If you’re getting a divorce, you know it’s a highly stressful time. But if you’re a business owner, tax issues can complicate matters even more. Your business ownership interest is one of your biggest personal assets. And of the interest, your marital property will include all or part of it. It’s imperative to thoroughly go over dividing a business in a divorce with a professional.
When dividing a business in a divorce, you can generally divide most assets. This is including cash and business ownership interests, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. When an asset falls under this 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).
For example, let’s say that, under the terms of your divorce agreement, you give your house to your spouse in exchange for keeping 100% of the stock in your business. That 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. This is as long as they’re made “incident to divorce.” This means transfers that occur within:
Eventually, there will be tax implications for the receiving tax-free assets in a divorce settlement. The ex-spouse who winds up owning an appreciated asset generally must recognize taxable gain when it’s sold, unless an exception applies. This is specifically when the fair market value exceeds the tax basis.
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 from the family business transfer of ownership or shares. Your ex will continue to apply the same tax rules as if you had continued to own the shares. This is including carryover basis and carryover holding period. When your ex-spouse ultimately sells the shares, he or she will owe any capital gains taxes. You will owe nothing.
Note that 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. That’s why you should always take taxes into account when dividing a business in a divorce and negotiating your agreement.
In addition, the IRS now extends the beneficial tax-free transfer rule to ordinary-income assets, not just to capital-gains assets. For example, say you transfer business receivables or inventory to your ex-spouse in divorce. These types of ordinary-income assets can also get a tax-free transfer. When the asset is later sold, converted to cash or exercised (in the case of non-qualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.
Like many major life events, divorcing a small business owner can have major tax implications. For example, you may receive an unexpected tax bill. This generally happens if you don’t carefully handle dividing a business in a divorce regarding qualified retirement plan accounts and IRAs. And if you own a business, the stakes are higher. Our team of professional CPA experts can help you minimize the adverse tax consequences of settling your divorce under today’s laws.