Opinion ID: 74618
Heading Depth: 4
Heading Rank: 2

Heading: a former spouse, but only if the transfer is

Text: incident to the divorce. 26 U.S.C. §1041. Thus, the provision is not limited to transfers in divorce, but also applies to conveyances between spouses who are not contemplating divorce. Under §1041(b), property received in a transfer subject to §1041 is excluded from the recipient’s gross income as if it were a gift, even if the transfer is a cash sale or is made without donative intent as part of a contested divorce. The recipient takes a “carryover” basis for the property equal to the transferor’s basis, even if it exceeds the value of the property at the time of the transfer. Shortly after the enactment of §1041, the Treasury department published a temporary regulation, which is still in effect, to provide guidance to taxpayers. The Ninth Question of 26 C.F.R. §1.1041-1T, which is relevant to the present appeal, states in pertinent part: Q-9 May transfers of property to third parties on behalf of a spouse (or former spouse) qualify under §1041? 11 A-9 Yes. There are three situations in which a transfer of property to a third party on behalf of a spouse (or former spouse) will qualify under §1041. . . . The first situation is where the transfer to the third party is required by a divorce or separation instrument. The second situation is where the transfer to the third party is pursuant to the written request of the other spouse (or former spouse). The third situation is where the transferor receives from the other spouse (or former spouse) a written consent or ratification of the transfer to the third party. . . . In the three situations described above, the transfer of property will be treated as made directly to the nontransferring spouse (or former spouse) and the nontransferring spouse will be treated as immediately transferring the property to the third party. The deemed transfer from the nontransferring spouse (or former spouse) to the third party is not a transaction that qualifies for nonrecognition of gain under §1041. An example of such an occurrence is where the husband owes a debt to a bank, and the wife, as part of the divorce settlement, transfers appreciated stock of her own directly to the bank in discharge of husband’s debt. Such a transfer would fall within the first “situation” described in the regulation, i.e., the transfer would be one “required by a divorce or separation instrument” and would be treated as made by the wife “on behalf of” the husband. Therefore, the stock would be deemed to go first from wife to husband in a nonrecognition transaction covered by §1041, with husband acquiring a carryover basis in the stock, and then from husband to the bank, which would trigger gain to husband measured by the excess of the discharged debt over the carryover basis. The effect of this would be to preserve the element of gain, but to shift the incidence of the tax from wife to husband, “on behalf of” whom wife made the transfer to the “third party” bank. 12 Linda contends that her transfer of stock qualified for nonrecognition treatment under §1041 as interpreted in Temp. Reg. §1.1041-1T(c). She argues that the transfer of the stock to the corporation was done pursuant to her divorce agreement and therefore was on behalf of her former spouse within the language and purposes of the temporary regulations. The IRS disputes that the transfer was “on behalf of” Billy Joe so as to come within the regulation and shield Linda from recognizing gain. It is undisputed that the transfer occurred incidental to the Cravens’ divorce. Therefore, the central question is whether the transfer was made by Linda “on behalf” of Billy Joe. Linda offered the district court three main reasons, which the district court agreed with, for why §1041 would apply to her redemption of the stock: (1) because Georgia law obligates the equal distribution of marital assets pursuant to a divorce agreement, Linda was obligated to redeem her stock to the corporation; (2) Billy Joe was the guarantor of the corporation’s payments that were due on the note, and because Georgia law makes guarantors jointly and severally liable for any debts incurred on the note, her redemption of the stock was “on behalf” of Billy Joe; and (3) because the corporation is a closely held one where, after the redemption, Billy Joe owned 98% of the stock, Linda’s transfer was, in effect, to her husband. 13 In agreeing with Linda’s arguments, the district court relied primarily on Arnes v. United States, 981 F.2d 456 (9th Cir. 1992) (“Arnes I). In Arnes I, the divorcing spouses, who each owned 50% of a corporation that ran a McDonald’s franchise, were required to transfer the entire ownership to one of the spouses according to McDonald’s policy. As a result, the divorce decree had one spouse sell her 50% stock interest to the corporation for a dollar amount which the other spouse guaranteed. See id. at 457. The Ninth Circuit ruled that this transaction came within the confines of §1041 because the redemption relieved the husband of an obligation to purchase his wife’s stock and thereby conferred a benefit upon him. See id. at 459. The district court in this case ruled the facts and analysis of Arnes I were squarely on point. The Arnes I decision has been called into question as being factually and analytically flawed. See Blatt v. Commissioner, 102 T.C. 77 (1994) (reviewed by the court). Blatt explained the faulty reasoning of Arnes I by pointing out that the Ninth Circuit never identified where the obligation of the husband to buy the stock came from. See id. at 82-83. Indeed, as the