IRS Issues Final Regs. On Marital-Related Stock Redemptions 

The IRS issued Regs. Sec. 1.1041-2, which applies the Sec. 1041 provisions only to marital-related stock redemptions. It has not withdrawn Temp. Regs. Sec. 1.1041-1T(c), Q&A-9, which continues to apply to transfers of property other than stock redemptions, by a spouse or a former spouse.

Background

Under Sec. 1041, gains or losses on property transfers between spouses or former spouses incident to a divorce are generally not recognized. However, if the particular transfer involves the redemption of stock by a corporation, the tax-free consequences become more complex.

The final regulations were preceded by Prop. Regs. Sec. 1.1041-2, issued in August 2001. In the preamble to the proposed regulations, the IRS noted the need for regulatory guidance, given the uncertainty created by the courts on marital-related stock redemptions. (For a thorough discussion of the Tax Courts divided decision in Read, 114 TC 14 (2000), a case that added further uncertainty, see Barton, Tax Clinic, The Tax Court Applies Sec. 1041 Nonrecognition Provisions to Stock Redemptions, TTA, June 2000.)

Discussion

The final regulations address marital-related stock redemptions, in general, and contain a special rule that allows spouses or former spouses to agree as to which party will be taxed on the stock redemption. The addition of this rule was a direct result of the need for such a provision, as expressed by commentators. According to the final regulations, stock redemptions will be taxed in one of two ways. Essentially, a marital-related stock redemption is either respected as a stock redemption to one spouse or, conversely, deemed a constructive distribution to the other. 

Regs. Sec. 1.1041-2(a)(1) provides that if the stock of a spouse or former spouse (transferor spouse) is redeemed by a corporation and the redemption is not treated under applicable tax law as a constructive distribution to the other (nontransferor) spouse, the transaction will be respected as a stock redemption. Further, Sec. 1041 will not apply, because the transfer is not a transfer of property between spouses. The transferor spouses proceeds are then tested under Sec. 302 as a sale or exchange or dividend equivalent (Regs. Sec. 1.1041-2(b)(1)). For example, if an ex-husband and -wife equally owned all the stock of a corporation, and the corporation redeemed all the stock of the ex-wife (or transferor spouse) for cash, she will receive sale or exchange treatment under Sec. 302(b)(3), provided the redemption is not treated under applicable tax law as a constructive dividend to the ex-husband (or nontransferor) spouse. 

Example 3 of the final regulations provides further guidance on the applicable tax law standard. Essentially, if the nontransferor spouse does not have a primary and unconditional obligation to purchase the transferor spouses stock, the redemption does not result in a constructive distribution to the nontransferor spouse, under Regs. Sec. 1.1041-2(d). 

If, however, the transferor spouses stock is redeemed by a corporation in a situation in which the nontransferor spouse does have a primary and unconditional obligation to purchase the transferor spouses stock, Sec. 1041 will apply to shield the transferor spouse from any gain or loss. The redeemed stock will be viewed as having been transferred first from the transferor spouse to the nontransferor spouse, then from the nontransferor spouse to the corporation. The nontransferor spouse will then test the constructive distribution proceeds under Sec. 302 or 301, as applicable; see Regs. Sec. 1.1041-2(a)(2), (b)(2) and (d), Example (1). 

Regs. Sec. 1.1041-2(c) provides a rule governing the tax treatment of agreements between spouses or former spouses. For this rule to apply, the parties must express their intentions in writing as to how the redemption will be treated for income tax purposes. The choice is between a redemption distribution to the transferor spouse and a constructive distribution to the nontransferor spouse. The agreed-on treatment must be set forth either in the divorce or separation instrument or in a separate valid written agreement between the spouses or former spouses. The agreement between the parties must supercede any previously existing agreements that govern the purchase, sale, redemption or other disposition of the subject stock. 

In addition, the final regulations indicate that the agreement must be executed before the date on which the designated taxable spouse timely files his return for the year within which the redemption occurs.

Effective Date

The final regulations are effective for redemptions occurring on or after Jan. 13, 2003, except for redemptions made pursuant to agreements in effect prior to that date. For agreements entered into after the date of the issuance of the proposed regulations (Aug. 3, 2001), the special rule as to agreements between spouses or former spouses applies.

From Mark D. Puckett, CPA, MST, Memphis, TN