790 / What are the tax results of corporate stock redemptions where a spouse or former spouse is treated as receiving or constructively receiving the proceeds, or where the redemption is incident to divorce?

Stock redemptions. If a corporation redeems stock owned by a taxpayer, and that taxpayer’s receipt of property with respect to the stock is treated, under applicable tax law, as a constructive distribution to his or her spouse (i.e., where the non-redeeming shareholder has a primary and unconditional obligation to purchase the redeeming shareholder’s stock), the final regulations treat the redemption as (1) a transfer of the stock by the taxpayer to the spouse, followed by (2) a transfer of the stock by the spouse to the redeeming corporation.¹ Nonrecognition treatment would apply to the deemed transfer of stock by the taxpayer to his or her spouse (assuming IRC Section 1041 requirements are otherwise satisfied), so that no gain or loss would be included on account of that portion of the transaction. However, nonrecognition treatment would not apply to the deemed transfer of stock from the spouse to the redeeming corporation.²

The receipt of any property by the taxpayer from the redeeming corporation with respect to the stock would be recharacterized as (1) a transfer of such property to the spouse by the redeeming corporation in exchange for the stock, in a transaction to which nonrecognition treatment would not apply, followed by (2) a transfer by the spouse to the taxpayer in a transaction, to which nonrecognition treatment would apply (assuming the requirements of IRC Section 1041 are otherwise satisfied).³ For details of the rules applicable to constructive transfers between spouses and former spouses, see Treasury Regulation Section 1.1041-2.⁴

A divided Tax Court held that a stock redemption incident to divorce qualified for nonrecognition treatment where the ex-wife was considered to have transferred property to a third party on behalf of her ex-husband. The court further held that the primary and unconditional obligation standard is not an appropriate standard to apply in a case involving a corporate redemption in a divorce setting.⁵ See also Craven v. U.S.⁶ (stock redemption incident to divorce qualified for nonrecognition treatment). But see FSA 200222008 (where the Service ruled that based on the language in the settlement agreement, the redemption should be treated as a complete termination of the wife’s interest; thus, the wife was taxable on the stock redemption. The Service reasoned that the intent of IRC Section 1041 and the parties involved was best served by respecting the form of the redemption transaction). For the tax treatment of stock options transferred incident to a divorce, generally, see FSA 200005006.

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1. Treas. Reg. § 1.1041-2(a)(2).

2. Treas. Reg. § 1.1041-2(b)(2).