Arnes v. United States Arnes v. Commissioner Judges: Hug, Fay

Arnes v. United States Arnes v. Commissioner Judges: Hug, Fay 981 F.2nd 456 102 T.C. 522

Petra Durova

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John and Joann Arnes formed Moriah Corporation to operate McDonald’s franchise. They were the sole shareholders. 1987 couple agreed to divorce; McDonald’s Corporation required no joint ownership after divorce. Agreement to have Moriah redeem Joann’s 50% interest in the outstanding stock for $450,000. Moriah paid $178,042 in 1988 and reminder in monthly installments over 10 years. Agreement incorporated into decree of dissolution of the marriage in January 1988. Joann surrendered her 2,500 shares and Moriah cancelled her stock certificate and issued another 2,500 shares to John.

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On her Federal Income Tax return Joann reported receiving $178,042 in 1988. She treated $177,045 as a long-term capital gain and the reminder as recovery of portion of her basis. On December 1989, she filed a claim for refund of $53,053 for 1988 claiming she was not required to recognize any gain as the transfer was made pursuant to divorce instrument (§1041). IRS didn’t allow the claim for refund. Joann initiated suit.

The district court found that:  Redemption of stock required by divorce instrument, John Arnes benefited.  Although stock transferred directly to Moriah, it was made on behalf of John.  Following Section 1041, transfer qualified for nonrecognition of gain pursuant to exemption for transfers made to spouses due to divorce settlement.  Joann won.

Government appeals:  Joann does not qualify for 1041 as shares transferred to Moriah, not to John.  Although Joann should be taxed, if district court’s ruling upheld, John should be taxed on a dividend (or $450,000 would be taken out tax-free). Court held:  Moriah relieved John of obligation, constructive transfer to John.  District court’s ruling affirmed.

John has tax liability, sues in Tax Court Issue: Was Moriah’s redemption of Joann’s stock a constructive dividend to John?  According to Rev. Rul. 69-608, tax liability if obligation of remaining shareholder is both primary and unconditional.  Situation 5 in Rev. Rul. 69-608 supports Johns case.  Court concluded John’s obligation was not primary and unconditional.  Joann’s stock not a constructive distribution / dividend to John.

Conclusion: The courts ruled in favor of both Joann and John and $450,000 were taken out of Moriah Corporation tax-free.