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.

Why use a quadro or QDRO?

In order to divide retirement plans in a divorce, qualified plans need a Qualified Domestic Relations Order (QDRO) to divide tax free. A QDRO will allow the plan to be paid out to the alternate payee (non- employee spouse) without tax consequences to the employee.

A QDRO is not used to divide IRAs which can be divided under IRC §408.

QDROs cannot be used to divide stock options or non-qualified deferred compensation plans.

Benefits under a QDRO may be rolled over tax-free into an IRA or other qualified retirement plan. Any amounts not rolled over will be taxable to the alternate payee - the spouse receiving the benefits.

A QDRO which allows a one- time withdrawal by the alternate payee without the early withdrawal penalty (IRC §72(t)(2)(C)).  Ordinary income taxes are still due on these withdrawals.

Withdrawing funds from an IRA to satisfy a divorce judgment will result in the IRA owner to be taxed on the distribution as well as the 10% early withdrawal penalty.

Divorce agreements should always state that any retirement transfer is intended to be tax free.

If you are seeking a QDRO, you can contact me at Amanda@gordonfamilylaw.com for more information.

What happens to the family home at divorce?

Some families choose to defer the sale of the family residence to a later time even though their divorce is final. While the Court has discretion to order a deferred sale of home, most of the time a deferred sale of home is the result of a settlement agreement between the parties – meaning that both owners have consented to the delay of sale.

Home-owners are responsible for paying capital gains taxes on any sale of a residence. However, the IRC allows for an exclusion for taxes on up to $250,000 (for single taxpayers) or$500,000 (for married taxpayers filing jointly) from the sale of the principal residence.  IRC 121.

In order to qualify for this exclusion, the family home must be used as the primary residence for 2 of the last 5 years and the full amount can be claimed only if there was no other sale for which a §121 exclusion was claimed within two years prior to the sale date. For joint filers to obtain the full exclusion, the home must have been owned by one of them for at least two of the five years before the sale, both spouses must have used the home for two of the last five years.

For a home that is received in a §1041 transaction, the spouse may count the joint ownership time towards his or her eligibility for the exclusion.

Even if a spouse has not lived in the home for 2 years, you can preserve the $500,000 exclusion by signing and executing a Stipulation that grants one spouse the exclusive use of the home under a court order and has both spouses on title. This is called a “Duke” order and the “out-spouse” is credited with the time the other spouse has exclusive use. Make sure to specify the duration of this order because only the time pursuant to a written agreement or order will be considered under this rule.

If it’s been more than 2 years, you can re-qualify for the exclusion but the house must be held by the parties for at least 2 more years for the out-spouse to re-qualify for the exclusion.

Keep in mind that this may not apply in the case of a “bird- nesting arrangement”. This is because under §121, one party must be granted use of the property under the divorce agreement.   

Even if you did not create a written agreement, you still may be in luck. A taxpayer can qualify for a partial exclusion if they cannot meet the two out of five year requirement due to an “unforeseen circumstance”. A divorce or separation under a qualified agreement is considered an “unforeseen circumstance.”  

If you are interested in learning more about nesting 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.

Are there different rules for property division in a divorce if my spouse is not a US Citizen?

Experienced Bay Area family law attorneys will inform their clients if they are transferring property to a non-resident alien spouse.

Are there different rules for property division in a divorce if my spouse is not a US Citizen? 
Yes. A transfer to a non-resident alien spouse is specifically excluded from §1041 which means that IRC §1041 (and the rule of no tax treatment) does not apply if a transfer is TO a non-resident alien.

Non-taxable treatment does apply if the transfer is FROM a non- resident alien to a US resident or citizen. These transfers become fully taxable subject to capital gains/losses. 

Further complications can arise if a non-citizen spouse ceases to be considered a US resident before the property is fully divided and or an equalizing note is fully paid.

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