It is very common for closely held corporations for both H and W to be stockholders and officers of the corporation. In situations where it is necessary to redeem either H or W’s stock as part of a martial settlement, a determination is necessary as to whether or not a stock buy-back is on behalf of the spouse remaining with the business (acquiring spouse) or not. Where the acquiring spouse benefits because of the redemption of the redeemed spouse, the determination above generally turns on whether the acquiring spouse is being relieved of a primary and unconditional obligation to purchase his ex-spouse’s stock. Where a closely held corporation’s stock redemption is deemed to relieve the acquiring shareholder of such an obligation, the redemption may result in the imposition of a constructive dividend to them. An ordinary stock redemption is a transfer of stock to the corporation in exchange for cash. In a deemed dividend scenario, under Reg. § 1.1041-2(a), § 1.1041-2(b), the transaction is viewed as the redeeming spouse first transferring stock to the acquiring spouse in a tax-free § 1041 exchange. Then the acquiring spouse is deemed to have transferred the redeeming spouse’s stock to the corporation in exchange for cash. The deemed cash fictionally obtained by the acquiring spouse is treated as if were transferred to the redeeming spouse tax-free via § 1041.
Accordingly, the final § 1041 related to stock redemptions come in two major flavors, redemptions of stock 1. Resulting, or 2. Not resulting, in a constructive distribution to the acquiring spouse. Under the default requirements dictated in Reg. § 1.1041-2(a)(1), that are appropriate where the acquiring spouse is not benefiting by being relieved of a primary obligation to the exiting spouse, where a corporation redeems the stock of a spouse or former spouse, the exiting spouse’s receipt of property in respect of such redeemed stock is not treated under applicable tax law as resulting in a constructive distribution to the other spouse or former spouse (the “acquiring spouse”). In this scenario, stock redemption treatment is respected and the exiting spouse is treated as having received a distribution redemption of stock and per Reg. § 1.1041-2(b)(1) the ordinary § 1041 non-recognition rules do not apply.
Where the acquiring spouse had an unconditional obligation to purchase the stock from the exiting spouse, Reg. § 1.1041-2(a)(2) dictates that the exiting spouse’s receipt of redemption proceeds from the corporation is treated as a constructive distribution to the acquiring spouse. The tax consequences of to the acquiring spouse related to the redemption proceeds received is determined under § 302.
Reg. § 1.1041-2(c) enables the parties to control which spouse will bear the tax consequences of the redemption via a written agreement by agreeing in advance which spouse will be treated for tax purposes as receiving the redemption distribution. The agreement must be executed before the date on which the agreed upon taxable spouse files his/her timely filed federal income tax return (including extensions).
To better understand the application of these rules, consider a scenario where a married couple’s corporation has 300 shares outstanding. At divorce H and W each own 150 shares. Under a martial property agreement H agrees to purchase W’s shares, and W agrees to sell her shares to H, in exchange for $100,000. The corporation redeems W’s shares for $100,000. Under local law, the agreement creates a primary obligation for H to purchase W’s stock, and thus the redemption results in a constructive distribution to H. W is treated as transferring her stock to H under § 1041 in a nontaxable transaction. H is deemed to have transferred W’s stock to the corporation in exchange for $100,000 in a taxable exchange that § 1041 does not apply to the taxability of which is determined under § 302.
While a complete discussion of the tax ramifications of stock redemptions is beyond the scope of this Q&A, where a stock redemption occurs, §302(b) generally classifies it as either a stock sale taxable under §1001, or a dividend distribution where a corporation has sufficient earnings and profits available. The determination of which of these two possible tax consequences result to the redeeming shareholder turn on whether the relative ownership percentage of the redeemed stockholder remains the same or significantly declines following the redemption. Where the relative ownership percentage remains the same, a deemed dividend results where it can be paid out of earnings and profits. Where a stock redemption significantly decreases the relative ownership percentage or the redeeming shareholder, the stock redemption will be treated as a sale of stock, resulting in either a capital gain or loss to the redeemed shareholder, just as if the stock was sold to a disinterested third party.