(Part 11 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)
C.Transfers of Closely Held Businesses
In a divorce, it is often the case that the family business will be one of the most valuable assets in the marital community. Generally, the transfer of the stock in a closely held business will enjoy the protection of Section 1041 in the context of divorce. Likewise, the basis and holding period will carry over to the transferee spouse, thereby deferring the recognition of any gain or loss to him/her. However, the transfer of closely held stock can be accomplished through various means, under a variety of circumstances, with the resulting tax burden born in some cases by the transferor spouse, and at other times by the transferee spouse.
1. Cash Buyout
The simplest scenario in a divorce related transfer of a closely held business would be a cash buy out of one spouse by the other.
Example: Barney and Betty are in the process of divorcing. They own 100% of the stock in a granite quarry that they acquired during the marriage. The stock has an appraised value of $500,000. As part of the divorce agreement it is decided that Barney will buy out Betty’s interest for $250,000. The basis of the shares in total is $50,000. Barney proceeds to buy out Betty’s interest for $250,000. In accordance with IRC Section 1041, no gain or loss is recognized on the transfer. Barney’s basis in the stock is increased from $25,000 to $50,000.
2.Stock Redemptions for the Family Business
It is often the case that the divorce agreement will require one spouse to buy out the business interest of the other. Frequently the purchasing spouse (transferee) may lack the cash to effectuate the buyout from the selling spouse (transferor).
The transferee spouse may then turn to the business itself as a source of cash for the buyout. This is a tricky situation since the tax result will be a Stock Redemption ending in taxable income to one or both spouses.
Tax Trap Alert: To the extent a C Corporation has earnings and profits, or a S Corporation had earnings and profits prior to converting to a C Corporation, using corporate funds to acquire the transferor spouse’s stock shares my result in a constructive dividend (and thus taxable income) to the transferee spouse. This is regardless of the nonrecognition provisions of IRC 1041. 
1.a) Capital Gain Verses Ordinary Income Treatment
As a general rule, a corporate stock redemption will be treated as either a constructive dividend taxable as ordinary income to the “transferor spouse”, or as the proceeds from a sale or exchange of the stock, qualifying as either long or short-term capital gain or loss.
For most transferor spouses it will be desirable to enjoy capital gain treatment of the redemption proceeds. However, if the corporation has earnings and profits,
- b) Exceptions to Ordinary Income Treatment of Stock Redemption
To avoid treatment as a constructive dividend (ordinary income), the stock redemption should be structured to meet one or more of the following five (5) exceptions:
- It is not an essentially equivalent dividend.
- The redemption is substantially disproportionate.
- The interest of the shareholder is completely terminated.
- A noncorporate shareholder is engaged in a partial liquidation.
- It is equal to or less than the death taxes and selected expenses of a deceased shareholder.1.c. Additional Issues with Divorce Related Stock Redemptions
(1) If the transferor spouse has basis in the transferred stock, such basis can be used to reduce the gain on the sale.
(2) If the transferor spouse has a gain on the redemption, the practitioner should check for capital loss carryovers as well as opportunities to harvest unrealized losses in the client’s investment portfolio so as to offset some or all of the gain on the redemption.
3) The practitioner should check to see if the stock redemption qualifies for Section 1202 (Qualified Small Business Stock) treatment, where in some or all of the proceeds may be excluded from taxable income.
(4) If the redemption results in a loss, the practitioner should check to see if it qualifies as a Section 1244 ordinary loss as opposed to a capital loss as would normally be expected.
(5) If possible, the redemption should occur after finalization or community property partition so as to avoid the spousal attribution rules of Section 318. If such timing is not possible, the spouses may execute a waiver of these rules. Otherwise, the shares of one spouse may be treated as being owned by the other. In such a case, the redemption may fail a complete termination of the transferor’s interest, thereby triggering ordinary income treatment instead of capital gain.
