Td 9035

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[Federal Register: January 13, 2003 (Volume 68, Number 8)]
[Rules and Regulations]
[Page 1534-1537]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13ja03-10]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9035]
RIN 1545-AX99

Constructive Transfers and Transfers of Property to a Third Party
on Behalf of a Spouse

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations
relating to the tax treatment of redemptions, during marriage or
incident to divorce, of stock in a corporation owned by a spouse or
former spouse.

DATES: Effective Date: These regulations are effective January 13,
2003.
Applicability Date: These regulations are applicable to redemptions
of stock on or after January 13, 2003 that are pursuant to instruments
in effect after January 13, 2003. These regulations are also applicable
to redemptions before January 13, 2003 or that are pursuant to
instruments in effect before January 13, 2003 if the spouses or former
spouses execute a written agreement on or after August 3, 2001, that
satisfies the requirements of Sec. 1.1041-2(c)(1) or (2).

FOR FURTHER INFORMATION CONTACT: Edward C. Schwartz at (202) 622-4960
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under
control number 1545-1751. Responses to this collection of information
are required for certain taxpayers to redeem stock in a corporation and
utilize the special rule in Sec. 1.1041-2(c) of these regulations.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number assigned by the Office of
Management and Budget.
The estimated annual burden per respondent/recordkeeper varies from
20 minutes to one hour, depending on individual circumstances, with an
estimated average of 30 minutes.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S,
Washington, DC 20224, and to the Office of Management and Budget, Attn:
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Desk Officer for the Department of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503.
Books or records relating to this collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On August 3, 2001, the IRS and Treasury Department published in the
Federal Register a notice of proposed rulemaking under section 1041
relating to certain redemptions, during marriage or incident to
divorce, of stock in a corporation owned by a spouse or former spouse
(REG-107151-00)(2001-2 C.B. 370)[66 FR 40659]). Written and electronic
comments were solicited, and a public hearing was scheduled for
December 14, 2001. Several comments were received and are discussed
below. Because no requests to speak were timely received, the public
hearing was cancelled. After consideration of all comments received,
the proposed regulations under section 1041 are adopted as revised by
this Treasury decision.

Explanation and Summary of Comments

1. Special Rules in Cases of Written Agreements Between the Spouses

The proposed regulations provided generally that if a corporation
redeemed stock owned by a transferor spouse and the redemption resulted
in a constructive distribution to the nontransferor spouse under
applicable tax law, then the redemption would be taxable to the
nontransferor spouse as if the nontransferor spouse had actually
received the redemption proceeds. The proposed regulations contained a
special rule in Sec. 1.1041-2(c) allowing the spouses the option of
treating the redemption as resulting in a constructive distribution to
the nontransferor spouse, and therefore taxable to the nontransferor
spouse, even if the redemption would not result in a constructive
distribution to the nontransferor spouse under applicable tax law. The
proposed regulations provided that the spouses could elect the special
rule by providing in the divorce or separation instrument, or other
written agreement, that the spouses must file their Federal income tax
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returns in a manner that reflects that the transferor spouse
transferred the redeemed stock to the nontransferor spouse in exchange
for the redemption proceeds and the corporation redeemed the stock from
the nontransferor spouse in exchange for the redemption proceeds. The
proposed regulations also provided that the special rule would be
effective for written agreements executed on or after August 3, 2001,
that met these requirements.
Commentators expressed concern that the proposed regulations
contained no provision addressing the situation where the redemption
results in a constructive distribution to the nontransferor spouse
under applicable tax law, but the spouses nevertheless would like to
agree that the redemption will be treated as a redemption distribution
to the transferor spouse. They suggested that the final regulations
expand the special rule in Sec. 1.1041-2(c) to allow the spouses to
agree in the divorce or separation instrument, or other valid written
agreement, that the redemption will be taxable to the transferor spouse
notwithstanding that the redemption might otherwise result in a
constructive distribution to the nontransferor spouse under applicable
tax law.
The IRS and Treasury Department believe that this suggestion is
consistent with the policy of section 1041 and its legislative history,
which is to provide flexibility to spouses and former spouses
concerning the structuring of their property transfers during marriage
and incident to divorce. Accordingly, this suggestion has been adopted
in Sec. 1.1041-2(c) of the final regulations. New Example 2 in Sec.
1.1041-2(d) illustrates the application of this new special rule.
The manner of electing the special rule also has been modified
somewhat in the final regulations. Under the final regulations, the
spouses can elect the special rule by expressly providing, in a divorce
or separation instrument or other valid written agreement, that
expressly supersedes any other instrument or agreement concerning the
purchase, sale, redemption, or other disposition of the stock that is
the subject of the redemption, their mutual intent concerning whether
the redemption should be treated as a redemption distribution to the
transferor spouse or to the nontransferor spouse. The IRS and Treasury
Department will treat a divorce or separation instrument or other valid
written agreement executed on or after August 3, 2001, and before May
13, 2003 that meets the

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requirements of the special rule of the proposed regulations as also
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meeting the requirements of the special rule in paragraph (c)(2) of the
final regulations.

