## Facts

- Joann and John Arnes married in 1970 and formed Moriah, a closely held corporation operating a McDonald’s restaurant, issuing 5,000 shares in their joint names.
- In connection with their 1987 divorce, McDonald’s required that the restaurant have no joint ownership after the divorce.
- To implement the marital property division and satisfy McDonald’s requirements, Moriah agreed to redeem Joann’s 2,500 shares (50% interest) for $450,000.
- The redemption price was to be paid by forgiving about $110,000 of Joann’s debt to Moriah, paying two $25,000 lump sums in 1988, and paying the balance in monthly installments over ten years beginning in February 1988.
- The redemption agreement was incorporated into the January 7, 1988 divorce decree; Joann surrendered her shares on December 31, 1987, and Moriah later cancelled her certificate and issued replacement shares to John, leaving him the sole shareholder.
- On her 1988 return, Joann reported the transaction as a taxable sale on the installment method, recognized long-term capital gain based on amounts received in 1988, and paid the resulting tax.
- Joann sought a refund, asserting the redemption was a nonrecognition transfer incident to divorce under I.R.C. § 1041 and Temp. Treas. Reg. § 1.1041-1T; the IRS denied the claim.
- The district court granted summary judgment to Joann and awarded a $53,053 refund; the United States appealed.

## Issues

1. Whether I.R.C. § 1041 applies to a corporate redemption of stock undertaken pursuant to a divorce property settlement, so that the redeeming spouse need not recognize gain.
2. Whether, under § 1041 and Temp. Treas. Reg. § 1.1041-1T, the redemption should be treated as an indirect transfer from the redeeming spouse to the other spouse incident to divorce, with the corporation’s payment treated as satisfying an assumed obligation.

## Decision

- The Ninth Circuit affirmed the judgment for Joann Arnes.
- The court held the redemption, as structured and incorporated into the divorce settlement, was treated as a transfer of property from Joann to John incident to divorce within § 1041.
- Because § 1041 applied, Joann did not recognize taxable gain on the redemption proceeds for the year at issue.

## Legal Principles

- Under I.R.C. § 1041(a), no gain or loss is recognized on a transfer of property to a spouse or former spouse if the transfer is incident to divorce.
- Temp. Treas. Reg. § 1.1041-1T broadly addresses divorce-related property transfers and can recharacterize certain third-party transactions, including corporate redemptions used to implement a divorce settlement, as transfers between spouses for § 1041 purposes.
- When a corporate redemption functions as a mechanism to complete a divorce property division, the tax consequences may be assigned consistent with the recharacterized interspousal transfer rather than treated as a taxable sale by the redeeming spouse.

## Conclusion

A corporate stock redemption carried out as part of a divorce property settlement may qualify as a nonrecognition transfer incident to divorce under I.R.C. § 1041, so the spouse whose shares are redeemed does not recognize gain when the transaction is properly treated as an indirect transfer to the other spouse under the temporary regulations.


Arnes v. United States, 981 F.2d 456 (9th Cir. 1992)