By Alex Krasnomowitz and Rory Gannon of Smolin, AAML NJ Gold Sponsor
A business owner’s ownership interest is often one of their most significant personal assets. Many business owners are surprised to learn that the courts consider some or all of it marital property. Tax issues related to the family business can complicate divorce matters, often to a far greater degree than owners anticipate.
Following a divorce, most assets can be divided between the business owner and their soon-to-be ex-spouse without any federal income or gift tax consequences. These tax-free transfer rules cover cash and business ownership interests.
Suppose the business owner’s spouse receives an asset under this rule. In that case, they inherit the tax basis (for tax gain or loss purposes) and its current holding period (for short-term or long-term holding period purposes) from the other spouse. In other words, the spouse who winds up with the asset will have the same tax liability as they would have had if they had been the one to own the asset from the beginning.
Say, for example, that a business owner swaps their share of the house in exchange for keeping 100% of the stock in their business. This type of transfer would be tax-free, and the existing basis and holding periods for the stock and house would carry over to the person who receives them.
This kind of transfer appeals to many business owners because their business is their source of pride and income. Most business owners have put in a lot of effort and sleepless nights to build or grow their business. They are often justifiably proud of what they’ve created.
Additionally, for small business owners, finding and keeping good employees can be a severe difficulty. This challenge often provides an extra incentive not to rock the boat by involving a soon-to-be ex-spouse in the business.
The tax-free federal transfer rule for the existing basis and holding period applies during a divorce or when it becomes final. It can also apply after the divorce, so long as changes are made “incident to divorce”—meaning that the transfer must occur within a year of when the marriage ends or within six years of the marriage ending if the transfers are made under the divorce agreement.
Additionally, the tax-free transfer rule is now extended to ordinary-income assets, not just to capital-gains assets. If a business owner transfers receivables or inventory to their ex-spouse in a divorce, the transfer is tax-free.
Tax implications down the road
However, while assets can be transferred tax-free during the divorce, that doesn’t mean they won’t be taxed ever. The person who winds up owning an appreciated asset (an asset for which the fair market value exceeds the tax basis) must recognize taxable gain if and when the asset gets sold.
For instance, if the business owner’s ex-spouse ends up owning a percentage of their highly appreciated small business stock, the ex-spouse won’t face any tax consequences when they initially receive the shares. Instead, it will be as if they owned the shares all along. That said, when the ex-spouse ultimately sells the shares, they’ll owe capital gains tax. Since the business owner no longer owns those shares, they won’t owe anything.
Thus, the person who winds up owning the appreciated assets must pay the built-in tax liability when they decide to sell them.
If you factor capital gains tax into the overall value of the appreciated assets, then their value isn’t the same as an equal amount of cash or assets that haven’t been appreciated. This net-of-tax perspective matters immensely for any business owner negotiating a divorce settlement.
Note that the same net-of-tax perspective would apply to any ordinary-income assets held or transferred during the divorce. 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.
Helping clients avoid surprises
For many people, getting divorced can feel like taking on an extra job. The legal process can make significant demands on a business owner's time, their most precious asset. However, it’s vitally essential for a divorce client to plan.
If you’re handling a divorce case that requires careful tax considerations around a business’s appreciated value or if you have questions about the process, the experienced professionals at Smolin Lupin can assist you—get in touch.