Assignment 6—Reading Conflicting Court Cases
Question 1
0 167 MC 1 4
R ead Arnes, 93-1 USTC
¶50,016. This case involves a divorcing couple who were joint shareholders in a corporation that owned a
McDonald's franchise. McDonald's Corp. required 100% ownership of the franchise by the owner-operator.
Accordingly, following their divorce, only one spouse would be allowed to have a continuing interest in the
franchise. The couple agreed to have their corporation redeem the former wife's shares in the company,
leaving the franchise in the name of the former husband.
Generally speaking, the redemption of stock is a taxable transaction for both the corporation (if it uses
property to repurchase its own stock) and the shareholder. In this case, the corporation used cash to fund
the redemption, so there was no corporate gain. The question was which spouse would be taxed on the
transaction -- the wife, who received the proceeds, or the husband, who remained the sole shareholder of
the corporation. In this case, the court struggled with the application of Section 1041, which provides that
property settlements incident to divorce are not subject to taxation, and Section 302 providing that stock
redemptions are taxable to the shareholder. The District Court for the Western District of Washington held
that the redemption was not taxable to Joann Arnes, and the IRS appealed the decision to the 9th Circuit
Court of Appeals.
Read this case carefully. Which of the following best characterizes the 9th Circuit's conclusion in this case?
a. Because the wife transferred her stock to the corporation, rather than to John, the exception in
§1041 does not apply, and the wife must recognize gain on the redemption transaction.
b. Because the former husband became the sole owner of the corporation after the stock redemption,
he is the person who ultimately benefitted from the transaction, and he should be the one to pay
the resulting tax.
c. The wife's transfer of stock should be treated as a constructive transfer to the former husband in
exchange for cash plus a note receivable. Thus characterized, she is protected from recognition of
gain by IRC §1041.
d. The ex-husband did not receive a taxable benefit when the corporation redeemed his former wife's
fifty percent interest in corporate stock. The redemption did not discharge any obligation of the
husband, and did not benefit him in any sense. Therefore, the tax consequences should be borne
by the wife (Joann).
Question 2
1 169 MC 1 2
Now check the citator for
the Arnes case. Note that one of the cases that cites this one is Arnes, TC, Dec. 49,765, 102 TC 522.
This appears to be unusual. What is the issue in Arnes, 102 TC 522?
a. The IRS also assessed the husband with tax liability on the redemption. This citation is from his
case in the Tax Court.
b. The 9th Circuit remanded the case back to the Tax Court for further consideration. In rehearing
the case, the Tax Court cited the 9th Circuit's reasoning in remanding the case.
Question 3
2 171 MC 1 4
Read Arnes, TC, 102 TC.
The IRS, having previously lost its argument that JoAnn Arnes was responsible for the tax liability on
redemption of her stock by the corporation, now assessed John Arnes, her former husband, for the tax due.
The Tax Court ruled that John Arnes was also not taxable on the transaction. These two rulings would
appear to be in conflict with one another.
Which of the following conclusions would not be accurate with regard to the Tax Court's reasoning in the
John Arnes case?
a. The second Arnes case, dealing with the tax treatment of the ex-husband, is particularly significant
because it was heard en banc and the Tax Court judges unanimously agreed with the majority
opinion.
b. Although the 9th Circuit Court of Appeals stated, in Arnes, 93-1 USTC ¶50,016, that John Arnes,
the former husband, was responsible for paying tax on the transaction, rather than Joann, the Tax
Court determined that it was not obligated to reach this conclusion because the statement was
dictum. John Arnes' obligation to pay tax on the redemption was not at issue before the court (in
the 9th Circuit case).
c. The Tax Court, both in its majority opinion and in a concurring opinion, chided the IRS for not
consolidating the two Arnes cases and allowing both the Tax Court and the 9th Circuit Court of
Appeals to treat the two cases consistently.
d. Many of the Tax Court judges hearing this case believed that the Golsen doctrine required the Tax
Court to rule in favor of the IRS.
Question 4
3 173 MC 1 2
Check the citator for
John Arnes, 102 TC 522.
Did the IRS appeal the Tax Court's decision?
a. No. For reasons unknown, the IRS did not appeal the Tax Court's decision.
b. Yes.
Question 5
2 171 MC 1 4
Now read Carol M. Read
et al., 114 TC 14. In this case, the Tax Court was faced again with essentially the same question as in the
Arnes cases. Carol Read and her husband, William Read, divorced. In connection with the divorce, the
couple’s jointly owned corporation, Mulberry Motor Parts, redeemed Carol’s shares, leaving William as the
sole remaining shareholder of the corporation. In this case, Mr. Read argued that under the Tax Court’s
reasoning in John Arnes, 102 TC 522, he should not be taxable on the redemption of his former wife’s
shares because he did not have a “primary and unconditional obligation” to purchase her shares.
What did the Tax Court conclude in this case?
a. The Tax Court concluded that the redemption of shares owned by a spouse in connection with the
division of property in a divorce may be a transfer on behalf of the other spouse even if the other
spouse did not have a “primary and unconditional obligation” to purchase the redeemed shares.
b. The redemption by Mulberry Motor Parts of Carol Read’s shares in this case was nontaxable to Ms.
Read under Sec. 1041 of the IRC.
c. Ms. Read’s transfer of her Mulberry shares to the corporation in connection with the redemption
was made on behalf of William Read.
d. All of the above answers are correct.
Question 6
2 171 MC 1 4
Sticking with Read, Ms.
Read apparently argued that Mr. Read had a primary and unconditional obligation to purchase her shares
and that as a result, the redemption of those shares by the corporation constituted a transfer by her of
shares to the corporation on his behalf. As such, she would not be taxable on the exchange under §1041.
Which of the following conclusions is most accurate with regard to the Tax Court's decision in this case?
a. The Tax Court rejected Ms. Read’s argument that Mr. Read had a primary and unconditional
obligation to purchase her shares, but still ruled in her favor on the question of who should pay tax
on the redemption transaction.
b. The Tax Court agreed with her that the terms of the divorce decree placed a primary and
unconditional obligation on Mr. Read to purchase her shares, and that she was therefore exempt
from taxation under §1041.
c. The Tax Court did not address the question of whether Mr. Read had a primary and unconditional
obligation to purchase Ms. Read’s shares.
d. The Tax Court ruled that because the redemption of Ms. Read’s shares was made on Mr. Read’s
behalf, he must recognize constructive dividend income in an amount equal to the payment(s) to
Ms. Read.
Question 7
The Tax Court distinguished Read from Blatt, 102 TC 77. In Blatt, the Tax Court ruled that Ms. Blatt, who
also received corporate payments in redemption of her shares in a jointly owned corporation, realized a
taxable gain on the exchange. Explain how the facts differed between these two cases. (Your answer should
be a single paragraph and should focus on the significant factual differences.
Question 8
Finally, explain in two paragraphs at most, what advisors should recommend to divorcing clients in similar
cases. For example, assume divorcing clients whose assets are heavily invested in a jointly owned
corporation. The only option for a reasonable division of property is to withdraw funds from the corporation.
What advice should we have for such clients?