What should I do to protect my finances now that we have filed for divorce?

If you are the person who asked for a divorce, you may be surprised by the emotional chasm between yourself and your spouse and how long the process is taking. You spouse may be shocked, hurt and feel confused by your decision and it can take time for your spouse to engage in the divorce process or “catch up”. Many of my clients are frustrated by this delay, but there are still steps you can take to prepare yourself for what happens next. Here are five financial steps that you should do after you file:

1.    Set up a divorce notebook.  Use a binder or file folder that have sides to them so that when you lift up the file, things don’t fall out the sides. There can be a lot of paper generated during your divorce and having those papers organized allows you to be more prepared and less disoriented.

2.    Open individual bank account(s) in your name. New accounts often have more restrictions such as deposit holds. The sooner you can start a history with a bank, credit union or other financial institution, the sooner you will establish credibility with that institution. These are accounts in your name individually, and minimally you need a checking account and a savings account.

3.    Apply for a credit card in your name. If you have kept your credit cards separate, then you already have individual accounts. If you’ve been operating your credit cards as joint accounts, however, you want to have an account in your name. If you’re not sure if you’ll qualify, then get your FICO credit score first.  Remember that whenever you apply for a credit card, you get an inquiry on your credit report.  

4.  Scan financial statements and documents. You’ll want to get into the habit saving and downloading any financial statements that you receive so that you have them at hand, or file them in your divorce file for easy access. These documents include investment and bank statements, tax returns (most recent two years), debt statements, social security reports (usually received before your birthday), and any other statements that have to do with assets and liabilities (debts).

5.    Get your credit report and credit score.  Your credit score will give you information about what your credit options are, and the credit report will let you know which of your existing credit cards are joint vs. individual, as well as letting you see if there are any financial items you don’t recognize.

You can contact me at Amanda@gordonfamilylaw.com for more information.

Stock Benefits – How are they divided at divorce and who pays the Taxes?

Experienced Bay Area family law attorneys can help answer questions regarding stock options, RSUs, and ESOPs. This is one of the most common assets in family law cases in the Bay Area. We encourage you to reach out to Gordon Family Law to have a full analysis of your situation, as each company plan is unique. We often find that clients and even professionals face confusion and difficulty when explaining these plans to the court and the other spouse. We encourage you to speak to a professional about your options early in the process as the financial and tax consequences can shift based on timing.  

What is a stock option benefit? Stock options to purchase a share of a company are sometimes granted to employees to provide financial incentive in the future growth of the company.

A stock option gives you or your spouse the right to purchase a specified number of shares of Common Stock at a fixed price per share (the “exercise price”) payable at the time the option is exercised.

How do I find out what options my spouse has?

The general terms governing all option grants are set forth in a document called the Company Plan.  The exact terms of the options, including (i) the type of option, (ii) the number of shares of Common Stock you may purchase, (iii) the exercise price per share and (iv) vesting schedule, can be found in either the Company Plan or the Grant Letter/Award Agreement.

How do I find out what my spouse’s stock options are worth?

The exercise price per share is generally a number by the Company Board and is typically equal to the fair market value per share of Common Stock on the date of the option grant. The exercise price will be fixed for the life of the option even if the value of the Common Stock increases or decreases in the future.  

If the company is not public, the “Fair Market Value” of the Stock on any given date is the fair market value of the Stock determined in good faith by the Company Board based on the reasonable application of a reasonable valuation method not inconsistent with Section 409A.  You should ask for your companies most recent 409A valuation.

When an option is “exercised,” the employee purchase shares of Common Stock by paying the exercise price for those shares to the Company.

Often, the shares of Common Stock purchasable under the option are subject to vesting provisions.  A stock options “vest” over time, meaning the employee must continue to work for the Company in order to “earn” the right to exercise stock options and keep the shares acquired upon the exercise of stock options. 

