When the major asset of a marital estate is a closely held business, fashioning an equitable settlement presents unique challenges. In most cases, the party retaining the business does not have sufficient cash on hand to pay the entire amount of the “equalizing payment” so the agreement provides for a deferred payment, most often in installments over a number of years. When a note is given to equalize the division of property incident to a divorce, careful drafting of the agreement or judgment can eliminate the unintended consequence of making the interest taxable to the payee but non-deductible by the payor.
In cases where the business has liquidity, effective tax planning can generate the funds needed to achieve equitable distribution. If the settlement is structured properly, cash otherwise locked inside a corporation can be used to redeem a spouse’s stock ownership interest in a closely held business at capital gains tax rates. If structured improperly, one spouse may be deemed to have received a constructive dividend and likely no cash with which to pay the tax. Additionally, creating capital gain income can provide a significant benefit if capital loss carryforwards exist.
If the party retaining the business executes a promissory note for the amount owed to the other party, it is generally assumed that the note will bear interest at the then prevailing rate. As discussed below, the treatment of the income component can have significant impact on both the payor and the payee.
General Rule: All interest is nondeductible personal interest except for investment interest, passive activity interest, and qualified residence interest. The character of the interest expense is determined by tracing the use of the related debt (Treasury Regulations section 1.163-8T). Underlying debt is allocated by tracing specific disbursements of the proceeds to specific expenditures. Thus, if the underlying debt is incurred as a personal expenditure, the interest on that debt may not be deducted except to the extent such interest is qualified residence interest.
If the underlying debt is incurred to acquire investment property, the interest on that debt is deductible as an investment interest expense. Investment interest is defined as any interest paid on indebtedness incurred for the acquisition of investment property. Investment property can be defined as any property producing gross income from interest, dividends, annuities, or royalties not derived in the taxpayer’s trade or business. Stated interest is taxable income to the payee.
A review of several Tax Court decisions and IRS rulings can provide a roadmap to successful drafting of a provision providing for equalization payments over a period of years.
Seymour (109 T.C. 279)
The property settlement agreement in Seymour required Wife to transfer her interests in a closely held bottling company, the building in which the business operated, the marital residence, and certain other personal property to Husband. Because the remaining property in the estate was insufficient to equalize the settlement, Husband agreed to execute a note for $925,000. The note required an immediate down payment of $300,000 with the balance to be paid over 10 years at 10% interest. Husband deducted the interest portion of the payments, arguing that the payments were related to his business and, thus, qualified as investment interest expense. The IRS issued a deficiency notice, disallowing the interest deduction as personal interest expense related to a divorce proceeding.
Because the agreement was silent on identifying the assets for which the note was given, the Tax Court said the interest should be allocated among all the assets awarded to the husband. As a result, the portion of the interest allocable to the business was treated as deductible investment interest expense. Interest allocable to personal property was non-deductible.
Armacost (T.C. Memo 1998-150)
This is another case in which the settlement agreement was silent on identifying assets for which a note was given. However, unlike Seymour, the court allowed all of the interest to be traced to the investment property. Husband convinced the court that the couple’s personal property had been equally divided and that the note was solely for Wife’s interest in investment property and qualified as deductible investment interest expense.
The Armacosts reached a property settlement dividing their assets, including stocks, bonds, a personal residence, vacation properties, and other liquid assets as well as several commercial properties on which they developed, constructed, and operated gas stations and convenience stores.
Because Husband received more property than Wife, he signed a promissory note in the amount of $250,000 payable to Wife to equalize the distribution of assets. The note was payable for 20 years at 10% interest. Husband deducted the interest portion of the payments as investment interest expense.
Husband was able to provide evidence that he received $12,000 less than Wife in noninvestment property and $496,000 more than Wife in investment property. The Tax Court agreed with Husband, finding that Wife’s deficit in investment property nearly equaled the $250,000 promissory note and concluded that the debt was attributable to the acquisition of Wife’s share of investment property and the interest on that indebtedness was deductible.
Caveat: Even an agreement identifying an asset given for a note may not have any effect if the spouse who receives the note has no preexisting property right in the asset. In FSA (Federal Service Advice) 200203061, the IRS held that interest on a note to a wife could not be allocated as investment interest because the company stock was 100% owned by the husband prior to the division of assets. Therefore, the intent to equally divide all jointly and separately held property may not mean that the interest can simply be allocated among all the property.
Gibbs (T.C. Memo 1997-196)
The above cases addressed the deductibility of the interest paid on a promissory note issued pursuant to a divorce settlement. In Gibbs, the Tax Court addressed whether the interest portion of such a note must be reported as taxable income by the payee.
After determining the value of the parties’ closely held business to be $250,000, the district court determined that Husband should retain the business and pay Wife $122,500 for her equitable interest in the property. Husband was ordered to pay $122,500 with an immediate payment of $22,500 and the balance to be paid in 10 annual installments of $15,583.
Wife did not include any of the payments in her income on her Federal income tax returns in the years of receipt. The IRS issued deficiency notices for the interest portion of the payments. She argued that the interest was excludible under the non-recognition provisions of IRC section 1041(a). Wife cited Balding (98 T.C. 368), another installment note case in which no interest was required to be included in income. The Tax Court pointed out that the interest was unstated in Balding. This is an important distinction and is consistent with Treasury Regulation § 1.1273-1(b)(3)(iii), which exempts instruments issued in consideration for property transferred incident to divorce from the original issue discount (OID) rules. Under the OID rules, a portion of each deferred payment will normally be re-characterized as interest where a debt instrument does not contain adequate stated interest.