Tax Court held in a subsequent case, Arnes v. Commissioner, 102 T.C. 522, 528-29 (1994) (“Arnes II”), it was the corporation which was under the obligation to buy the wife’s stock, and not the husband. Thus, the redemption was “on behalf” of the corporation, and not the 14 husband, and §1041 should not have been implicated as a result. See Blatt, 102 T.C. at 81-83. Fortunately, a recent Tax Court decision that came down after the district court reached its decision in this case, and after both parties had already completed their briefing before this Court, resolved the tension between Blatt, Arnes I, Arnes II, and the facts of this case. See Read v. Commissioner, [Current] Tax. Ct. Rep. (CCH) No. 53,736, at 3911 (Feb. 4, 2000) (reviewed by the court). The parties were aware of Read before oral argument because both submitted Federal Rules of Appellate Procedure 28(j) notices regarding this new case, and the matter was debated extensively at oral argument. In Read, the Tax Court was confronted with facts that are basically identical to the ones at issue in this case. In that case, a husband (“H”) and a wife (“W”) owned all the voting, and virtually all of the non-voting stock of a corporation (“C”). See Read at 3912-13. When H and W divorced, pursuant to the divorce order, H elected to buy out W’s shares in C by having C purchase W’s stock, and by having C issue a promissory note to W bearing 9% interest for the balance of the purchase price. See id. at 3913-15. H then unconditionally guaranteed the payments by C to W in his individual capacity. See id. at 3916. 15 As in this case, the issue in Read was whether §1041, as interpreted in Q&A 9, operated to deny recognition of the gain resulting to W on the transfer of her stock to C. The Tax Court held that under §1041, the gain was not to be recognized for tax purposes. See id. at 3924. In interpreting the meaning of the term “on behalf” from Q&A 9, the Tax Court rejected the notion that under Q&A 9, §1041 only applies if H had a “primary-and-unconditional-obligation” to purchase W’s stock, stating that the “primary-and-unconditional-obligation” standard was “not an appropriate standard to apply in any case involving a corporate redemption in a divorce setting in order to determine whether the transfer of property by the transferring spouse to a third party is on behalf of the nontransferring spouse within the meaning of Q&A 9.” Id. at 3921. The Tax Court noted that the “primary-and-unconditional-obligation” standard applies when the corporation pays H’s debt for H and such payment is deemed a dividend to H. See id. at 3918. Rather, the Tax Court gave the term “on behalf” a plain meaning such as “in the interest of” or “as a representative of,” and ruled that because W was acting under H’s election as mandated by their divorce decree, W was acting “on behalf” of H and therefore fell within the rubric of §1041 and Q&A 9. See id. at 3923-24. 16 Given the detailed and comprehensive analysis undertaken by the Read court, and the factual similarities between Read and this case, we find the Read result persuasive. As illustrated above, the meaning of the phrase “on behalf” reflects the notion that a transfer from A to C is treated for tax purposes as a transfer from A to B to C, when A is in fact transferring on behalf of B to C. See e.g. Blatt, 102 T.C. at 81; Read, [Current] Tax. Ct. Rep. at 3923. The facts of this case show that the transfer from Linda to the corporation squarely comports with this understood definition of “on behalf.” The three facts that place Linda within the framework outlined by the Read court are: (1) she was redeeming her stock pursuant to the divorce settlement; (2) Billy Joe guaranteed the note; and (3) in that note Billy Joe acknowledged that its terms were of “direct interest, benefit and advantage” to him. The first fact enumerated above would be enough on its own to qualify Linda’s transfer to the corporation for nonrecognition under §1041. The other two facts simply add strength to this conclusion. When the Cravens settled their divorce, they agreed to this redemption, and subscribed to a document that obligated Linda to transfer her stock to the corporation. In so doing, Linda was acting “on behalf” of Billy Joe because the divorce settlement reflected Billy Joe’s wishes on the matter. Therefore, the Cravens’ divorce settlement is akin to H’s election in Read, which 17 the Read court found decisive in its ruling that W was acting on H’s behalf in transferring her stock to C. See Read at 3923-24. This implication is confirmed by Billy Joe’s explicit action of guaranteeing the note in his individual capacity, something H did as well in Read, and expressing in the guarantee that such an action was in his “interest.” “Interest” is exactly what precedent instructs us is the plain meaning of “on behalf” and we need not look any further to determine that Billy Joe’s interest, as admitted by him and as evidenced by his agreeing to the divorce settlement, was being served by Linda’s transfer of her stock to the corporation. We hold that the proceeds of Linda’s transfer to the corporation fit within the terms outlined by §1041 and Q&A 9, and therefore qualify for nonrecognition. This holding follows the rationale behind the adoption of §1041 because it “facilitates the division of a marital estate incident to divorce without taxation to the spouse who is withdrawing assets from the marital estate.” See Read at 3926 (Colvin, J., concurring). As such, Congress’ stated purpose of broadly applying §1041 to transactions between divorcing spouses incident to their divorce is properly served.