The employee may not exercise any portion of stock options until that portion has vested, unless the Award Agreement provides otherwise with an early exercise program.  The shares subject to the option will typically vest in installments over a period of years.  We commonly see vesting over a four-year period, with 25 percent of the shares vesting upon completion of one year of service measured from the grant date, and the remaining shares vesting in equal monthly installments over the next 36 months.

Stock options permit an employee to pay a price equal to the fair market value of the stock on the date they were granted. Generally, the stock will be purchased at a future date when, presumably, the price of the stock will have increased.   

What are the types of stock options that my spouse may have?

There are two types of stock options:

1.     Qualified Option - Incentive Stock Option (ISO). These are the “best” types of options because if certain requirements are met, ISOs are given special tax treatment unless they are ‘disqualified’ ISOs.

2.     Non-Qualified Stock Options (NQ). Most options are NQs and there is no special tax treatment, but they also have no special requirements or restrictions.

Exercise of stock options creates a taxable event. This is because the fair market value of property transferred from an employer to an employee in connection with the employment relationship is treated as compensation to that employee in the year received and all restrictions removed. NQs are taxed in this manner.

In general, the employee will have to pay ordinary income tax for the value of the stock over the price paid once the stock has been transferred to the employee and all risk of forfeiture has lapsed. The taxable event for NQs and disqualified ISOs is the date the options are exercised and the stock purchased by the employee. For example, if the exercise price of stock is $10 but the fair market value at the time the option vests is $20 dollars, the employee must pay ordinary income taxes on the difference in value (20-10). If the stock is held for more than a year and sold at $35 a share, the employee will pay capital gains on the $15 of increase between the FMV on the date of exercise and the FMV on the date of sale.  This is also true for tax losses.  The employee spouse will also have additional FICA taxes on the amount of the difference.

Sometimes employees can elect to an early exercise of NQs. The taxable event for early exercise is the vesting of the stock and there are generally no U.S. federal income tax consequences to you with respect to the unvested shares you acquire.  As the shares vest, the employee will realize taxable ordinary income in an amount equal to the fair market value of such number of shares of Common Stock that have vested on the vesting date, less the exercise price of the shares. 

One special option for early exercise is that an employee may make a Section 83(b) Election within 30 days of exercise and recognize taxable ordinary income in the year of exercise in an amount equal to the fair market value of the shares at the time of exercise, less the exercise price.  If an employee expects that a private company is going to increase in value due to an upcoming fundraising round, they may want to early exercise all of their stock and take a Section 83(b) Election so that their ordinary income taxes are based on an exercise price that is close to the FMV at the time of exercise.

Here is an example:

Harry joins EmojiUniversity an up and coming Chat platform in June 2017 as a product manager. Harry receives a stock option grant from his company EmojiUniversity of 100 Non qualified options with a strike price of .50 cents.  EmojiUniversity tells Harry that the most recent 409A valuation says that the FMV is .60 cents a share. These NQ options will vest over a period of 4 years with a 1 year cliff and monthly thereafter. Harry is allowed to purchase these options early through the companies early exercise program. Harry knows that EmojiUniversity is looking to raise Series B funds in January 2018 and VentureBeat says that EmjoiUniversity is going to be the next WhatsApp.  Harry is uncertain about the hype but nonetheless knows it’s a good idea to exercise all of his options because of the tax consequences.

Harry purchases all 100 of his options for $50 in February 2017 and elects a Section 83(b) election.  Section 83(b) requires the employee to pay taxes in an amount equal to the fair market value of the shares at the time of exercise, less the exercise price. This means that for Federal Income Taxes in 2017, Harry pays ordinary income taxes on .10 x 100 or (.6-.5)(100) or $10.

In January 2018, sure enough as predicted by VentureBeat, EmjoiUnversity receives a valuation equal to .85 cents per share. If Harry had purchase his NQ without taking the 83(b) Election he may have had to pay more taxes.  This is because under the early exercise rules, as the shares vest, Harry will realize taxable ordinary income in an amount equal to the fair market value of such number of shares that have vested on the vesting date, less the exercise price of the shares. Harry would have to pay ordinary income taxes on the difference in FMV at vesting and exercise price on the 25 shares that vest in July 2018. 

If EmojiUnversity is a success, Harry is better off having elected Section 83(b) and paying the smaller amount of ordinary income tax during the first year.  However, there are some risks with Section 83(b).  If he makes a Section 83(b) Election and subsequently forfeit the shares, he will not be entitled to a deduction or tax credit as a consequence of that forfeiture.

What are the tax rules for Incentive Stock Options?

For ISOs, the exercise of the options will result in alternative minimum taxable (AMT) income. This means that if the employee holds the stock for a required period of time, he/she will recognize capital gain income when sold for the difference between the sales price and the exercise price paid. Generally, any difference between the exercise price and the value of the shares at the time of exercise may be subject to AMT taxation.

There are often holding periods associated with ISOs. If the employee sells the shares acquired upon exercise of ISOs after (i) the two-year period following the date on which you were granted your option and (ii) the one-year period following the date after the shares are transferred to you upon your exercise of the Incentive Option, the employee will realize a capital gain to the extent that the price at which the shares were sold exceeds the exercise price you paid for your shares.  In the event the employee does not satisfy the holding period, the tax consequences associated with the sale of such shares will change and the employee must pay ordinary income taxes with respect to some or all of the gain. 

This has the advantage over NQs by converting ordinary income to all capital gain and paying the lower rates.  As the shares vest, an amount equal to the fair market value of such number of shares of Common Stock that have vested, less the option price of the shares, could be subject to AMT taxation. 

ISOs are also entitled to special Section 83(b) treatment. With respect to any unvested shares you acquire upon the early exercise of your Incentive Option, an employee may make an election with the Internal Revenue Service (the “IRS”) under Section 83(b) of the Internal Revenue Code (a “Section 83(b) Election”) within 30 days of exercise to recognize, in the year of exercise, any AMT tax liability for all such shares. If the employee makes a Section 83(b) Election and subsequently forfeit the shares, they will not be entitled to a deduction or a tax credit as a consequence of that forfeiture.

What is restricted stock?

Restricted Stock Units (RSU) are units payable in shares or cash. These are granted to the employee subject to a vesting schedule. In Silicon Valley, RSUs are the most common form of stock compensation.

Restricted Stock (RS) are shares granted to the employee subject to restrictions on sale until vested.

Performance Stock Units (PSU) – the employee is granted units versus actual shares. These units or range of units are generally subject to a vesting schedule and often further subject to the company meeting certain goals.

Employee Stock Purchase Plan (ESPP).  Allows an employee to use funds withheld from paychecks to purchase stock for less than the current fair market value. There are generally holding periods required to not recognize income from this discount.

RSUs are taxable as compensation based on their fair market value when vested and all restrictions on the shares are released. No action on the part of the employee is required.  Typically, the company automatically sells enough shares to pay the required withholdings and payroll taxes. The remaining shares released to the employee who can choose to sell immediately or anytime in the future.

Should I purchase my spouse’ interest in stock options?

The variability in the dollar value of stock benefits makes it difficult to recommend the employee spouse purchase the other spouse’s interest in the community options.  Additionally, due to the fact that there are always tax consequences associated with stock options and stock plans, we recommend that clients carefully consider their options.

Experienced Bay Area family law attorneys will emphasize that the goal is the divide the “property” with each party reporting his or her share of the income. Because of the tax complications, you will need communication between the parties (or at least their tax preparers) to share the employee’s W-2 each year and work out the allocations between you and your spouse.

This results in the parties diving the options and the tax consequences. You can divide the tax consequences between the divorced spouses “property” becomes taxable in the future:

The good news is that there is IRS guidance on how the tax consequences of some of these divisions shake out. 

A non-employee spouse who wants to exercise their ½ of the community options in their employee-spouse’s plan should contact the employer to determine whether the stock is transferable.

Revenue Ruling 2002-22 talks about the exercise of vested NQ options by the non-employee spouse incident to divorce. Upon (1) the exercise of vested non- qualified stock options (NQ) by the non-employee spouse of his or her shares (under community property laws), the difference in ordinary income will be taxable to that non-employee spouse and (2) payments from a non-qualified deferred compensation plan to the non-employee spouse (as his or her share of the community interest in the plan) will be taxable to that non-employee spouse. The employee spouse will still be responsible for the social security and Medicare taxes on the transaction.

If the NQs may not be divided according to the terms of the employer, the employee spouse should insist that the tax consequences should still be divided.

Additionally, if the employer allows for transfer, the transfer of non-qualified options or non-qualified deferred compensation plans from the employee spouse to the non-employee spouse should not be a taxable transaction at the time of the transfer.  

You should request that the employer provide the non-employee spouse with a 1099 to report the tax consequences on his or her shares. Some employers will transfer the non-employee spouse’s share of the options into his or her name and social security number. The non-employee spouse can then exercise his or her shares directly with the employer.  

For ISOs, the IRS has provided a letter ruling that allows for a mechanism to allocate the income from the exercise of ISOs between the spouses. Though the income received will continue to be reported on the employee’s W-2, both the income and the income tax withholdings should be partially allocated to and reported by the non- employee spouse for his/her exercises. The AMT income should be allocated as well.  

The IRS has also indicated that the designation of the non-employee spouse as the beneficiary of a share of the community options in a trust arrangement will not disqualify the ISOs, but they cannot actually be transferred to him/her.

One option that is utilized if transfer of stock is not permissible is that spouses coordinate the sale of stock. The employee spouse provides the non-employee spouse with ½ of the community stock after taxes are withheld. For example, if 45 RSUs vest and the company sells 15 RSUs to pay for withholdings, the non employee spouse will receive 15 RSUs or (45-15) ÷ 2. 

This is often accepted by the IRS despite the incorrect tax treatment of the RSUs. However, the IRS may audit the returns and prompt responses to the notices with sufficient calculations and documentation generally resolve these notices. It is advised for preparers to warn the clients of this possibility so as to not look as though an “error” was made.

It’s important to provide the non-employee spouse with the actual benefits of the stock transactions, not just the tax consequences. The spouse should immediately receive his or her share of the cash or shares so the taxes can be paid. It may be prudent to require that the non-employee spouse’s share of the stock benefits be liquidated immediately to remove the risk of future stock decline and ensure that he or she can pay the taxes as they come due.

The information set forth in this Question and Answer was not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of avoiding United States federal tax penalties that may be imposed on the taxpayer.  The information was written to support the promotion or marketing of the matters addressed in this Question and Answer.  All taxpayers should seek advice based upon the taxpayer’s particular circumstances from an independent tax advisor.  The foregoing language is intended to satisfy the requirements under the regulations in Section 10.35 of Circular 230.

If you want to learn more about stock benefits and divorce,  you can contact me at Amanda@gordonfamilylaw.com for more information.

I own a small business, how is that divided at a divorce?

Experienced Bay Area family law attorneys will talk to their clients about the division of a small business.

Many divorces involve the transfer of a small business. It’s fairly uncommon for two spouses to co-own a business after a divorce. This means that most of the time one spouse is required to purchase the other spouses interest in the small business.

One option is to exchange the business for property of equal value – such as the marital home. However, most of the time the business is bought out through a cash transfer.

The source of the cash for the transfer is one of the trickiest issues in a divorce. In many cases, the only source of cash for a small business owner is the cash from the business. This is an area that can easily result in an IRS audit if the tax consequences of the transaction are not specific and clear to both parties.

Partnership or S Corporation

If you own a partnership or S Corporation, then the business can distribute cash to both spouses, provided the business has sufficient capital/basis. The calculation of the basis and capital available should also include the personal guarantees for the business debt.