2. Constructive Distribution Standard

Some commentators also expressed concern that taxpayers and divorce
practitioners may not be aware of the situations in which a redemption
of stock owned by the transferor spouse could result in a constructive
distribution to the nontransferor spouse under applicable tax law. They
therefore suggested that the final regulations either provide that the
redemption will be treated as a redemption distribution to the
transferor spouse regardless of applicable tax law, unless the spouses
provide otherwise in a written agreement and file their federal income
tax returns accordingly, or provide specific definitions and examples
of situations in which a redemption would result in a constructive
distribution to the nontransferor spouse under applicable tax law.
The IRS and Treasury Department continue to believe that the
approach in the proposed regulations is appropriate. Under existing tax
law, a redemption of stock owned by one shareholder may result in a
constructive distribution to another shareholder if such nonredeeming
shareholder has a primary and unconditional obligation to purchase the
redeeming shareholder's stock. See Rev. Rul. 69-608 (1969-2 C.B. 42),
Wall v. United States, 164 F.2d 462 (4th Cir. 1947), and Sullivan v.
United States, 363 F.2d 724 (8th Cir. 1966). This ``primary and
unconditional obligation'' standard applies to all redemptions,
including those involving stock of closely held corporations by spouses
or former spouses. A rule that provides that a redemption of stock
owned by the transferor spouse will always be treated as a redemption
distribution to the transferor spouse would be inconsistent with this
established law. Furthermore, if taxpayers and divorce practitioners
are uncertain about the application of the ``primary and unconditional
obligation'' standard, they may take advantage of the special rules of
Sec. 1.1041-2(c), which permit spouses to avoid any question of
whether a redemption results in a constructive distribution to the
nontransferor spouse under applicable tax law relating to the primary
and unconditional obligation standard by providing in a written
agreement which spouse will bear the tax consequences of the
redemption.

3. Withdrawal of Sec.

1.1041-1T(c), Q&A-9

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Section 1.1041-1T(c), Q&A-9, of the temporary Income Tax
Regulations provides that 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 section 1041 (provided all other requirements
of that section are met): (1) if such transfer is required by the
divorce or separation instrument; (2) if the transfer is pursuant to a
written request of the other spouse; and (3) where the transferor
spouse receives a written consent or ratification from the
nontransferor spouse. Under Q&A-9, a transfer of property made to a
third party on behalf of a spouse is treated first as a deemed transfer
of the property made directly to the nontransferor spouse in a transfer
to which section 1041 applies, and then as a deemed transfer of the
property from the nontransferor spouse to the third party in a
transaction to which section 1041 does not apply.
Two commentators recommended that Q&A-9 be withdrawn. They
suggested that retaining that provision would lead to confusion since
it would apply to all transfers of property other than stock
redemptions while this final regulation would apply only to stock
redemptions. Another commentator advocated replacing existing Q&A-9
with a single standard applicable to all transfers of property to third
parties under which the tax consequences of the transfer would follow
the transfer's form unless the spouses agreed in writing otherwise.
The ``on behalf of'' standard has not led to the same confusion and
litigation outside the area of stock redemptions because, in such
cases, it does not conflict with any other standard of tax law. See,
e.g., Ingham v. United States, 167 F.3d 1240 (9th Cir. 1999). In
addition, as discussed above, a single standard applicable to all
transfers of property to third parties under which the tax consequences
of the transfer would follow the transfer's form would be inconsistent
with the primary and unconditional obligation standard applicable to
stock redemptions under existing tax law. Consequently, the IRS and
Treasury Department continue to believe that the final regulations
should be limited to stock redemptions and that Q&A-9 should not be
withdrawn.

