Buying Out an Ex-Spouse's Stock in a Closely Held Firm

Let's say divorcing spouses own part of the stock in a closely held corporation. One of them now want to buy out the other party's shares by transferring some assets in exchange for the stock.

As long as the transfer happens before the divorce is final, there are usually no federal income tax or gift tax consequences. This is because of the tax-free transfer rule that generally applies to transfers of assets between spouses. (Source: Section 1041(a) of the Internal Revenue Code.)

The same tax-free treatment also usually applies to stock buyouts that occur within six years after a divorce, provided they are done pursuant to the terms of a divorce property settlement. Assuming the tax-free transfer rule applies, one spouse simply takes over from the other spouse the tax basis and holding period for the stock purchased. It is as if the buyer had always owned the shares and the selling spouse has no taxable gain or loss on the deal. This harmless tax outcome is generally acceptable to both spouses.

When the Buyer is the Corporation, Things Can Get Complicated

However, the tax outcome is not quite so simple when a closely held C or S corporation redeems, or buys back, an ex spouse's shares in the same company. Such third-party divorce-related stock redemptions can fall into two situations, both of which have tax consequences:

Situation 1: The redemption transaction is considered to be strictly between the selling ex-spouse and the corporation. There are no federal tax consequences for the other ex-spouse. Depending on the circumstances, the selling ex-spouse may be able to treat the redemption as a sale of his or her stock back to the corporation or as a dividend paid by the company.

Generally, sale treatment is preferred, because the selling ex-spouse can offset the stock redemption payment with his or her basis in the redeemed shares. In this situation, the seller bears all the tax consequences. For the other ex-spouse, the corporation's redemption of the stock has no tax impact.

Situation 2: The tables are turned. The actual transaction is still between the corporation and the ex-spouse redeeming the shares. However, for tax purposes, the deal is treated as if the other ex-spouse collected the redemption payment and then transferred it in exchange for the shares. So in this situation, the redeeming ex-spouse has no tax consequences while the other party bears all of the tax burden.

Depending on the circumstances, the spouse who owes taxes may be able to treat the constructive redemption as a sale of his or her stock back to the corporation or as a dividend.

So Which Situation Applies?

This is where it gets tricky. In a nutshell, Situation 2 applies if the corporation redeems a former spouse's shares to fulfill a binding legal obligation that the other spouse had to buy those shares under the couple's divorce agreement. In essence, because the corporation actually supplies the money to buy the shares, one spouse is taxed as if he or she received the money from the company and then spent it to buy the stock from the selling ex-spouse, as legally required by the divorce agreement.

But There is a Way to Reverse the Tax Results

Regardless of which situation applies, the former spouses can together elect to reverse the tax results. In other words, when Situation 2 would otherwise apply (meaning one party would bear all the tax consequences), the couple can elect to reverse the results and have Situation 1 apply instead.

The two parties may be willing to cooperate in making this election -- for example, because the redemption would be treated as a sale and one ex-spouse has a large capital loss that would offset the gain from the redemption. Needless to say, some paperwork is involved to make the election, and there are deadlines, so planning ahead is critical. (Source: Treasury Regulation 1.1041-2.)

Conclusions: Looking at it from an arm's-length perspective, a divorce is a major financial transaction. As such, it has important tax consequences for both former spouses. This is especially true when business ownership interests are involved. The ability to choose which ex-spouse will be taxed on a divorce-related stock redemption allows the couple to tailor the tax outcome to suit their respective circumstances. Done properly, there's more left for the two to divide up, because the tax collector gets less.