New Regulation Helps Plan Stock Redemptions

The U.S. Treasury Department has promulgated a final tax regulation intended to remove the uncertainty surrounding the tax treatment of stock redemptions that resulted from recent case law. Treasury Decision 9035, 68 Fed. Reg. 1534 (Jan. 10). The final regulation adopts and expands upon the proposed regulations that were issued by the Department in August 2001.

To understand the significance of the final regulation, it is helpful to review the transaction pattern that these regulations address. In our example, Spouse B (the business spouse) operates a business that is owned by a corporation (X Corp.), all the stock of which is owned by B or by B and N (the non-business spouse) as marital property. Pursuant to the marital settlement agreement between B and N, B will end up owning all the stock of the corporation, through which B will continue to operate the business, and N will be paid his or her share in cash, usually through deferred payments. The parties anticipate that the income used to make the deferred payments will be generated by the business, and that payments to N for N's marital share will be made ' directly or indirectly ' by X Corp. The income used for this purpose is taxable to either or both spouses. How much and to whom will depend on the structure of the settlement worked out by the parties.

Prior to the proposed regulations, the tax effects were uncertain, and even careful planning might not have prevented unexpected and harmful tax consequences. The proposed regulations, however, contained a 'special rule' that endorsed a more certain tax result if the parties chose to treat B as the taxable party. Furthermore, according to the proposed regulations, the tax treatment of payments to N would have been determined for both spouses under a single test. The final regulation takes this one step further by permitting the parties to choose the tax effect that gives them the most
cost-effective solution, provided that both parties agree in writing to report
the transaction consistently for tax purposes.

How Does the New Regulation Work?

Let us see how this works: Suppose that the parties agree that the stock of X Corp. has a value of $1 million, that husband B will own or control all the stock and that wife N will be paid $500,000 in cash, plus interest, in equal installments over the ensuing 5-year period. The parties also agree that X will make the payments directly to N. The optimal tax result depends on X's tax status. Let's assume that X has been profitable and is a regular C corporation with accumulated earnings and profits. Cash distributions to X's shareholders will be taxed as dividends, unless the distributions meet the definition of a redemption as provided in IRC ' 302. A distribution in redemption of stock is taxed as a sale of the stock, subject to capital gains. N owned 50 % of X stock. Under the redemption agreement among B, N and X, as provided in the marital settlement agreement executed by B and N on March 1, 2003, X Corp. will pay N $100,000 on June 1 of this year (2003) and in each of the next 4 years. N's tax basis for her stock is $10,000. The marital settlement agreement specifically provides that B and N intend that the payments by X to N will be taxed as a redemption, and that N will file her tax return, reporting the payments by X as having been received by her in exchange for her stock. The settlement agreement also states that it 'supersedes all other instruments or agreements' relating to the marital settlement of the parties. Reg. ” 1.1041-2(c)(1), -2(d) Example 2, provide that, under these circumstances, the payments to N will be taxed as the agreement states. N, therefore, would report capital gain from the sale of stock on the installment basis, that is, a gain of $98,000 for each payment (plus interest).

A 'Safe Harbor'

As long as the controlling agreement contains the provisions outlined above, the regulation prescribes the tax result. A provision like this one in a regulation creates what is known as a 'safe harbor,' in that compliance with the requirements spelled out therein assures the tax treatment of the transaction. How closely the parties should adhere to the stated requirements, including the provision that the governing agreement 'supersedes' all other agreements, is not clear. But if this is the desired result, why would the parties make it a close call?

Note that the safe harbor may not be invoked retrospectively; the agreements must be executed or be effective before the taxable party (in this case, N) files her (or his) tax return for the calendar year in which the redemption has occurred, but no later than the due date for that return. The date in this case would be April 15, 2004.If the parties do not meet the conditions for the safe harbor, the final regulation specifies that the tax effect of the redemption will be determined under 'applicable tax law.' Reg. ' 1.1041-2(a). It also amends the temporary regulations under ' 1041 to provide that the 'on behalf of' standard, which had been relied on in recent judicial decisions to hold the nonbusiness spouse not taxable on the payments to her in redemption of her stock, will not apply when 'a corporation redeems stock owned by a spouse' in a marital settlement. Temp. Reg. ' 1.1041-1T(c) A'9. The Tax Court had indicated in Read v. Commissioner , 114 T.C. 14 (2000), aff'd sub nom Mulberry Motor Parts Inc. v. Commissioner, 88 AFTR2d 6182 (11th Cir. 2001), that it would follow this regulatory guidance.

