption of her stock). I think that Hayes was rightly decided. I can't see that H should have been surprised by the conclusion that he was responsible for the tax consequences of the stock disposition outside the marital unit, since the divorce agreement actually required him to purchase the stock from W. The tax results should have come as no surprise in view of the form chosen by the parties, unlike in Arnes, where H did not have a legal obligation to purchase W's stock and yet was held (by the Ninth Circuit, at least) to have been the object of a deemed transfer of the stock from W, which was then redeemed, with the redemption proceeds then deemed transferred from H to W. (Lots of deemed transfers!) In February of 2000, the full Tax Court, in a lengthy reviewed decision, with one concurring and four dissenting opinions, revisited its approach in this respect in Read v. Commissioner 325 and essentially abandoned the approach in Hayes that looked for guidance regarding the meaning of the terms "on behalf of" by looking to the law outside divorce. Carol Read owned about 48% and William Read owned about 52% of all of the stock of Mulberry Motor Parts, Inc., when they decided to divorce. Under the terms of their divorce agreement, William Read was required either to purchase Carol's stock or to cause Mulberry Motor Parts to redeem the stock. If he chose the latter, which he did, he would guarantee the payment, which would make him secondarily liable for payment under state law. Carol Read did not include any capital gain regarding the stock redemption, and William Read also did not include any constructive dividend equal to the consideration received by Carol. The issue, of course, was whether the direct redemption should be respected for tax purposes or whether Ms. Read should be considered as having transferred the stock to the corporation "on behalf of" Mr. Read, thus shifting the tax consequences of the redemption to him. To protect its interest as stakeholder, the government issued notices of deficiency to both parties. The opinion relates: "[The government's] role here is that of a stakeholder. Nonetheless, [the government] has indicated that 'Ms. Read has the better argument that she should not recognize any gain from the sale of her stock pursuant to I.R.C. § 1041.326 It's fairly clear that William did not have a "primary and unconditional obligation" to purchase Carol's stock at the time of the redemption, since the divorce settlement required that either William or the corporation purchase Carol's stock. This is similar, though not precisely on point, to Situation 5 in Revenue Ruling 69-608, where the ruling concludes that the nonredeemed shareholder did not realize a dividend when he was only secondarily obligated to purchase the shares if the corporation failed to redeem them. 327 327 See supra note 310 and accompanying text. The ruling cites S.K. Ames, Inc v. Comm'r, 46 B.T.A. 1020 (1942). In that case the nonredeemed shareholder entered into a contract that provided that he had the obligation "to purchase or cause to be purchased" the shares of the redeemed shareholder. Under this language, the nonredeemed shareholder was held not to have had the "primary and unconditional obligation" to purchase the shares that were instead redeemed. But all of that is irrelevant under the Tax Court's decision, because the Tax Court majority concluded that the standard developed outside the divorce context for measuring when a nonredeemed shareholder should be considered to have received a constructive dividend-i.e., the "primary and unconditional obligation" standard-should not be considered commensurate with the standard determining whether a property transfer is made "on behalf of" the nontransferring spouse within the meaning of Treasury Regulations § 1.1041-1T(c), Q&A 9. A quick reading of the case might first imply that the case stands for the proposition that satisfaction of the primary-and-unconditional-obligation test is but one means by which a transfer will be considered "on behalf of" the other spouse but that the latter language can go much further as well. But the court explicitly disclaimed any relevance at all of the primary-andunconditional-obligation standard to stock redemptions in divorce. We hold that the primary-and-unconditional-obligation standard is not an appropriate standard to apply in the instant cases in order to determine whether Ms. Read's transfer of her ..... stock to [the corporation] was a transfer of property by the transferring spouse (Ms. Read) to a third party ([the corporation]) on behalf of the nontransferring spouse (Mr. Read) within the meaning of Q&A-9. We further hold that the primary-and-unconditional-obligation standard is not an appropriate standard to apply in any case involving a corporate redemption in a divorce setting in order to determine whether the transfer of property by the transferring spouse to a third party is on behalf of the nontransferring spouse within the meaning of Q&A-9. In short, the meaning of "on behalf of" in Q&A 9 should be determined afresh, without regard to the primaryand-unconditional-obligation test that is applied outside of the divorce context. ,,329 328 The Tax Court concluded that, although the stock redemption did not satisfy a legal obligation of Mr. Read, the stock transfer was nevertheless made "on behalf of" him under the "common, ordinary meaning' of those words. Parsing the language "on behalf of" as though it appeared in the statute itself, rather than a regulation that apparently attempted simply to provide some planning flexibility to the parties, the Tax Court majority quoted Webster's Ninth New Collegiate Dictionary (1990) in concluding that "on behalf of" meant “in the interest of" or “as a representative of."330 Applying those standards, the Tax Court concluded: 328 Read, 114 T.C. at 14. 329 330 Id. The terms "on behalf of" are not in the statute, though the court parses that language as though they were. They are in a regulation that attempts to further the purpose of the statute by giving effect to the parties' agreement that a deemed transfer between the spouses prior to the transfer outside the marital unit should be respected when the parties' intent that such a deemed transfer occur is made clear. The court's approach, by excising those words and analyzing them independently of the entire context of Q&A 9 as well as I.R.C. § 1041 as a whole, can apparently result in a holding that a deemed transfer occurred, even if neither of the parties intended or bargained for such a transfer, if the court believes that the transfer by one spouse was nevertheless made "as a representative of" the other. Ms. Read was acting as Mr. Read's representative in transferring her ... stock to The Tax Court further concluded that the transfer came within "situation one" of the Q&A 9 regulation, since the transfer was made pursuant to the divorce decree. 