Business Tax Issues to Consider When Small Owners Get Divorced
For many small business owners, their ownership interest is one of their biggest personal assets. What will happen to your ownership interest if you get divorced? In many cases, your marital estate will include all (or part) of your business interest.
Sometimes, divorcing spouses continue to participate in the business's operations after the divorce settles, and then both spouses retain an ownership interest in the business. But, more commonly, former spouses are unable to effectively co-manage the business. So, one spouse retains a controlling interest and the other spouse 1) retains a passive stake in the business, 2) is bought out, or 3) is allocated other marital assets in a property settlement agreement.
How a marital estate is divvied up can have significant tax consequences. Here's what you need to know to get the best tax results.
Tax-Free Transfer Rule
In general, you can divide most assets, including cash and ownership interests in a business, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. When an asset falls under the tax-free transfer rule, the spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).
To illustrate how this works, suppose that, under the terms of your divorce agreement, you give your primary residence to your ex-spouse in exchange for keeping all the stock in your small business. This asset swap would be tax-free. And the existing basis and holding periods for the home and the stock would carry over to the person who receives them.
Tax-free transfers can occur before the divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they're made incident to divorce. Transfers incident to divorce are those that occur within:
•A year after the date the marriage ends, or
•Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.
In recent years, the IRS has extended the beneficial tax-free transfer rule to ordinary-income assets, not just to capital-gain assets. For example, if you transfer business receivables or inventory to your ex-spouse in divorce, these types of ordinary-income assets also can be transferred tax-free. When the asset is later sold, converted to cash or exercised (in the case of nonqualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.
Tax Implications of Tax-Free Transfers
Eventually, there will be tax implications for assets received tax-free in a divorce settlement. The ex-spouse who winds up owning an appreciated asset — where the fair market value exceeds the tax basis — generally must recognize taxable gain when it's sold, unless an exception applies.
For example, if you qualify for the principal residence gain exclusion break, you can exclude up to $250,000 of gain from your federal taxable income, or up to $500,000 of gain if you file a joint return with a future spouse.
What if your ex-spouse receives 49% of your highly appreciated small business stock? Thanks to the tax-free transfer rule, there's no tax impact when the shares are transferred. Your ex continues to apply the same tax rules as if you had continued to own the shares, including carryover basis and carryover holding period. When your ex ultimately sells the shares, he or she (not you) will owe any resulting capital gains taxes.
Important: The person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven't appreciated. Always take taxes into account when negotiating your divorce agreement.
Splitting Up Qualified Retirement Plan Accounts
Many business owners set up qualified retirement plans, such as a profit-sharing, 401(k) or defined benefit pension plan. A percentage of the account balance or plan benefits may need to be transferred to your ex-spouse as part of the divorce property settlement.
To execute a transfer without owing taxes on amounts that go to your ex, you must use a qualified domestic relations order (QDRO). In effect, the QDRO causes your ex-spouse to become a co-beneficiary of your retirement account. The tax advantage comes from the fact that the QDRO also makes your ex responsible for the income taxes on retirement account money that he or she receives in the form of account withdrawals, a pension or an annuity. In other words, the QDRO causes the tax bill to follow the money.
The QDRO also allows your ex to withdraw his or her share of the retirement account balance and roll the money over tax-free into his or her own IRA (to the extent such withdrawals are permitted by your plan's terms). The rollover strategy allows your ex to take over management of the money while continuing to postpone taxes until funds are withdrawn from the rollover IRA. When your ex withdraws funds from the rollover IRA, he or she (not you) will owe the related income taxes.
Warning: Without a QDRO, money that's transferred from your qualified retirement plan account to your ex-spouse is treated as a taxable distribution to you. So, your ex gets a tax-free windfall at your expense. To add insult to injury, you may also owe the 10% early withdrawal penalty tax on money that goes to your ex before you've reached age 59½.
Splitting Up IRAs
You don't need a QDRO to obtain an equitable tax outcome when you turn over IRA funds to your ex under your divorce agreement. This includes money held in SEP accounts, SIMPLE IRAs, traditional IRAs and Roth IRAs. QDROs are only relevant in the context of qualified retirement plans.
However, with IRAs, you still must be careful to avoid getting taxed on money that goes to your ex. The key to a tax-free transfer is to specifically order the transfer in your divorce or separation instrument. For this purpose, the tax code narrowly defines a divorce or separation instrument as a "decree of divorce or separate maintenance or a written instrument incident to such a decree."
A transfer that meets this requirement can be arranged as a tax-free rollover of the applicable amount from your IRA into an IRA set up in your ex-spouse's name. Your ex can then manage the money in the rollover IRA as he or she sees fit and can continue to defer taxes until withdrawals are taken. Any future income taxes are paid by your ex (not you).
Important: When it comes to IRA transfers, don't jump the gun. If you voluntarily give your ex-spouse some IRA funds before it's required under a divorce or separation instrument, it will be treated as a taxable distribution to you. If a taxable distribution occurs before you're 59½, you also may be hit with the 10% early withdrawal penalty.
New Treatment for Alimony Payments
Allocating marital assets is just one part of settling your divorce. Deciding on maintenance payments is another critical component.
The Tax Cuts and Jobs Act (TCJA) permanently disallows deductions for alimony payments required by divorce agreements signed after December 31, 2018. Such payments are federal income-tax-free to the recipient. Under prior law, payers could deduct alimony, and recipients had to include alimony in their taxable income.
This recipient-favorable change should be taken into account when negotiating divorce agreements — and when drafting prenuptial agreements in the future.
Like any major life event, divorce can have major tax implications, especially if you own a private business interest. Your tax advisor can help you minimize the adverse tax consequences of settling your divorce under today's laws.