'Applicable tax law' is regulatory language referring to the corporate tax law on redemptions under which a formal redemption will be respected, and the transferor spouse taxed on the sale of his or her stock, unless the non-transferor spouse has a 'primary and unconditional obligation' to purchase the transferor spouse's stock at the time the redemption occurs. So, in the example discussed here, unless B had agreed to purchase N's stock, and X Corp. assumed or otherwise paid B's obligation to N, the redemption will result in tax to N. This would be the case even though B will have guaranteed payment by X Corp. See Rev. Rul. 69-608, 1969'2 C.B. 42, situation 5; Reg. ' 1.1041-2(d) Example 3.

Suppose that N did not own any X Corp. stock, although the stock was marital property and, under local law, N could expect to receive value equal to 50% of the value of X Corp. The regulation no longer requires that both spouses own stock either immediately before or immediately after the redemption. So, N could be assigned a portion of the stock of X Corp. equal in value to her marital property interest in the stock of X Corp., which would then immediately be redeemed by X Corp. under the parties' marital settlement agreement. The agreement should impose the conditions described above to qualify for the safe harbor. Effectively, N would never have owned any X Corp. stock, but she would still be treated as having sold the stock nominally allocated to her in a taxable redemption. This planning technique revives the plan described in an early technical advice memorandum (TAM 9046004), as long as conditions of the safe harbor have been met. 

Note also that the parties may also agree to treat the payment by X Corp. to N as if it were a distribution by X Corp. to B, the business spouse, followed by a payment by B to N in exchange for N's stock. In this case, the corporate distribution would be taxable to B, and B's payment to N would not be taxable to her under ' 1041. Reg. ” 1.1041-2(c)(2), -2(d) Example 4. The parties may find that this form results in a more favorable tax result if Corp. X did not have any earnings and profits, or more likely, had elected to be taxed under subchapter S. In the latter case, B would be taxable on corporate income allocated to him under subchapter S. Treating the payment to N as a distribution to B would avoid incurring an additional tax on the redemption of N's stock.

The regulation solves many of the structural problems in planning for the buy-out of a non-business spouse using corporate funds. This may be true even if the safe harbors provided in the regulation are not used. Because the tax consequences are significant in these transactions, however, the invitation extended by the regulation to negotiating parties to specify the tax consequences of their plan and thus to avoid uncertain tax results should be accepted.

NOTE: The author purposely refers to the proposed regulations (plural) and the final regulation (singular).

The U.S. Treasury Department has promulgated a final tax regulation intended to remove the uncertainty surrounding the tax treatment of stock redemptions that resulted from recent case law. Treasury Decision 9035, 68 Fed. Reg. 1534 (Jan. 10). The final regulation adopts and expands upon the proposed regulations that were issued by the Department in August 2001.

To understand the significance of the final regulation, it is helpful to review the transaction pattern that these regulations address. In our example, Spouse B (the business spouse) operates a business that is owned by a corporation (X Corp.), all the stock of which is owned by B or by B and N (the non-business spouse) as marital property. Pursuant to the marital settlement agreement between B and N, B will end up owning all the stock of the corporation, through which B will continue to operate the business, and N will be paid his or her share in cash, usually through deferred payments. The parties anticipate that the income used to make the deferred payments will be generated by the business, and that payments to N for N's marital share will be made ' directly or indirectly ' by X Corp. The income used for this purpose is taxable to either or both spouses. How much and to whom will depend on the structure of the settlement worked out by the parties.

Prior to the proposed regulations, the tax effects were uncertain, and even careful planning might not have prevented unexpected and harmful tax consequences. The proposed regulations, however, contained a 'special rule' that endorsed a more certain tax result if the parties chose to treat B as the taxable party. Furthermore, according to the proposed regulations, the tax treatment of payments to N would have been determined for both spouses under a single test. The final regulation takes this one step further by permitting the parties to choose the tax effect that gives them the most
cost-effective solution, provided that both parties agree in writing to report
the transaction consistently for tax purposes.

How Does the New Regulation Work?

