Getting a divorce is a stressful time for anyone. Business owners going through a divorce should pay special attention to tax issues that could complicate matters of divorce. Business ownership is likely one of your most significant personal assets, and marital property will include all or part of this ownership.
Transferring property tax-free
Most assets, including cash and business ownership interests, can be divided without any federal income or gift tax consequences. This tax-free transfer rule requires that the spouse receiving the asset takes over the existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).
For example, if under the terms of your divorce agreement your home is given to your spouse in exchange for keeping 100% of the stock in your business; the swap of assets would be tax-free. The existing basis and holding periods for the home and stock would carry over to the spouse receiving them.
Tax-free transfers can occur both before the divorce or at finalization. Tax-free treatment continues to apply to postdivorce transfers so long as they are made “incident to divorce.” Incident to divorce transfers must occur within either:
- One year after the date the marriage ends, or
- Six years after the date the marriage ends if the transfers are made pursuant to the divorce agreement.
Future tax implications
Assets received in a tax-free divorce settlement will eventually have tax implications. The ex-spouse receiving an appreciated asset (when the fair market value exceeds the tax basis) will generally need to recognize taxable gain when it is sold (unless an exception applies).
Under the tax-free transfer rule, there is no tax impact when partial shares of a small business stock are transferred to an ex-spouse. If over 49% is shared with the ex-spouse, the same tax rules will apply as would if you had continued to own all the shares, including carryover basis and carryover holding period. When your ex-spouse sells the shares, he or she will owe any capital gains taxes. You will owe nothing.
The person who owns up with appreciated assets is responsible for paying the built-in tax liability associated with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that don’t appreciate. Taxes should always be taken into account in a divorce agreement.
The IRS now extends the beneficial tax-free transfer rule to ordinary-income assets, not just to capital-gain assets. For example, transfers of business receivables or inventory to an ex-spouse in a divorce can be transferred tax-free as ordinary-income assets. When the asset is later sold, converted to cash, or exercised (in the case of nonqualified stock options), the owner of the asset at the time must recognize the income and pay the tax liability.
Avoid adverse tax consequences
Divorce can have major tax implications. For example, if you don’t carefully handle the splitting of a qualified retirement plan accounts (such as a 401(k) plan and IRAs, you could receive an unexpected tax bill. Business owners have more tax consequences to consider.
We can help you minimize the adverse tax consequences of divorce under current laws. Contact us at 818-334-8623 or click here, and we will contact you.