332 The most recent case was Craven v. United States, decided in June of 2000 by the Eleventh Circuit, a case which confirms that any transfer made directly to a third party pursuant to a divorce decree should be deemed to be made "on behalf of" the other spouse, regardless of whether the parties knowingly intend that result. Billy Joe and Linda Craven started and subsequently incorporated a pottery business, with 51% of the stock owned by Billy Joe, 47% owned by Linda, and the remaining 2% owned by their two children, 1% each. Under the terms of their 1991 divorce agreement, Linda was obligated to sell her stock to the corporation for a promissory note of $4.8 million, guaranteed by Billy Joe, who acknowledged that the terms of the arrangement were of "direct interest, benefit and advantage" to him. Linda argued that the redemption should be considered to have been made “on behalf of" Billy Joe under Treasury Regulation § 1.1041-1T(c), Q&A 9, thus shifting the tax consequences to him, solely because it was required by the divorce decree, consistent with the broadest possible reading of "situation one" of that regulation. "She argues that the transfer of stock to the corporation was done pursuant to her divorce agreement and therefore was on behalf of her former spouse within the language and purposes of the temporary regulations." The government argued that the form of the transaction should be respected, with Linda taxed on the redemption. ,,333 Both the District Court and the Eleventh Circuit held in favor of Linda, in opinions that confirmed the scope of the Q&A 9 language to include virtually all transfers of property outside the marital unit to third parties, without regard to the parties' apparent or actual intent, so long as the transfers are required by the divorce decree. The District Court held that the transfers were made "on behalf of" Billy Joe "because the redemption came as a result of Billy Joe's obligation under Georgia law to equitably divide all marital assets." You can't get any broader than that. Virtually all such transfers are made as part of the parties' property settlement. The Eleventh Circuit recounted with approval the Tax Court majority's opinion in Read, including its reading of the terms "on behalf of" to mean "in the interest of" or "as a representative of." The Eleventh Circuit then cited three factors as supporting Linda's position: (1) that the redemption was mandated by the divorce decree, (2) that Billy Joe guaranteed the redemption note issued by the corporation, and (3) that he acknowledged that the terms were of "direct interest, benefit and advantage to him." But—and this is critical—the court made it clear that, even if the second and third factors were entirely absent, Linda would win simply because the redemption was mandated by the divorce decree. "The first fact enumerated above [that the redemption was required by the divorce decree] would be enough on its own to qualify Linda's transfer to the corporation for nonrecognition under § 1041. The other two factors simply add strength to this conclusion."334 This myopic reading of the "first situation" in Q&A 9 (that any transfer to a third party required by a divorce decree should be considered as made by the other spouse), lifted from its surrounding context, is just the sort of reading that not merely drains the pro-taxpayer regulation of the very ability to specify who should be responsible for the tax consequences of a third-party transfer that I believe was its purpose but actually mandates a "one-size-fits-all" approach that can require precisely the opposite result that the parties intended. There is no reason to believe that simply because a divorce decree requires one of the spouses to transfer property outside the marital unit that the parties will understand that to mean that the transferring spouse should first be deemed to have transferred it to the other spouse, shifting the tax responsibility to her. Indeed, if a divorce decree explicitly requires John to transfer property that he owns to someone outside the marital unit, the natural assumption on the part of the divorcing couple would quite likely be just the opposite that John is responsible for that gain—since he owned the property, and the decree could have just as easily required John to transfer it to Mary first but did not. I think that it should be fairly obvious that the primary-and-unconditional-obligation test could not provide the outer reaches of the standard regarding when a transfer is made “on behalf of” a spouse, if for no other reason than that the Q&A 9 regulation applies to transfers of all kinds of property to all kinds of third parties-not simply stock transfers to corporations. Nevertheless, I also think that it should be clear that whenever H is required by a divorce settlement to purchase W's stock, but instead the corporation redeems W's stock, W should be considered as transferring the stock to H first. This would result in the tax consequences of the redemption falling on H, consistent with the parties' apparent agreement that H should take ownership of the stock, so that when it's transferred to the corporation, he should be deemed to have made that transfer. This tax treatment also happens to be the same tax treatment that would arise outside the divorce context under the primary-and-unconditional-obligation test. In other words, I think it should be clear that satisfaction of the primary-and-unconditional-obligation test should also satisfy the standards of the on-behalf-of test in the stock-redemption context, since the on-behalf-of test under I.R.C. § 1041 ultimately turns on the parties' intent, and when the nonredeemed spouse is legally obligated to purchase stock that is instead redeemed, the parties intent that he should take title before the stock leaves the marital unit is sufficiently clear. But if W and H state in their divorce settlement that Blackacre is required to be transferred by W directly to a third party, and further state that it should be considered first as going to H, thus shifting the tax liability to H (even though the transfer was made directly to the third party for the sake of expediency), that agreement should be respected—even if H did not have any scintilla of legal obligation to purchase Blackacre from W at the time she made the transfer, let alone a "primary and unconditional obligation." |