Soshnick: The perils of constructive dividends in divorce cases

How do I pay? This is a very common question from business owners dividing a family-owned corporation at divorce. When buying out a spouse’s business interest, the temptation is to draw funds from the corporation to pay. However, the potential unintended tax consequences of this approach can be both significant and detrimental.

In divorce cases, most lawyers rely on § 1041 of the Internal Revenue Code for tax-free transfers of marital property incident to a divorce decree. The redemption of stock (i.e., “cashing out” one spouse from a business owned by both divorcing spouses) may lead to unintended tax consequences. A review of case history and clarifying input from taxing authorities can help to avoid issues.

The genesis of this debate is Arnes v. United States, 981 F.2d 456 (9th Cir. 1992) (Arnes I). In Arnes I, the husband and the wife jointly formed a corporation to operate a McDonald’s franchise. As a part of the parties’ divorce decree, the corporation was to purchase the wife’s 50% interest in the corporation, with the husband guaranteeing the corporation’s payments. The wife requested a tax refund from the Internal Revenue Service on the grounds that she did not need to recognize any gain on the transfer of the stock to the corporation because the transfer occurred incident to divorce. The IRS denied the wife’s request, determining that the stock transfer was not incident to divorce. Following the United States District Court for the Western District of Washington’s grant of summary judgment in favor of the wife, the U.S. Court of Appeals for the 9th Circuit affirmed, concluding that the redemption by the corporation of the wife’s shares was a constructive transfer “on behalf of” the husband and a tax-free exchange. Cf. Blatt v. Commissioner, 102 T.C. 77 (1994) (disavowing and factually distinguishing Arnes I and holding that § 1041 typically does not apply to transfers to third parties).

The U.S. Tax Court took a further opportunity to comment on Arnes I in Arnes v. Commissioner, 102 T.C. 522 (1994) (Arnes II). The husband in Arnes II challenged the subsequent imposition of a constructive dividend upon him as a result of the corporation’s redemption of the wife’s stock. The Tax Court agreed with the husband, forgoing the general rule that a constructive dividend results to a remaining shareholder when a corporation redeems stock the remaining shareholder was obligated to purchase. The Tax Court determined the husband’s obligation to purchase the wife’s shares was secondary, rather than “primary and unconditional.” Oddly enough, the result of Arnes I and Arnes II is that neither side of the transaction (the wife redeeming her shares and the husband, who received the shares via the corporate redemption) incurred tax consequences — creating what is known as a “whipsaw” effect.

Read v. Commissioner, 114 T.C. 2 (2000), dramatically impacted the Arnes I, Blatt and Arnes II analyses and added further confusion to corporate redemptions in divorce cases. The husband had the corporation redeem the wife’s stock, and the husband guaranteed the corporate note per the parties’ settlement agreement. The parties agreed that the issue before the Tax Court was whether the husband’s obligation to repurchase the wife’s corporate stock was “primary and unconditional.” The Tax Court, in a sharply divided opinion (there were four dissenting opinions involving seven of the 16 participating Tax Court judges), held the corporate redemption to be “on behalf of” the husband, a constructive dividend to the husband and not taxable to the wife. See also Craven v. U.S., 215 F.3d 1201 (11th Cir. 2000) (retracing the history of Arnes I, Blatt and Arnes II, and relying upon Read in affirming that the husband would incur tax liability via the imposition of a constructive dividend).

Read and Craven diverged from prior decisions by saddling the non-transferor spouse with tax liability for a constructive dividend. Although eliminating the “whipsaw” effect of Arnes I and Arnes II, these opinions did not lay to rest the questions about what standard should apply.

The U.S. Treasury Department finally brought clarity to the issue of constructive dividends. Treasury Regulation 1.10412, applicable to corporate redemptions pursuant to divorce instruments in effect after Jan. 12, 2003, provides for the allocation of the tax consequences of corporation redemptions. This regulation applies the general tax principles of constructive dividends and the specific principle of “primary and unconditional” obligation to corporate redemptions incident to divorce. Under Treas. Reg. 1.10412(a)(1), if a corporation redeems stock and the transfer is not treated as a constructive dividend to the non-transferor spouse, that election will be respected for federal income tax purposes and the transferor spouse will be treated as having received a taxable constructive dividend. Treas. Reg. 1.10412(a)(2) provides that if a corporation redeems stock and there is an election of a taxable constructive dividend to the non-transferor spouse, then the redeemed stock shall be deemed first transferred to the non-transferor spouse and then to be transferred by the non-transferor spouse to the corporation. Additionally, any payment received by the transferor spouse from the corporation shall be deemed to be received from the transferor spouse. Treas. Reg. 1.10412(c) permits parties in a divorce settlement agreement to elect taxation principles and allocate tax consequences differently than under Treas. Regs. 1.10412(a)(1) and (a)(2). Additionally, the election agreement can be separate from the divorce instrument and can be executed as late as the timely-filing tax return due date.

Dividing family-owned corporations at divorce is a complex endeavor — especially when funds are drawn from the corporation to redeem the stock of a transferor spouse. A firm understanding of prior precedent and current Treasury Regulations is essential to properly understanding and allocating tax consequences and avoiding unintended tax consequences. While now much clearer than prior to the 2003 Treasury Regulations, the Byzantine world of corporate redemptions and constructive dividends remains perilous for the uninformed. Be informed.•

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Drew Soshnick is a partner in the Indianapolis office of Faegre Drinker Biddle & Reath LLP. He is a past chair of the Indiana State Bar Association Family & Juvenile Law and Indianapolis Bar Association Family Law sections and a fellow of the American Academy of Matrimonial Lawyers and International Academy of Family Lawyers. Opinions expressed are those of the author.