Stocks

May 2022 : Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

General

Use of a stock redemption can be a “tax-smart” way to structure a divorce-related buy-out of the non-owner spouse’s marital interest in the stock. To do so, the owner spouse transfers stock to the non-owner, which is then immediately redeemed by the corporation. The difference between what the non-owner receives and the owner’s carryover tax basis in the stock is taxed favorably as a capital gain or loss. Stock redemptions can be particularly suitable in the following circumstances:

  • The company has excess liquidity.
  • The stock has a relatively high tax basis, as is not uncommon if the company is an S corporation.
  • The spouse who will not end up with the business individually owns stock.
  • The owner spouse may not draw more compensation because of “reasonable compensation” tax constraints or legal restrictions.
  • The dilution, if any, caused by the redemption will not be problematic for the owner spouse.

Other than in a divorce context, this approach would be treated by the IRS as a step transaction—the non-owner spouse’s stock ownership would be considered merely transitory and lacking independent legal significance, which would result in a constructive dividend to the owner spouse. However, this technique is available in a divorce setting because of an expansive IRS interpretation of IRC 1041 incorporated in regulations issued by the IRS. Treas Reg 1.1041-2.

Regulations and Illustrations

The following example explains the essential provisions of the regulations by way of illustration:

  • H and W each own 50 percent of ABC Company. They agree that H will continue to own and operate the company while W will tender her stock for redemption.
  • H has at no time assumed a “primary and unconditional obligation” to acquire W’s stock.
  • He has agreed, however, (1) to cooperate in his role as a corporate officer and shareholder so that the company implements the planned redemption and (2) to guarantee the company’s payment of the redemption proceeds.
  • Because H does not have a “primary and unconditional obligation” to acquire W’s stock before ABC redeems it, the redemption is not a constructive distribution to him.
  • Thus, W will be taxed at the long-term capital gain rate on the difference between the redemption proceeds she receives and her tax basis in the stock.

In the above illustration, both spouses own stock in the company. It is more common, of course, for the interest in the company to be owned by one of the spouses. The regulations do not directly address the situation involving (1) one spouse—say, H—owning 100 percent of the stock and (2) a divorce settlement providing for the following transactions:

  • H’s transfer of 50 percent of his stock to W.
  • W’s tender of the stock to the company in redemption of her newly acquired stock interest.

Though not specifically addressed in the regulations, it appears that the tax treatment for this fact pattern would be the same that applies when both spouses initially own stock, as follows:

  • The form of the transactions—(1) the nontaxable transfer under IRC 1041 of stock from, in our example, H to W, followed by (2) the redemption of W’s stock taxable at capital gains rates—will be honored, provided H does not have a primary and unconditional obligation to pay W for her interest in the stock.
  • Alternatively, if there is such a primary and unconditional obligation, the redemption distribution would be deemed constructively received by H and taxed to him as a dividend.

To illustrate, assume that H is the sole owner of the company and that, as part of his divorce settlement with W, they agree he will transfer a 50 percent interest to her, which she will tender to ABC in exchange for redemption proceeds. Though not expressly covered in the regulations, this fact scenario would appear subject to the following tax treatment:

  • Provided H does not have a preexisting primary and unconditional obligation to pay W for her marital interest in the stock, the form of the two-step transaction will be honored for tax purposes.
  • In effect, the transfer of the 50 percent interest from H to W as part of the divorce settlement will be tax free under IRC 1041, and the redemption distribution is not a taxable dividend to H.

A principal reason to assume the above tax treatment will apply when one spouse owns all the stock is the following statement in the background section of the regulations:

“By enacting the carryover basis rules in section 1041(b), Congress has, in essence, provided spouses with a mechanism for determining between themselves which one will pay tax upon the disposition of property outside the marital unit. For example, assume Spouse A owns appreciated property that he or she wishes to sell to a third party. The spouses may agree that Spouse A will sell the property to the third party and recognize the gain. Any subsequent transfer from Spouse A to Spouse B of the sales proceeds will be nontaxable under section 1041. In the alternative, the spouses may agree that Spouse A will first transfer the property to Spouse B. This transfer is nontaxable under section 1041, with Spouse B taking a carryover basis in the transferred property. Spouse B will then recognize the gain or loss on the sale of the property to the third party because a sale to a third party is not covered by section 1041. In this latter scenario, the tax consequences of the sale are shifted to Spouse B.”

 

66 Fed Reg 40,659 (2001).

Viability of Redemptions in Divorce

Certainty of Tax Treatment. Provided there is no such primary and unconditional obligation, the parties may structure a divorce-related redemption with certainty of the tax treatment. Nonetheless, because things change, including the minds of divorcing parties, a savings clause appears advisable.

Guarantee Allowed. With the IRS’s clear statement that a primary and unconditional obligation does not include a guarantee of another party’s performance, there should be no concern to provide that the remaining shareholder guarantee the corporation’s performance under the redemption agreement.

This is highly significant because, without a guarantee, it is conceivable, particularly where the remaining spouse would transfer a minority interest to the other spouse, that the remaining spouse would use his or her influence to obstruct the redemption, leaving the other spouse with a minority interest in a closely held company.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations”
View / Download May 2022 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “May 2022 : Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations”

Mar 2022 : ROBACH VS. ROBACH

Posted by Joseph W. Cunningham, JD, CPA

View / Download March 2022 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

This Month’s Column: Court of Appeals distinguishes McNamara vs. Horner in ruling that allocation of appreciation between a pre-marital employee benefit account balance and contributions during marriage is acceptable where information to do so is available. Robach vs. Robach, Mich App Docket No. 352077 (12/16/21) – Unpublished.

