|
|
|
|
 |
|
June 2003 Stock redemption and divorce Flexibility for divorcing couples in structuring the division of a closely held corporation Marital dissolutions can get complicated. And that complexity increases when a valuable, closely held corporation is part of the marital property. In most cases, the net worth of the splitting couple will be equalized in the divorce process, with the corporate business entity retained by the spouse who has primarily managed and operated the business. But if that corporate entity represents more than half of the couple’s net worth, as is often the case with a valuable business, the spouse receiving the business may need to move cash to the other spouse. And often, the only source of that cash is the corporate entity itself. Example: Peter and Constance are about to divorce. Their assets consist of a closely held corporation valued at $2 million, a residence worth $600,000, and miscellaneous investments valued at $400,000. Peter founded the corporation, and his engineering skills are critical to its ongoing success, so the couple agrees that he will take the corporation and Constance will receive the house and other assets, plus $500,000 cash from Peter to equalize the division of assets. Because Peter’s only source of the $500,000 is the business, he proposes that the corporation buy the shares of stock held by Constance for $500,000. Constance’s redemption of her stock will produce a favorable capital gain tax rate. They agree to split the tax cost on this stock redemption because it is an inexpensive way to get cash out of their corporation in a manner that allows them to equally divide their assets. In the past, when the IRS encountered a transaction like the one Peter has proposed, they were quick to cast it in a different light. The IRS position would be that the corporation had assumed Peter’s personal obligation to pay Constance for a portion of her stock. Accordingly, the IRS view was that the corporation had first issued a $500,000 dividend to Peter and that he in turn made a marital dissolution payment for the division of their property to Constance. Under this approach, the IRS converted what appeared to be a lower-rate capital gain redemption into a fully taxed ordinary income dividend. But earlier this year, the IRS reversed its position in a new favorable set of regulations. These regulations adopted an approach that gives flexibility to spouses in structuring the division of a closely held corporation. The spouses are allowed to agree to capital gain redemption treatment if the corporation acquires the stock of one of the spouses. Securing this favorable tax treatment requires the agreement of the spouses in the actual divorce document. If the spouse who retains the business has a primary and unconditional obligation to personally acquire the other spouse’s stock in their dissolution documents, the IRS will still assert its former position of unfavorable dividend treatment. Continuing with the preceding example, if Peter and Constance place language in their divorce instrument under which they agree that the redemption of Constance’s stock would be treated for federal income tax purposes as a complete redemption distribution to Constance, the IRS should allow the favorable capital gain treatment. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |