A business owner going through a divorce has an added source of anxiety beyond dealing with the end of their relationship, whether the process is acrimonious or not. Depending on when the business was formed, and in the absence of any legal agreement that establishes their ownership interest as separate property, the spouse can have a community property interest in the business, even if they were not directly involved in creating or running it. In such cases, some or all of the business’ value may be subject to division in the divorce.
It’s rarely the case that spouses who have chosen to go their separate ways would choose to remain business partners. More often, one spouse wants to walk away with full ownership of the business and is willing to trade their share of other community assets to get it. Before they reach any agreement, however, business owners and their spouses should consult financial and legal professionals to ensure they understand the potential tax consequences of their choices.
- Tax-Free Transfers of Property Incident to Divorce
- Business Valuation and Divorce Tax Implications
- Business Income, Alimony, and Taxes
Unsure How Divorce Might Affect the Future of Your Business?
Tax-Free Transfers of Property Incident to Divorce
Business ownership interests, like most other kinds of assets, can be transferred between former spouses without a gain or loss being recognized if the transfer is considered incident to the divorce. Generally, this rule applies to transfers made within a year of the end of the marriage or up to six years afterward if the transfer is pursuant to the couple’s divorce agreement. No immediate capital gains or gift tax would be owed for receiving a portion of those ownership interests or for receiving other assets in lieu of a share in the business instead.
In such transfers, the assets in question will retain their existing cost basis and holding period, and the recipient will be responsible for any tax owed on the proceeds when selling the property. For example, a spouse who receives a share of appreciated business stock from their ex in the divorce and then sells it years later for a profit will have to pay the capital gains tax. This future potential tax liability must be considered in property division, especially when one spouse is attempting to buy the other out of their share of business interests, as assets that may seem to be of equal value at the time of the divorce may turn out not to be so if they’re subject to a high tax bill later.
Business Valuation and Divorce Tax Implications
For closely held businesses, even determining what the business is worth can become a matter of contention. Unlike when a business is to be sold, determining business valuation for a divorce is most likely to rest on a combination of looking at the value of the assets it holds (including intangible assets such as intellectual property), minus its costs and liabilities, and of the income it generates. Because this figure has implications for both property division and any support payments, errors in valuation can result in unfair distributions and an unfair allocation of future tax burdens.
One potential issue can arise is when the income approach is used to produce a valuation estimate. If the owner has been paying themselves a higher-than-market-value income for their role, an appraiser may adjust it downward for valuation purposes, with the surplus being considered business profits. That boosts the value of the business, making the share the non-owner spouse is entitled to in property division more valuable as well. If the higher actual salary is used to calculate alimony and/or child support payments, then the difference between the actual salary and the market rate salary has effectively been used twice, financially penalizing the business-owning spouse.
Bringing in a third-party evaluator to produce an independent assessment of the business’ worth will help provide a mutually agreed-upon foundation to start negotiations for property division. Examining their methods can also guard against assumptions that may financially favor one spouse over the other.
Business Income, Alimony, and Taxes
As of 2019, due to the passage of the Tax Cuts and Jobs Act in 2017, alimony can no longer be used to claim a federal tax deduction. However, the payer can deduct alimony payments on their California state income tax forms. The recipient of spousal support is not required to report the payments on their federal taxes but must include them as income for California state taxes. This adds to the importance of ensuring that the business income used to calculate support awards is accurate, because the business-owning spouse will also owe federal income taxes on alimony.
Protecting Your Business in Divorce in Northern California
Unexpected taxes for divorcing business owners can come as a shock in a situation that is already stressful and emotional. If you’re unsure of what impact divorce might have on the future of your business or your long-term financial well-being, the experienced family law attorneys at Hoover Krepelka are the resource you need to get answers. We can help you anticipate potential tax issues, work with the right experts to get an accurate valuation for your business, and negotiate on your behalf for a fair settlement agreement. To schedule a consultation, fill out the form below.
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