(a) Tax Consequences to Transferee Spouse
In some cases, a stock redemption may result in constructive dividend treatment to the transferee spouse (the spouse not giving up his/her shares). This could happen if the divorce agreement definitively calls for the transferee spouse to buy out (in whole or in part) the interest of the transferor spouse (the spouse giving up his/her shares).
If the corporation redeems the stock of the transferor spouse, it has in effect stepped into the shoes of the transferee spouse and fulfilled the terms of the divorce or separation agreement on his/her behalf.
In other words, the corporation has provided the funds to meet the personal obligation of the transferee shareholder. This is no different, from a tax perspective, then if the corporation were to pay the transferee spouse’s personal household expenses. Of course, when a corporation pays the personal expanses of a shareholder, such shareholder will realize ordinary income to the extent the corporation has earnings and profits.
Example: Redemption as a constructive dividend to transferee spouse.
Lucy and Ricky have been divorced for eight (8) months. Each of them owns 50% of the stock in the Tropical Nights Bar and Grill, Inc. The final divorce agreement calls for Ricky to purchase Lucy’s share of the Corporation within two (2) years of the divorce. Since Ricky is short on cash it is agreed that the corporation will redeem all of Lucy’s shares, leaving Ricky as the remaining 100% shareholder. Because the corporation satisfied Ricky’s unambiguous obligation to redeem Lucy’s stock on his behalf, he will recognize ordinary income in the form of a constructive dividend (assuming the corporation has sufficient earnings and profits).
Note: The above example assumes that Ricky does not meet one of the IRC Section 302 exceptions that would allow him to treat the redemption proceeds as capital gain. Lucy is not required to recognize gain or loss under the general rule of IRC Section 1041. She is deemed to simply have traded her shares in the corporation for cash from Ricky. What turns the scheme into taxable income for Ricky is the fact that the corporation has put up the cash on his behalf.
(b) Alternative Elections
In order to provide some level of certainty relating to the ultimate tax treatment of stock redemptions in closely held corporations in divorce situations, the regulations offer the opportunity to elect that a designated spouse be burdened with the tax consequences of the redemption.
Such an election may prove particularly beneficial if circumstances permit favorable tax planning due to issues such as basis, Section 1202 Qualified Small Business Stock Exclusions, offsetting capital losses in the year of redemption and the like.
(c) Making the Election
The election to tax either the transferor or transferee spouse must be affirmatively made in the couples’ divorce or separation agreement, or another valid written instrument.
- Transferor Spouse Taxed
If the redemption would result in constructive distribution treatment to the transferee spouse, the election may be made to instead place the tax burden on the transferor. The election must in affirmatively in writing state that it is the intention of both parties, that for federal income tax purposes, it is to be treated as a constructive distribution to the transferor spouse, and… such election supplants any other agreement in writing or otherwise, regarding the purchase, transfer, sale or redemption of the stock at issue.
- Transferee Spouse Taxed
If the redemption would result in constructive distribution treatment to the transferor spouse, the election may be made to instead place the tax burden on the transferee. The election must affirmatively in writing state that it is the intention of both parties that for purposes of federal income tax, said redemption is to be taxed as a constructive distribution to the transferee spouse, and such election supplants any other agreement in writing or otherwise, regarding the purchase, transfer, sale or redemption of the stock at issue.
- Deadline for Filing the Election
The effective date of the election must be no later than the due date, (including extensions) of the initial return of the spouse to whom the stock redemption is to be taxed. Likewise, the written agreement which affirmatively puts forth said election must be signed by both spouses (or former spouses) no later than the due date of the tax return (including extensions) of the spouse to whom the stock redemption is to be taxed.
Have a question? Contact David Ellis, Ellis & Ellis CPAs.
(Next Post in Series, Part 12 Will Discuss Dividing Interest in S- Corporations And Other Pass-Through Entities)
(This material is for informational purposes only and is not a substitute for tax advice from a qualified professional and the author assumes no liability whatsoever in connection with its use. No advisor/client relationship exists.)
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