TIPS: A Divorce Court Can Alter Ownership of Stock for Tax Purposes

In the recent United States Tax Court case of Friscone v. Commissioner, the Court held that Mrs. Friscone was liable for 55% of the capital gain tax due on the sale of stock that was registered entirely in the name of her ex-husband, Mr. Friscone. In substance, the Court held that a divorce decree awarded 55% of Mr. Friscone’s ownership in the stock of a closely-held business to Mrs. Friscone, even though the decree did not order title of the stock to be changed.

As a general rule, no taxable gain or loss is recognized on a transfer of property to a former spouse if the transfer is incident to the divorce. The tax basis to the recipient in the property is the adjusted basis of the transferor. If the property is sold subsequent to the divorce, the recipient will be subject to tax on the excess of the sales proceeds over the basis in the property.

The terms of the divorce decree between the Friscones specified that Mr. and Mrs. Friscone would receive 45% and 55%, respectively, of all proceeds derived from the future redemption of stock titled to Mr. Friscone under the provisions of a buy-sell agreement between Mr. Friscone and his brother. It also provided that each spouse would be liable and responsible for payment of any income taxes due on the sale in proportion to the percentage of the proceeds received. Because the redemption price was unknown until after the decree was final, the allocation of the marital asset between the parties was expressed as a percentage of the proceeds from the future redemption rather than as a transfer of the shares.

Mr. Friscone included 45% of the principal received on a long-term note (issued after the decree to redeem his stock) in his computation of capital gain from sale of the stock. The IRS contended that Mr. Friscone was the owner of all of the stock and, therefore, responsible for the entire capital gain on the redemption.

The tax court ruled that, although the decree did not transfer title to 55% of the shares directly to Mrs. Friscone, it plainly provided for a transfer to her of beneficial ownership of the stock. Mrs. Friscone received both the benefits – in her entitlement to 55% of the sale proceeds and the burden – in her obligation to pay tax on such proceeds of stock ownership. The substance of the transaction was that ownership of 55% of the stock was transferred to Mrs. Friscone. Accordingly, Mr. Friscone was only responsible for the tax on 45% of the proceeds while Mrs. Friscone would be liable for tax on the remaining 55%.

This case is highly unusual in that the tax court gave substantial weight to the divorce decree’s provision that each spouse would be liable for the payment of taxes on their respective shares of the sales proceeds. Neither the parties to a divorce nor a state court have any authority to determine the tax consequences of a particular transaction. The tax court rarely relies on such language; rather, it looks to the underlying economics of the transaction. In this case, the court concluded that the agreement as to federal taxes can throw strong light on what was intended by the parties and the decree with respect to the division of marital property.