Redemption of Stock in Closely-Held Business Incident to a Divorce

A closely-held business often represents a couple’s largest marital asset and a sizeable portion of their net worth. Such an asset is generally very illiquid, which can necessitate the payoff of one of the spouses out of the earnings of the business. Until recently, uncertainty existed as to the proper tax treatment of a redemption of one spouse’s stock by a corporation pursuant to a divorce decree. The Ninth Circuit Court of Appeals has ruled that the proceeds from the redemption of a spouse’s stock can be tax-free to the recipient under Internal Revenue Code Section 1041.

Internal Revenue Code Section 1041 provides (among other things) that no gain or loss is recognized on transfers of any type of property between spouses, if incident to a divorce. In Arnes, 981 F.2d 456 (CA-9, 1992), aff’g DC Wash., 4/11/91, the appellate court held that Section 1041 applied to a redemption, incident to divorce, of one spouse’s stock in a jointly-owned corporation. Accordingly, the spouse whose stock was redeemed did not recognize a gain on the redemption. The Ninth Circuit held that the redemption was a constructive distribution from the corporation to the other (i.e., non-transferring) spouse. The court did not specifically address the tax treatment of the non-transferee spouse. However, the holding may result in the distribution being taxed as a dividend or capital gain to the non-transferee spouse. This could have the effect of accelerating tax on the non-transferee.

In Arnes, Husband and Wife jointly owned the stock of Moriah Valley Enterprises, Inc., which owned a McDonald’s franchise. The franchise agreement stipulated that only the operator could be the sole shareholder. It indicated that either spouse could succeed to sole ownership.

In compliance with the franchise agreement, H and W structured their divorce property agreement to provide that Moriah would redeem W’s stock, leaving H as the sole remaining shareholder. First, the jointly owned stock was surrendered to Moriah and cancelled, and equivalent shares of new stock were simultaneously issued 50% each to H and W in their separate names. W then transferred her new, separately owned shares to Moriah. The $450,000 redemption price was paid as follows: (1) Moriah forgave a note of approximately $110,000 owed to it by W, (2) $50,000 was paid in cash, and (3) the $290,000 balance would be paid to W in ten annual installments. In addition, H personally guaranteed the installment payments.


W’s basis in her stock was nominal ($2,500), and virtually all of the redemption proceeds were taxable. W reported the resulting gain on the installment method ¾ $177,000 in the year of redemption. Subsequently, W filed a claim for a refund on the theory that the redemption was shielded from tax by Section 1041 as a transfer incident to divorce. The transfer, although in form between Moriah and W, was in substance made “on behalf of” H and thus was a qualifying transfer between former spouses.

The court found that the stock redemption from Moriah Enterprises was required by a divorce instrument to which both plaintiff and her ex-husband were parties. The Court also held that H benefitted by the transaction because it was part of the marital property settlement with W. The Court observed that H had limited future marital property claims that W might have brought against him by agreeing to Moriah’s redemption of W’s stock for $450,000.

Accordingly, the Court held that the corporation made distributions to H who purchased W’s stock in a transaction which qualified for non-recognition of income pursuant to §1041.

Stock in a closely-held corporation can be redeemed tax-free to a spouse incident to a divorce. Although not specifically addressed, the spouse who retains the interest in the company may incur a substantial tax since the proceeds paid to the redeemed spouse may be treated as a dividend or capital gain to the non-transferring spouse. In structuring such a redemption, the tax cost to the remaining shareholder spouse should be considered in a property division.