In summary, if the parties intend to treat the interest portion of a promissory note as taxable/deductible, the judgment should specify the investment property for which the note is given, including the value of the property in relation to the amount of the note. If the note cannot be allocated directly to a qualifying investment property, the series of payments should be calculated using a “baked-in” after-tax interest rate and stated as a dollar amount. The judgment must not contain a stated interest rate.
If a settlement is structured properly, cash otherwise locked inside a corporation can be used to redeem a spouse’s stock ownership interest in a closely held business at capital gains tax rates. If structured improperly, the spouse retaining ownership may be deemed to have received a constructive dividend.
In general, under IRC §301, a corporation’s distribution of property to its shareholders is taxable first as a dividend to the extent of the corporation’s earning and profits and then as a return of basis to the extent of the shareholder’s basis in the shares. Any amount received in excess of basis is taxed as capital gain.
A brief review of the significant cases involving corporate redemptions pursuant to a divorce will illustrate some of the pitfalls involved in structuring a corporate redemption.
1) Arnes, 981 F.2d 456 (9th Cir. 1992) (Arnes I), aff’g No. C90-728C (W.D. Wash 4/11/91) In this case, the Ninth Circuit held that, although Wife transferred her stock directly to the corporation, the transfer was actually made on behalf of Husband because he was obligated to buy Wife’s stock and he benefitted from the redemption in that he guaranteed the corporation’s payments and was liable for the payments. By inference, one would assume that Husband received a constructed dividend.
2) Arnes, 102 T.C. 522 (1994) (Arnes II) (separate case involving the same stock transaction as Arnes I with an inconsistent result) In Arnes II, the IRS contended that Husband was liable for tax on the constructive dividend to him resulting from the corporation’s redemption of Wife’s shares. The Tax Court disagreed, holding that Husband was not liable for tax on the transfer. The Tax Court’s ruling was also based on its conclusion that Husband’s guarantee of the corporation’s liability to Wife did not create a “primary and unconditional obligation” under applicable state law.
3) Blatt, 102 T.C. 77 (1994) In Blatt, a corporation was owned jointly by Husband and Wife. Pursuant to a divorce decree, the corporation redeemed all of Wife’s stock. In her Tax Court case, Wife cited Arnes I, arguing that the redemption was on behalf of Husband and therefore was nontaxable under section 1041 and Q&A-9. The Tax Court, however, stated that it did not agree with Arnes I and “respectfully refused to follow it.” The court also noted that a transfer “on behalf of a person” must satisfy an obligation of that person, and concluded that the redemption did not satisfy any liability of Husband since he did not personally guarantee the corporation’s obligation to redeem the stock.
4) Read, 114 T.C. 2 (Feb. 2000) In Read, the Tax Court resolved many of the perceived differences between Blatt, Arnes I, and Arnes II. Pursuant to the judgment of divorce, Wife was obligated to sell her stock to her Husband, or at Husband’s option, to their corporation in exchange for cash and a promissory note. At Husband’s direction, Wife sold her stock to the corporation. The Tax Court held that the redemption was a transfer on behalf of Husband and that Husband had received a taxable constructive dividend and Wife had no gain on the transaction. Based on Arnes II, Husband could have avoided dividend treatment if the judgment had required the corporation to redeem the stock.
5) Craven, No. 99-12803 (11th Cir. 6/19/00) Pursuant to the divorce decree, Wife agreed to sell alI of her stock in the parties’ jointly owned corporation to the corporations in exchange for a note. The Eleventh Circuit held that the redemption was on behalf of Husband because Wife was redeeming her stock pursuant to the divorce settlement, Husband guaranteed the corporation’s note, and Husband acknowledged that the terms were of direct benefit to him. Thus, the redemption was not taxable to Wife.
Fortunately, IRC § 1041 provides taxpayers a mechanism for determining which spouse will pay the tax on the disposition of corporate shares. Treasury Regulation 1.1041-2(c) allows taxpayers to choose which spouse will be responsible for the tax consequences of a corporate redemption under the following circumstances:
1) The judgment or other written agreement must state how the spouses intend the redemption to be treated for tax purposes.
2) The agreement must be executed before the date the spouse responsible for the tax files his or her tax return for the year of redemption.
Specifically, Regs. Sec. 1.1041-2(c)(1) indicates that if a divorce or separation agreement between the spouses or former spouses includes the following, the transferor spouse will be taxable:
1) 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
2) Such instrument or agreement supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other disposition of the stock that is subject to the redemption.
Conversely, Regs. Sec. 1.1041-2(c)(2) relates to situations in which the nontransferor spouse will be taxable, including circumstances under which the nontransferor spouse will be deemed to have received a constructive distribution from the corporation followed by the deemed transfer of cash to the transferor spouse in redemption of his or her stock. If the divorce or separation agreement sets forth the following agreements of the parties, the transfer will be treated as a constructive distribution to the nontransferor spouse:
1) 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
2) Such instrument or agreement supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other distribution of the stock that is the subject of the redemption.
When buying out a spouse’s equitable interest in a closely held business, care should be taken to achieve the intent of the parties. Careful attention should be paid to the tax ramifications of any proposed division to ensure that the intent of the parties is achieved without unintended tax consequences.