Let us see how this works: Suppose that the parties agree that the stock of X Corp. has a value of $1 million, that husband B will own or control all the stock and that wife N will be paid $500,000 in cash, plus interest, in equal installments over the ensuing 5-year period. The parties also agree that X will make the payments directly to N. The optimal tax result depends on X's tax status. Let's assume that X has been profitable and is a regular C corporation with accumulated earnings and profits. Cash distributions to X's shareholders will be taxed as dividends, unless the distributions meet the definition of a redemption as provided in IRC ' 302. A distribution in redemption of stock is taxed as a sale of the stock, subject to capital gains. N owned 50 % of X stock. Under the redemption agreement among B, N and X, as provided in the marital settlement agreement executed by B and N on March 1, 2003, X Corp. will pay N $100,000 on June 1 of this year (2003) and in each of the next 4 years. N's tax basis for her stock is $10,000. The marital settlement agreement specifically provides that B and N intend that the payments by X to N will be taxed as a redemption, and that N will file her tax return, reporting the payments by X as having been received by her in exchange for her stock. The settlement agreement also states that it 'supersedes all other instruments or agreements' relating to the marital settlement of the parties. Reg. ” 1.1041-2(c)(1), -2(d) Example 2, provide that, under these circumstances, the payments to N will be taxed as the agreement states. N, therefore, would report capital gain from the sale of stock on the installment basis, that is, a gain of $98,000 for each payment (plus interest).

A 'Safe Harbor'

As long as the controlling agreement contains the provisions outlined above, the regulation prescribes the tax result. A provision like this one in a regulation creates what is known as a 'safe harbor,' in that compliance with the requirements spelled out therein assures the tax treatment of the transaction. How closely the parties should adhere to the stated requirements, including the provision that the governing agreement 'supersedes' all other agreements, is not clear. But if this is the desired result, why would the parties make it a close call?

Note that the safe harbor may not be invoked retrospectively; the agreements must be executed or be effective before the taxable party (in this case, N) files her (or his) tax return for the calendar year in which the redemption has occurred, but no later than the due date for that return. The date in this case would be April 15, 2004.If the parties do not meet the conditions for the safe harbor, the final regulation specifies that the tax effect of the redemption will be determined under 'applicable tax law.' Reg. ' 1.1041-2(a). It also amends the temporary regulations under ' 1041 to provide that the 'on behalf of' standard, which had been relied on in recent judicial decisions to hold the nonbusiness spouse not taxable on the payments to her in redemption of her stock, will not apply when 'a corporation redeems stock owned by a spouse' in a marital settlement. Temp. Reg. ' 1.1041-1T(c) A'9. The Tax Court had indicated in Read v. Commissioner , 114 T.C. 14 (2000), aff'd sub nom Mulberry Motor Parts Inc. v. Commissioner , 88 AFTR2d 6182 (11th Cir. 2001), that it would follow this regulatory guidance.

'Applicable tax law' is regulatory language referring to the corporate tax law on redemptions under which a formal redemption will be respected, and the transferor spouse taxed on the sale of his or her stock, unless the non-transferor spouse has a 'primary and unconditional obligation' to purchase the transferor spouse's stock at the time the redemption occurs. So, in the example discussed here, unless B had agreed to purchase N's stock, and X Corp. assumed or otherwise paid B's obligation to N, the redemption will result in tax to N. This would be the case even though B will have guaranteed payment by X Corp. See Rev. Rul. 69-608, 1969'2 C.B. 42, situation 5; Reg. ' 1.1041-2(d) Example 3.

Suppose that N did not own any X Corp. stock, although the stock was marital property and, under local law, N could expect to receive value equal to 50% of the value of X Corp. The regulation no longer requires that both spouses own stock either immediately before or immediately after the redemption. So, N could be assigned a portion of the stock of X Corp. equal in value to her marital property interest in the stock of X Corp., which would then immediately be redeemed by X Corp. under the parties' marital settlement agreement. The agreement should impose the conditions described above to qualify for the safe harbor. Effectively, N would never have owned any X Corp. stock, but she would still be treated as having sold the stock nominally allocated to her in a taxable redemption. This planning technique revives the plan described in an early technical advice memorandum (TAM 9046004), as long as conditions of the safe harbor have been met. 

Note also that the parties may also agree to treat the payment by X Corp. to N as if it were a distribution by X Corp. to B, the business spouse, followed by a payment by B to N in exchange for N's stock. In this case, the corporate distribution would be taxable to B, and B's payment to N would not be taxable to her under ' 1041. Reg. ” 1.1041-2(c)(2), -2(d) Example 4. The parties may find that this form results in a more favorable tax result if Corp. X did not have any earnings and profits, or more likely, had elected to be taxed under subchapter S. In the latter case, B would be taxable on corporate income allocated to him under subchapter S. Treating the payment to N as a distribution to B would avoid incurring an additional tax on the redemption of N's stock.

The regulation solves many of the structural problems in planning for the buy-out of a non-business spouse using corporate funds. This may be true even if the safe harbors provided in the regulation are not used. Because the tax consequences are significant in these transactions, however, the invitation extended by the regulation to negotiating parties to specify the tax consequences of their plan and thus to avoid uncertain tax results should be accepted.

NOTE: The author purposely refers to the proposed regulations (plural) and the final regulation (singular).