Facts

  • H & W were married in 2011 and divorced in 2019.
  • H had various stock options, stock grants, and additional shares of stock in the company at which he worked.
  • Most of these stock interests were acquired before the marriage though some did not vest until after.
  • H claimed that his stock options and grants were not received “on account of service credit accrued during marriage” (emphasis added) and, accordingly, were not part of the marital estate under MCL 552.181(1).
  • Further, he hired an expert to allocate the appreciation on his retirement account between growth attributable to (1) their pre-marital balances and (2) contributions during marriage.
  • The expert was able to do so because H had Fidelity account statements for the entire period of the marriage.
  • The trial court agreed with H and his expert, and, correspondingly, awarded his company stock and appreciation allocated to his pre-marital retirement account balances to him as his separate property.
  • W appealed.

Court of Appeals Decision

  • W claimed that because the expert relied on statements provided by H the expert’s analysis was unreliable.
  • She further claimed that, pursuant to the published case of McNamara vs Horner, 249 Mich App 177 (2002), contributions during marriage were commingled with premarital funds in the retirement account and, hence, could not be separately identified for the allocation.
  • The Court ruled, essentially, that it had not been demonstrated that the account statements used by the expert were unreliable.
  • It also upheld the expert’s allocation of appreciation during marriage because the expert was able to specify preand post-marital funds in the Fidelity statements.

Comments on the Case

  • As readers of this column may recall, the decision in McNamara vs. Horner has been criticized as arbitrarily narrow with its strict application often resulting in gross unfairness.
  • Where sufficient documentation is available – as in the Robach case – it is quite possible to allocate appreciation during marriage between a pre-marital retirement account balance and (2) contributions during marriage.
  • Having all the statements for the subject period is certainly ideal. But, if a few are missing, interpolating between statements is sometimes possible.
  • While the published McNamara vs. Horner case remains the law in Michigan, the unpublished Robach decision indicates that a common-sense result may be attained where sufficient information is available.
  • As a matter of full disclosure, the author hereof was the expert in Robach.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “ROBACH VS. ROBACH”
View / Download March 2022 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “Mar 2022 : ROBACH VS. ROBACH”

Oct 2020 : Court of Appeals Rules on JOD Provision for the Division of Restricted Stock Redemption Proceeds—Blight v Blight, Mich App No. 349034 (6/25/20) (Unpublished)

Posted by Joseph W. Cunningham, JD, CPA

View / Download October 2020 Article – PDF File

Tax Trends and Developments Column – Michigan Family Law Journal

Facts

  • H and W agreed to a divorce settlement at mediation which was then recorded and later incorporated into a Judgment of Divorce (JOD) entered in 2015.
  • H owned 102,857 shares of restricted stock which the JOD awarded to him except that –

    if the restricted stock were redeemed pursuant to a specific Company agreement – then W would receive 50% of the portion attributable to the years of marriage during which H owned the stock.

  • In pertinent part, the JOD provision stated that the marital portion of potential redemption proceeds would be:

    “proportional to the number of years Plaintiff owned said stock while the parties were married and the total number of years Plaintiff owned said stock prior to the date of redemption.”

  • The restricted stock was redeemed about a year after the divorce.
  • H applied the coverture fraction in determining the marital portion of which W was to receive 50%.
  • W filed a motion claiming that, according to the JOD, she was entitled to 50% of the total redemption proceeds.
  • The trial court, after (1) conducting a hearing on the issue, (2) reading briefs of both parties, and (3) reviewing a relevant portion of the transcript of the settlement recording, decided that (1) the JOD provision regarding the restricted stock was ambiguous and (2) W was entitled to 50% of the total redemption proceeds.

H appealed.

Court of Appeals Decision

  • The Court of Appeals (Court) found that the JOD provision regarding the restricted stock was not ambiguous but rather clearly set forth a formula for determining the portion of eventual redemption proceeds to be deemed marital.
  • The Court noted that the latter half of the JOD provision designates that W’s share of the proceeds to be “proportional” and would need to be ignored by the trial court to award W 50% of the total redemption proceeds.

Comments on the Case

  • Use an Example – For provisions regarding the future divisions of various forms of executive compensation, it is often advisable to include an example using hypothetical amounts. This significantly reduces the chance of differing interpretations down the road.
  • Provide for Tax Consequences – It is noteworthy that the JOD restricted stock provision in Blight was silent on tax consequences. Restricted stock is generally taxable on the expiration of the last of restrictions to which the stock is subject. It is advisable to provide for tax consequences when dividing various forms of compensation in a divorce settlement.
  • Skelly Does Not Prevent Parties’ Agreement – In the Court of Appeals published Skelly v. Skelly decision (286 Mich. App. 578 (2009)), the Court ruled that an executive benefit awarded during marriage but subject to a vesting event occurring after divorce was not marital property.

It has previously been expressed in this column that:

  • The Court’s decision in Skelly is over broad and arbitrary, and could result in inequitable divisions of property in fact attributable to years of the marriage.
  • However, parties, in reaching a divorce settlement, are free to disregard Skelly in reaching an equitable division of property. Whether done knowingly or not, that is what the Blights did in dividing H’s restricted stock which they knew would not vest until after the divorce.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Court of Appeals Rules on JOD Provision for the Division of Restricted Stock Redemption Proceeds—Blight v Blight, Mich App No. 349034 (6/25/20) (Unpublished)”
View / Download October 2020 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “Oct 2020 : Court of Appeals Rules on JOD Provision for the Division of Restricted Stock Redemption Proceeds—Blight v Blight, Mich App No. 349034 (6/25/20) (Unpublished)”