Arnes v. U.S.

• Decision Date: 11 December 1992
• Docket Number: No. 91-35752,91-35752
• Citation: 981 F.2d 456
• Parties: -369, 93-1 USTC P 50,016 Joann C. ARNES, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 456

981 F.2d 456

71 A.F.T.R.2d 93-369, 93-1 USTC P 50,016

Joann C. ARNES, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 91-35752.

United States Court of Appeals Ninth Circuit.

Argued and Submitted Oct. 9, 1992.

Decided Dec. 11, 1992.

Charles Bricken, U.S. Dept. of Justice, Tax Div., Washington, DC, for defendant-appellant.

Margo T. Keller and Paul A. Tonella, Lasher, Holzapfel, Sperry & Ebberson, Seattle, WA, for plaintiff-appellee.

Appeal from the United States District Court for the Western District of Washington.

Before: HUG, FLETCHER, and BRUNETTI, Circuit Judges.

HUG, Circuit Judge:

The issue in this case is whether a taxpayer must recognize for income tax purposes the gain that she realized when, pursuant to a divorce settlement, a corporation redeemed her half of the stock in the corporation, the remaining stock of which was owned by her former husband. The district court, ruling on cross-motions for summary judgment, held that Section 1041 of the Internal Revenue Code of 1986 (I.R.C.) relieved the taxpayer of having to recognize the gain, and awarded the taxpayer a refund of $53,053 for 1988.

The district court had jurisdiction over the taxpayer's claim pursuant to 28 U.S.C. § 1346(a)(1) (1988). We have jurisdiction over the Government's timely appeal pursuant to 28 U.S.C. § 1291 (1988). We affirm.

I.

Joann Arnes, the Taxpayer-Appellee, married John Arnes in 1970. In 1980, they formed a corporation, "Moriah," to operate a McDonald's franchise in Ellensburg, Washington. That corporation issued 5,000 shares of stock in the joint names of John Arnes and Joann Arnes. In 1987, the couple agreed to divorce. McDonald's Corporation required 100% ownership of the equity and profits by the owner/operator, and informed John Arnes that there should be no joint ownership of the restaurant after the divorce.

Joann and John Arnes entered into an agreement to have their corporation redeem Joann Arnes' 50 percent interest in the outstanding stock for $450,000. The corporation would pay that money to Joann Arnes by forgiving a debt of approximately $110,000 that she owed the corporation, by making two payments of $25,000 to her during 1988, and by paying the remainder of approximately $290,000 to her in monthly installments over ten years beginning in February 1988. The agreement was incorporated into the decree of dissolution of the marriage, dated January 7, 1988. Joann Arnes surrendered her 2,500 shares to the corporation on December 31, 1987, and the corporation cancelled her stock certificate on May 4, 1988, then issuing another 2,500 shares to John Arnes.

On her federal income tax return for 1988, Joann Arnes reported that she sold her stock in Moriah on January 2, 1988, for a price of $450,000, and that her basis was $2,500, resulting in a profit of $447,500. She received $178,042 in 1988 as part of the sales price. Using an installment method, she treated $177,045 as long-term capital gain and the remainder as recovery of a portion of her basis.

On December 27, 1989, she filed a timely claim for refund of $53,053 for 1988 on the ground that she was not required to recognize any gain on the transfer of her stock because the transfer was made pursuant to a divorce instrument. The IRS did not allow the claim for refund, and Joann Arnes initiated this suit.

The district court found that the redemption of Joann Arnes' stock in Moriah was required by a divorce instrument, and that John Arnes had benefitted from the transaction because it was part of the marital property settlement, which limited future community property claims that Joann Arnes might have brought against him. The court, in applying the IRS regulations, found that, although Joann transferred her stock directly to Moriah, the transfer was made on behalf of John and should have been treated as having been made to John. Therefore, the transfer qualified for nonrecognition of gain pursuant to the I.R.C. exemption for transfers made to spouses or former spouses incident to a divorce settlement. See 26 U.S.C. § 1041 (1988). Summary judgment was granted in favor of Joann Arnes.

The Government appeals. Meanwhile, in order to insure that the capital gain will be taxed, the Government has asserted a protective income tax deficiency against John Arnes, who has contested the deficiency by filing a petition with the Tax Court. His case is pending but not before this court. The Government maintains that, although Joann Arnes is the appropriate party to be taxed for the gain, John Arnes should be taxed if the district court's ruling is upheld. If neither John nor Joann is taxed, the $450,000 used to redeem Joann's appreciated stock apparently will be taken out of the corporation tax-free.

II.

A grant of summary judgment is reviewed de novo. T.W. Elec. Serv., Inc. v. Pacific Elec. Contractors Ass'n, 809 F.2d 626, 629 (9th Cir.1987).

III.

The Government contends that the gain resulting from Moriah's redemption of Joann Arnes' stock does not qualify for exemption under section 1041, which is limited to transfers made directly to one's spouse or former spouse, or transfers made into trust for that person. Joann Arnes' transfer to Moriah, the Government contends, is outside the scope of the exemption.

Joann Arnes contends that her transfer of stock to Moriah should be considered a transfer to John, resulting in a benefit to John, and absolving her of the obligation to bear the burden of any resulting tax.

Section 1041 provides in part:

(a) General rule. No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)--

(1) a spouse, or

(2) a former spouse, but only if the transfer is incident to the divorce.

(b) Transfer treated as gift; transferee has transferor's basis. In the case of any transfer of property described in subsection (a)--

(1) for purposes of this subtitle, the property shall be treated as acquired by the transferee by gift, and

(2) the basis of the transferee in the property shall be the adjusted basis of the transferor.

26 U.S.C. § 1041 (1988) ("Transfers of property between spouses or incident to divorce").

The purpose of the provision is to defer the tax consequences of transfers between spouses or former spouses. See H.R.Rep. No. 432, Pt. II, 98th Cong., 2d Sess. 1491 (1984), reprinted in 1984 U.S.Code Cong. & Admin.News 697, 1134 ("a husband and wife are a single economic unit"). Property received in such a transfer is excluded from the recipient's gross income. The recipient's basis is then equal to the transferor's basis. 26 U.S.C. § 1041(b)(2) (1988). Later, when the recipient transfers the property to a third party, the gain or loss must be recognized.

After section 1041 was enacted, the Treasury Department published a temporary regulation to implement the statute. Temp.Treas.Reg. § 1.1041-1T (1992). The regulation explains that in certain cases a transfer of property to a third party "on behalf of" a spouse or former spouse should be treated as a transfer to the spouse or former spouse. Id. at Q-9, A-9. One example supplied in the regulation is the case where the transfer to the third party is required by a divorce or separation instrument. Such a transfer of property

will be treated as made directly to the nontransferring spouse (or former spouse) and the nontransferring spouse will be treated as immediately transferring the property to the third party. The deemed transfer from the nontransferring spouse (or former spouse) to the third party is not a transaction that qualifies for nonrecognition of gain under section 1041.

Temp.Treas.Reg. § 1.1041-1T, A-9 (1992).

The example suggests that the tax consequences of any gain or loss arising from the transaction would fall upon the nontransferring spouse for whose benefit the transfer was made, rather than upon the transferring spouse. Consistent with the policy of the statute, which is to defer recognition until the property is conveyed to a party outside the marital unit, the regulation seems to provide for shifting the tax burden from one spouse to the other, where appropriate.

Thus, a transfer by a spouse to a third party can be treated as a transfer to the other spouse when it is "on behalf of" the other spouse. Whether the redemption of Joann's stock can be...