4. Use of IRS Form To Designate Intent

One commentator proposed that the final regulations include a
requirement that the spouses or former spouses attach a form to their
Federal income tax returns showing which spouse or former spouse has
the tax consequences of the redemption. After careful consideration,
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the IRS and Treasury Department have concluded that requiring spouses,
and particularly spouses who have divorced or are divorcing, to
complete and file an additional form in order to obtain the result of
the special rules would unnecessarily increase the administrative
burden on taxpayers and on the IRS. The divorce or separation
instrument, or other valid written agreement of the spouses, provides
adequate evidence of the spouses' intent regarding which spouse has the
tax consequences of the redemption.

5. Legal Guardians and/or Executors of Estates of Spouses

One commentator suggested that the final regulations provide
specific authority for a legal guardian of a spouse or former spouse or
the executor of a spouse's or former spouse's estate to elect the
application of one of the special rules of Sec. 1.1041-2(c). However,
a legal guardian, custodian, or executor of an estate that has the
general authority to act on behalf of a spouse or former spouse (or his
or her estate) for federal income tax purposes needs no additional or
special authority to elect one of the special rules under Sec. 1.10412(c). Accordingly, this suggestion has not been adopted.

6. Other Changes

In an effort to improve the clarity of the final regulations, the
order of the two paragraphs in Sec. 1.1041-2(a) has been reversed and
conforming changes have been made in the remainder of the final
regulations. Also, the final regulations remove the provision of the
proposed regulations that would have limited their application to
transactions in which both spouses or former spouses own stock
immediately before or after the redemption. On further reflection, the
IRS and Treasury Department believe it is appropriate to apply the
regulations to all stock redemptions, regardless of whether both
spouses own stock of the corporation before or after the redemption.

7. Effective Date

One comment was received suggesting that the effective date
provision of the final regulations be changed to include all stock
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redemptions that were pending on the day the proposed regulations were
issued (August 2, 2001) and to include all cases involving stock
redemptions at issue on that date at any level of audit, review,
appeal, or collection by the IRS or before the Tax Court or any other

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federal court. It was argued that this proposal would be consistent
with the current state of the law and would resolve numerous cases
involving taxpayers and the IRS. Adopting this suggestion would have
the effect of making the application of the final regulations
retroactive. Apart from the special rules of Sec. 1.1041-2(c), which
are based upon the stated intent of the spouses, the IRS and Treasury
do not believe it is appropriate to apply the final regulations
retroactively. Therefore, the final regulations do not adopt this
suggestion.

Special Analysis

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act (5
U.S.C. chapter 5) does not apply to these regulations, and because the
regulations do not impose a collection of information on small
entities, a Regulatory Flexibility Analysis under the Regulatory
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to
section 7805(f) of the Internal Revenue Code, the notice of proposed
rulemaking preceding these regulations was submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment
on its impact on small business.

Drafting Information

The principal author of these regulations is Edward C. Schwartz of
the Office of the Associate Chief Counsel (Income Tax and Accounting).
However, other personnel from the IRS and Treasury Department
participated in their development.
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List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In Sec. 1.1041-1T, paragraph (c) is amended by adding a
sentence at the end of A-9 to read as follows:

Sec. 1.1041-1T Treatment of transfers of property between spouses or
incident to divorce (temporary).

* * * * *
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(c) * * *
A-9: * * * This A-9 shall not apply to transfers to which Sec.
1.1041-2 applies.
* * * * *

Par. 3. Section 1.1041-2 is added to read as follows:

Sec.

1.1041-2

Redemptions of stock.