This can allow one spouse to receive the other’s share of the business and provide the funds to equalize the transfer. The parties can also implement sales of interests to other partners/shareholders or even back to the partnership itself.

Where you get the cash from the business is important.  If you take the cash from untaxed income like accounts receivable – those accounts are treated as ordinary income and the spouse receiving those assets must pay ordinary income taxes on those funds.

C Corporation

If the business is a C Corporation, then finding the cash available is more complicated. A C Corporation is not a pass through company and therefore the owner-spouse cannot distribute cash.

Instead, the funds must come from one of these sources:

1.     Dividend.  A dividend - it is fully taxable to the shareholder who is to benefit but is not deductible by the corporation

2.     A constructive dividend occurs when a corporation pays money or transfers property to or for the benefit of any shareholder (directly or indirectly) without expectation of reimbursement. A constructive dividend is taxed in the same manner as a regular dividend.

In a divorce buy-out, the managing spouse has to absorb the taxes because they will be treated as receiving the dividend.  The out- spouse (one who is bought out the managing spouse) will receive the cash and will not have to pay taxes on that amount.

3.     Redemption – A redemption of stock is not deductible by the corporation for tax purposes but is taxable to the out- spouse who will receive the cash in exchange for his or her stock. This transaction occurs directly between the corporation and the out-spouse and is generally taxed as a capital gain or loss. NOTE – you are allowed to choose whether the managing spouse or the out-spouse pays taxes for a Redemption but you must clearly state how the tax will be handled in a divorce agreement.

If you have questions about your business, you can contact me at Amanda@gordonfamilylaw.com for more information.

What is the tax basis for property transferred under IRC 1041?

What is the tax basis for property transferred under IRC 1041?

Experienced Bay Area family law attorneys will tell their clients about property transferred under IRC 1041.

Property transferred under § 1041 use a carryover basis. This means that the transfer of property is treated similarly to a gift (for income tax purposes only) from one spouse to the other.

“Basis” is the net capital investment in a property. To calculate basis, you need to find the original cost or capital investment.  For example, if you purchase a family home in 2011 for $1,300,000, the basis would be $1,300,000.  Next, you add the cost of capital improvements and depreciation.  In some cases, you are also allowed to add income that passed through the asset and to deduct or subtract the losses.  From this number you get the “adjusted basis.”

When it comes to taxation of these assets, the value used for taxation purposes (gain/loss) Is determined by subtracting the “adjusted basis” from the net amount at a sale.

In a divorce situation, parties divide property based on their current fair market values. If one spouse trades the property for another asset, they will be receiving the asset with a basis equal to the original community investment in the property and will pay taxes based on the original community investment when the asset is sold.

In negotiation over marital assets, experienced attorneys will help their clients understand that some assets are more valuable when they are looked at on an after – tax basis compared to when they are viewed on a pre-tax basis. 

Remember tax basis is not the same as debt.

It’s important to keep in mind that an asset with a low basis is usually worth less in the final settlement because of its higher tax burden. Additionally, unless taxes are “immediate and specific”, a Court may not consider the impact of tax basis of assets when dividing them.

This means that it is possible to have a division of assets which is equal according to net market value, but which is unequal when the taxes are taken into account.

For instance, consider two assets, Hawaii Rental Property and Tahoe Ski Chalet, each worth $1,000,000 but the Hawaii Rental Property has a basis of $200,000 and the Tahoe Ski Chalet has a basis of $900,000k.  If Wife gets the Tahoe Ski Chalet and Husband gets Hawaii Rental Property, the division is equal as far as the Court is concerned because each spouse received property worth $1,000,000.

