Farid-Es-Sultaneh v. Commissioner: Tax Basis Rules
Learn how relinquishing marital rights in a prenuptial agreement establishes a property's tax basis, a rule distinct from transfers made during marriage.
The case Farid-Es-Sultaneh v. Commissioner is a significant decision in U.S. tax law that addressed how to determine the cost basis of property transferred as part of a prenuptial agreement. The ruling provided clarity on the financial starting point for assets received by a prospective spouse who, in return, relinquishes marital rights. This outcome established a lasting principle for pre-marital financial settlements.
Factual Background of the Case
The case involved S.S. Kresge, the founder of the S.S. Kresge Company that later became Kmart, and his fiancée, Farid-Es-Sultaneh. Before their marriage in 1924, the couple entered into a prenuptial agreement. At the time, Kresge’s fortune was estimated at $375,000,000.
As part of their arrangement, Kresge transferred a substantial block of Kresge Company stock to Farid-Es-Sultaneh. In return for this transfer, she agreed to release all marital rights she would otherwise acquire, including dower rights and any potential claims against his estate.
The couple’s marriage ended in divorce in 1928. Years later, in 1938, Farid-Es-Sultaneh sold shares of the Kresge stock she had received. This sale led to the tax dispute with the Commissioner of Internal Revenue.
The Central Tax Dispute
The legal conflict revolved around calculating the taxable gain from Farid-Es-Sultaneh’s 1938 stock sale, which depended on establishing the correct tax basis. The tax basis is the value from which any capital gain or loss is measured upon the sale of an asset. The Commissioner of Internal Revenue argued that the stock transfer was a gift, requiring Farid-Es-Sultaneh to use a “carryover basis.” This would set her basis at S.S. Kresge’s original cost of $0.159 per share, resulting in a large taxable gain.
Conversely, Farid-Es-Sultaneh contended that the stock was not a gift but was acquired through a purchase. She argued that by relinquishing her marital rights, she provided legal consideration for the stock. Therefore, her basis should be the fair market value (FMV) of the shares at the time she received them, which was $10.66 per share. The case hinged on whether the prenuptial transfer was a gift or a purchase for income tax purposes.
The Court’s Ruling and Rationale
The U.S. Court of Appeals for the Second Circuit sided with Farid-Es-Sultaneh, reversing a lower court’s decision. The court’s ruling established that the stock transfer was not a gift for income tax purposes but rather a purchase. The court’s rationale centered on the concept of “consideration.”
It determined that Farid-Es-Sultaneh’s relinquishment of her marital rights, such as dower and other claims to Kresge’s estate, constituted valid consideration. These rights had significant value, and by giving them up, she was actively exchanging something of value for the stock, not passively receiving a gift.
Because she had “purchased” the shares by trading her marital rights, the court reasoned that her basis in the stock should be its cost to her. This cost was determined to be the fair market value of the stock on the date of the transfer. The court distinguished this situation from a true gift, which lacks such a bargained-for exchange and is characterized by donative intent.
Tax Implications of the Decision
The Farid-Es-Sultaneh decision created a lasting tax principle for property transfers made under prenuptial agreements. The ruling established that when an individual receives property before marriage in exchange for giving up marital rights, they are treated as a purchaser for tax purposes.
The primary consequence is the determination of the recipient’s cost basis in the transferred property. The basis is not the transferor’s original cost, but rather the fair market value of the property at the time of the transfer. This “stepped-up” basis reduces the amount of taxable capital gain if the recipient later sells the asset.
The gain is calculated as the difference between the sale price and this higher basis. This principle specifically applies to transfers executed before the marriage takes place, as the transaction is viewed as an arm’s-length negotiation.
Modern Context and Section 1041
While the Farid-Es-Sultaneh ruling remains relevant for pre-marital transfers, its application has been significantly narrowed by subsequent legislation. In 1984, Congress enacted Internal Revenue Code Section 1041, which established different rules for property transfers that occur between spouses or are incident to a divorce.
Under Section 1041, transfers of property between spouses or former spouses are treated as gifts for income tax purposes. This means no gain or loss is recognized by the transferor at the time of the transfer. The recipient of the property takes a carryover basis, meaning their basis is the same as the transferor’s adjusted basis. This postpones any tax on the asset’s appreciation until the recipient spouse eventually sells it.
This creates an important distinction for tax planning. The rule from Farid-Es-Sultaneh, which allows for a basis equal to fair market value, applies to property transfers made via a prenuptial agreement before the marriage begins. In contrast, the Section 1041 rule governs transfers that happen during the marriage or as part of a divorce settlement. A transfer is considered incident to divorce if it occurs within one year of the divorce date or is related to the cessation of the marriage.