Arnes v. United States
981 F.2d 456 (1992)
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Rule of Law:
A transfer of property from a taxpayer to a third party is treated as a non-taxable transfer to a former spouse under I.R.C. § 1041 if the transfer is made 'on behalf of' the former spouse. A transfer is 'on behalf of' the former spouse if it satisfies a specific obligation or liability of that former spouse created by the divorce instrument.
Facts:
- Joann Arnes and John Arnes, a married couple, jointly owned 100% of the stock in their corporation, 'Moriah,' which operated a McDonald's franchise.
- As part of their divorce proceedings in 1987, McDonald's Corporation informed them that the franchise could not have joint ownership after the divorce.
- Joann and John Arnes entered into a property settlement agreement, later incorporated into their divorce decree, requiring their corporation, Moriah, to redeem Joann Arnes' 50% stock interest for $450,000.
- The payment terms included forgiveness of a debt Joann owed the corporation, cash payments, and a ten-year installment note from the corporation to Joann.
- John Arnes personally guaranteed Moriah's note and payments to Joann Arnes.
- Pursuant to the agreement, Joann Arnes surrendered her stock shares directly to the Moriah corporation.
Procedural Posture:
- On her 1988 federal income tax return, Joann Arnes initially reported the capital gain from the stock redemption and paid the corresponding taxes.
- Joann Arnes later filed a timely claim for a refund of $53,053 with the IRS, arguing the transfer was non-taxable under § 1041.
- The IRS denied her claim for a refund.
- Joann Arnes (Taxpayer) filed suit against the United States (Government) in U.S. District Court to recover the tax payment.
- On cross-motions for summary judgment, the district court ruled in favor of Joann Arnes, holding the transfer qualified for non-recognition of gain.
- The United States (Government) appealed the district court's judgment to the U.S. Court of Appeals for the Ninth Circuit.
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Issue:
Does a taxpayer's transfer of stock to a corporation for redemption, when done pursuant to a divorce decree to buy out her interest, qualify as a non-taxable transfer 'to a former spouse' under I.R.C. § 1041, thereby absolving the taxpayer of recognizing capital gains from the transaction?
Opinions:
Majority - Hug, J.
Yes. A taxpayer's transfer of stock to a corporation for redemption qualifies as a non-taxable transfer under I.R.C. § 1041 when it is made on behalf of the former spouse pursuant to a divorce instrument. The court reasoned that Treasury Regulation § 1.1041-1T provides that a transfer to a third party 'on behalf of' a spouse should be treated as a transfer to that spouse. A transfer is made 'on behalf of' someone if it satisfies an obligation of that person. In this case, the divorce property settlement created an obligation for John Arnes to arrange for the purchase of Joann Arnes' stock. The corporation's redemption of the stock satisfied this obligation, thereby benefitting John. Because John also personally guaranteed the corporation's payment, he was directly liable. Therefore, Joann's transfer to the corporation is treated as a constructive, non-taxable transfer to John, who is then deemed to have transferred the stock to the corporation. This shifts the tax consequences to John, consistent with the purpose of § 1041 to defer taxation until property leaves the marital economic unit.
Analysis:
This decision clarifies the scope of I.R.C. § 1041 by extending its non-recognition treatment to transactions involving a third-party entity, such as a closely held corporation, when the transfer is made 'on behalf of' an ex-spouse. The ruling establishes that a stock redemption structured within a divorce can be re-characterized as a constructive transfer between the spouses, placing the ultimate tax burden on the spouse who remains and benefits from the transaction. This provides a crucial framework for structuring buyouts in family businesses during a divorce and created a precedent that the substance of the transaction—fulfilling a spouse's obligation—matters more than its form.