However, if you look at the tax ramifications of an immediate sale, wife’s taxable gain would be $100,000 (her basis is $900,000), while husband’s gain would be $800,000 (his basis is $200,000). Wife taking the Tahoe Ski Chalet means that she ends up with the better deal and more cash. In this case, the Husband should determine if requiring the assets sold prior to division is a better strategy so that taxes can be taken into account in the overall property division

It should be noted that §1041 also applies to property that is under-water or valued at a loss.  For example, if your real estate is worth $1,400,000 but has a basis of $2,000,000, the spouse who receives the property will get the tax benefit of a built in loss. If you have Estate Planning documents in place, it’s important to note that the non-recognition treatment does not apply to negative basis property which has been transferred into an irrevocable trust, even if pursuant to a divorce.

The information set forth in this Question and Answer was not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of avoiding United States federal tax penalties that may be imposed on the taxpayer.  The information was written to support the promotion or marketing of the matters addressed in this Question and Answer.  All taxpayers should seek advice based upon the taxpayer’s particular circumstances from an independent tax advisor.  The foregoing language is intended to satisfy the requirements under the regulations in Section 10.35 of Circular 230.

If you are interested in learning more, you can contact me at Amanda@gordonfamilylaw.com for more information.

Will I be taxed on when I transfer property to my spouse in a divorce?

Experienced Bay Area family law attorneys will advise clients about the tax consequences in a divorce.

Section § 1041 of the Internal Revenue Code says that if you transfer property from one spouse to another during marriage or incident to divorce, then there is no recognition of tax gain or loss.

This is true regardless of where the property is located. The no tax transfer rule includes any property, real or personal, tangible or intangible can be transferred tax free, including an promissory note, life insurance, pension buyout payment.

There is no limit on the amount or type of property that spouses can transfer to each other without incurring tax.

The IRS allows for non-recognition of gain/loss between spouses and ex-spouses up to one year after the date of termination of marital status and transfers within six years of the divorce may qualify if the transfers are “incident to the divorce”.

The transfer must be to or “on behalf of” a spouse or former spouse. A transfer to a third party on behalf of a spouse qualifies for §1041 treatment if the transferee spouse requests or ratifies the transfer in writing. The writing must state that the parties intend §1041 to apply and the transferor must receive the document before filing his or her first tax return for the year of the transfer. Approved writings include (1) a divorce or separation instrument, (2) the transferee’s written request and (3) the transferee’s written consent or ratification which includes a reference that the transfer is intended to qualify for non-tax treatment under IRC §1041.  A transfer will be “on behalf of” the other party if it satisfies an obligation of the transferee spouse.  

Transfers More Than One Year After Judgment of Marital Termination. Transfers more than one year after termination of marital status will qualify for §1041 if they are “related to the cessation” of the marriage.  If the transfer occurs within six years after the date on which the judgment dissolving the marriage was entered, the transfer is presumed to be “related to the cessation of the marriage”. If the transfer is more than six years after the termination of the marriage, it is presumed not to be related to the cessation of the marriage.

If you are concerned about timing problems you can solve them by creating a specific reference in your marital settlement agreement where you cite IRC §1041.  The six-year presumption of “related to the cessation of the marriage” is different from a “transfer within one year of the marriage termination” which is mandatory and not a presumption.  A transfer within the first year will be subject to §1041 rules no matter what business or other reasons are present.

The six-year presumption is rebuttable. For example, if there is a transfer three years after the marriage ends but it can be established that it was required for business reasons, the transfer may not be considered as one related to the cessation of the marriage.

After six years from the date of dissolution, the presumption that it is not related to the cessation of marriage may also be rebutted if it can be proven that it was to affect the division of marital property. While most transfers occur within 6 years, it is possible that the transfer may take longer due to extended litigation or delayed sale of property if there are minor children.

The information set forth in this Question and Answer is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of avoiding United States federal tax penalties that may be imposed on the taxpayer.  The information was written to support the promotion or marketing of the matters addressed in this Question and Answer.  All taxpayers should seek advice based upon the taxpayer’s particular circumstances from an independent tax advisor.  The foregoing language is intended to satisfy the requirements under the regulations in Section 10.35 of Circular 230.