(a) In general--(1) Redemptions of stock not resulting in
constructive distributions. Notwithstanding Q&A-9 of Sec. 1.10411T(c), if a corporation redeems stock owned by a spouse or former
spouse (transferor spouse), and the transferor spouse's receipt of
property in respect of such redeemed stock is not treated, under
applicable tax law, as resulting in a constructive distribution to the
other spouse or former spouse (nontransferor spouse), then the form of
the stock redemption shall be respected for Federal income tax
purposes. Therefore, the transferor spouse will be treated as having
received a distribution from the corporation in redemption of stock.
(2) Redemptions of stock resulting in constructive distributions.
Notwithstanding Q&A-9 of Sec. 1.1041-1T(c), if a corporation redeems
stock owned by a transferor spouse, and the transferor spouse's receipt
of property in respect of such redeemed stock is treated, under
applicable tax law, as resulting in a constructive distribution to the
nontransferor spouse, then the redeemed stock shall be deemed first to
be transferred by the transferor spouse to the nontransferor spouse and
then to be transferred by the nontransferor spouse to the redeeming
corporation. Any property actually received by the transferor spouse
from the redeeming corporation in respect of the redeemed stock shall
be deemed first to be transferred by the corporation to the
nontransferor spouse in redemption of such spouse's stock and then to
be transferred by the nontransferor spouse to the transferor spouse.
(b) Tax consequences--(1) Transfers described in paragraph (a)(1)
of this section. Section 1041 will not apply to any of the transfers
described in paragraph (a)(1) of this section. See section 302 for
rules relating to the tax consequences of certain redemptions;
redemptions characterized as distributions under section 302(d) will be
subject to section 301 if received from a Subchapter C corporation or
section 1368 if received from a Subchapter S corporation.
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(2) Transfers described in paragraph (a)(2) of this section. The
tax consequences of each deemed transfer described in paragraph (a)(2)
of this section are determined under applicable provisions of the
Internal Revenue Code as if the spouses had actually made such
transfers. Accordingly, section 1041 applies to any deemed transfer of
the stock and redemption proceeds between the transferor spouse and the
nontransferor spouse, provided the requirements of section 1041 are
otherwise satisfied with respect to such deemed transfer. Section 1041,
however, will not apply to any deemed transfer of stock by the
nontransferor spouse to the redeeming corporation in exchange for the
redemption proceeds. See section 302 for rules relating to the tax
consequences of certain redemptions; redemptions characterized as
distributions under section 302(d) will be subject to section 301 if
received from a Subchapter C corporation or section 1368 if received
from a Subchapter S corporation.
(c) Special rules in case of agreements between spouses or former
spouses-- (1) Transferor spouse taxable. Notwithstanding applicable tax
law, a transferor spouse's receipt of property in respect of the
redeemed stock shall be treated as a distribution to the transferor
spouse in redemption of such stock for purposes of paragraph (a)(1) of
this section, and shall not be treated as resulting in a constructive
distribution to the nontransferor spouse for purposes of paragraph
(a)(2) of this section, if a divorce or separation instrument, or a
valid written agreement between the transferor spouse and the
nontransferor spouse, expressly provides that-(i) Both spouses or former spouses intend for the redemption to be
treated, for Federal income tax purposes, as a redemption distribution
to the transferor spouse; and
(ii) Such instrument or agreement supersedes any other instrument
or agreement concerning the purchase, sale, redemption, or other
disposition of the stock that is the subject of the redemption.
(2) Nontransferor spouse taxable. Notwithstanding applicable tax
law, a transferor spouse's receipt of property in respect of the
redeemed stock shall be treated as resulting in a constructive
distribution to the nontransferor spouse for purposes of paragraph
(a)(2) of this section, and shall not be treated as a distribution to
the transferor spouse in redemption of such stock for purposes of
paragraph (a)(1) of this section, if a divorce or separation
instrument, or a

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valid written agreement between the transferor spouse and the
nontransferor spouse, expressly provides that-(i) Both spouses or former spouses intend for the redemption to be
treated, for Federal income tax purposes, as resulting in a
constructive distribution to the nontransferor spouse; and
(ii) Such instrument or agreement supersedes any other instrument
or agreement concerning the purchase, sale, redemption, or other
disposition of the stock that is the subject of the redemption.
(3) Execution of agreements. For purposes of this paragraph (c), a
divorce or separation instrument must be effective, or a valid written
agreement must be executed by both spouses or former spouses, prior to
the date on which the transferor spouse (in the case of paragraph
(c)(1) of this section) or the nontransferor spouse (in the case of
paragraph (c)(2) of this section) files such spouse's first timely
filed Federal income tax return for the year that includes the date of
the stock redemption, but no later than the date such return is due
(including extensions).
(d) Examples. The provisions of this section may be illustrated by
the following examples:

Example 1. Corporation X has 100 shares outstanding. A and B
each own 50 shares. A and B divorce. The divorce instrument requires
B to purchase A's shares, and A to sell A's shares to B, in exchange
for $100x. Corporation X redeems A's shares for $100x. Assume that,
under applicable tax law, B has a primary and unconditional
obligation to purchase A's stock, and therefore the stock redemption
results in a constructive distribution to B. Also assume that the
special rule of paragraph (c)(1) of this section does not apply.
Accordingly, under paragraphs (a)(2) and (b)(2) of this section, A
shall be treated as transferring A's stock of Corporation X to B in
a transfer to which section 1041 applies (assuming the requirements
of section 1041 are otherwise satisfied), B shall be treated as
transferring the Corporation X stock B is deemed to have received
from A to Corporation X in exchange for $100x in an exchange to
which section 1041 does not apply and sections 302(d) and 301 apply,
and B shall be treated as transferring the $100x to A in a transfer
to which section 1041 applies.
Example 2. Assume the same facts as Example 1, except that the
divorce instrument provides as follows: ``A and B agree that the
redemption will be treated for Federal income tax purposes as a
redemption distribution to A.'' The divorce instrument further
provides that it ``supersedes all other instruments or agreements
concerning the purchase, sale, redemption, or other disposition of
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the stock that is the subject of the redemption.'' By virtue of the
special rule of paragraph (c)(1) of this section and under
paragraphs (a)(1) and (b)(1) of this section, the tax consequences
of the redemption shall be determined in accordance with its form as
a redemption of A's shares by Corporation X and shall not be treated
as resulting in a constructive distribution to B. See section 302.
Example 3. Assume the same facts as Example 1, except that the
divorce instrument requires A to sell A's shares to Corporation X in
exchange for a note. B guarantees Corporation X's payment of the
note. Assume that, under applicable tax law, B does not have a
primary and unconditional obligation to purchase A's stock, and
therefore the stock redemption does not result in a constructive
distribution to B. Also assume that the special rule of paragraph
(c)(2) of this section does not apply. Accordingly, under paragraphs
(a)(1) and (b)(1) of this section, the tax consequences of the
redemption shall be determined in accordance with its form as a
redemption of A's shares by Corporation X. See section 302.
Example 4. Assume the same facts as Example 3, except that the
divorce instrument provides as follows: ``A and B agree the
redemption shall be treated, for Federal income tax purposes, as
resulting in a constructive distribution to B.'' The divorce
instrument further provides that it ``supersedes any other
instrument or agreement concerning the purchase, sale, redemption,
or other disposition of the stock that is the subject of the
redemption.'' By virtue of the special rule of paragraph (c)(2) of
this section, the redemption is treated as resulting in a
constructive distribution to B for purposes of paragraph (a)(2) of
this section. Accordingly, under paragraphs (a)(2) and (b)(2) of
this section, A shall be treated as transferring A's stock of
Corporation X to B in a transfer to which section 1041 applies
(assuming the requirements of section 1041 are otherwise satisfied),
B shall be treated as transferring the Corporation X stock B is
deemed to have received from A to Corporation X in exchange for a
note in an exchange to which section 1041 does not apply and
sections 302(d) and 301 apply, and B shall be treated as
transferring the note to A in a transfer to which section 1041
applies.

(e) Effective date. Except as otherwise provided in this paragraph,
this section is applicable to redemptions of stock on or after January
13, 2003, except for redemptions of stock that are pursuant to
instruments in effect before January 13, 2003. For redemptions of stock
before January 13, 2003 and redemptions of stock that are pursuant to
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instruments in effect before January 13, 2003, see Sec. 1.1041-1T(c),
A-9. However, these regulations will be applicable to redemptions
described in the preceding sentence of this paragraph (e) if the
spouses or former spouses execute a written agreement on or after
August 3, 2001 that satisfies the requirements of one of the special
rules in paragraph (c) of this section with respect to such redemption.
A divorce or separation instrument or valid written agreement executed
on or after August 3, 2001, and before May 13, 2003 that meets the
requirements of the special rule in Regulations Project REG-107151-00
published in 2001-2 C.B. 370 (see Sec. 601.601(d)(2) of this chapter)
will be treated as also meeting the requirements of the special rule in
paragraph (c)(2) of this section.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 4. The authority citation for part 602 continues to read as
follows:

Authority: 26 U.S.C. 7805.

Par. 5. In Sec. 602.101, paragraph (b) is amended by adding an
entry in numerical order to the table to read as follows:

Sec.

602.101

OMB Control numbers.

* * * * *
(b) * * *

-----------------------------------------------------------------------Current OMB
CFR part or section where identified and described
control No.
------------------------------------------------------------------------

* * * * *
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http://frwebgate3.access.gpo.gov/cgi-bin/waisgate.cgi?WAISdocID=3284984671+3+0+0&WAISaction=retrieve

1.1041-2...................................................

1545-1751

* * * * *
------------------------------------------------------------------------

David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
Approved: December 30, 2002.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-646 Filed 1-10-03; 8:45 am]
BILLING CODE 4830-01-P

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