Blatt v. Commissioner, 102 T. C. 77 (1994)

A stock redemption incident to divorce is not tax-free under Section 1041 unless it is on behalf of the non-redeeming spouse.

Summary

In Blatt v. Commissioner, the U. S. Tax Court ruled that a stock redemption pursuant to a divorce decree was taxable to the redeemed spouse unless it directly benefited the non-redeeming spouse. Gloria Blatt’s shares in a jointly owned corporation were redeemed for cash as part of her divorce settlement. The court held that this transaction was not a transfer ‘on behalf of’ her ex-husband under Section 1041, thus she must recognize the gain from the redemption. The decision clarified that any benefit to the non-redeeming spouse, such as relief from potential marital property claims, does not suffice for nonrecognition treatment under Section 1041. This case distinguished itself from the Ninth Circuit’s Arnes decision, refusing to apply its broader interpretation of ‘on behalf of’ to the facts at hand.

Facts

Gloria T. Blatt and her husband, Frank J. Blatt, owned Phyllograph Corp. equally. As part of their divorce finalized in 1987, the divorce decree ordered the corporation to redeem Gloria’s shares within ten days for $45,384. The redemption occurred on July 16, 1987. Gloria did not report this income on her 1987 tax return, asserting it was non-taxable under Section 1041. The Commissioner of Internal Revenue determined a deficiency in her 1987 taxes, arguing the redemption was taxable to her.

Procedural History

Gloria Blatt petitioned the U. S. Tax Court for a redetermination of the deficiency. The case was submitted without trial, based on pleadings and a joint stipulation of facts. The Tax Court issued its opinion on January 31, 1994, ruling that the stock redemption was taxable to Gloria Blatt.

Issue(s)

1. Whether the redemption of Gloria Blatt’s stock by Phyllograph Corp. , pursuant to a divorce decree, is a transfer ‘on behalf of’ her ex-husband under Section 1041, making it non-taxable to her.

Holding

1. No, because the redemption was not a transfer ‘on behalf of’ Frank J. Blatt. The court found no evidence that the redemption satisfied any obligation of Frank, and thus it did not fall under the nonrecognition provisions of Section 1041.

Court’s Reasoning

The Tax Court applied the regulations under Section 1041, specifically Q&A 9 of the Temporary Income Tax Regulations, which allows for nonrecognition of gain if the transfer to a third party is ‘on behalf of’ a spouse or former spouse. The court determined that Gloria’s redemption of her shares was not ‘on behalf of’ Frank because it did not discharge any obligation of his. The court rejected the broader interpretation of ‘on behalf of’ from Arnes v. United States, which considered any benefit to the non-redeeming spouse sufficient for nonrecognition. The court noted that Michigan, where the Blatts resided, is not a community property state, further distinguishing the case from Arnes. The majority opinion emphasized that without evidence of a direct obligation satisfied by the redemption, the transaction was taxable to Gloria. The court also highlighted the policy of Section 1041 to treat spouses as one economic unit, deferring gain recognition until property is transferred outside this unit.

Practical Implications

This decision impacts how stock redemptions in divorce settlements are treated for tax purposes. It clarifies that for a redemption to qualify for nonrecognition under Section 1041, it must directly benefit the non-redeeming spouse by discharging their obligation. Practitioners must carefully structure divorce agreements to ensure that any corporate redemption of stock explicitly satisfies an obligation of the non-redeeming spouse to avoid unexpected tax liabilities. This case also highlights the importance of jurisdiction, as state property laws can influence tax outcomes. Subsequent cases have cited Blatt to distinguish it from situations where a redemption did satisfy a spouse’s obligation, and it serves as a reminder of the narrow interpretation of ‘on behalf of’ under Section 1041.