Michael B. Lehner, CPA/ABV, CFE, ASA
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Factoring taxes into divorce settlements

Divorce taxes

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How assets are split up in a divorce can have significant tax consequences, especially when the marital estate includes a private business interest. Valuation is just part of the picture. Equitable distributions require the parties to premeditate tax issues, too.

What’s at stake?

Common marital assets allocated in divorce settlement agreements include:

  • Cash,
  • Investments,
  • Retirement accounts,
  • Autos and personal property,
  • Real estate and mortgage debt, and
  • Private business interests, shareholder loans and stock options.

The perceived values of these items vary, depending on their tax consequences, liquidity, risk and the parties’ personal preferences. Cash is generally the most desirable asset, because it’s liquid and risk-free and has no hidden tax consequences when you spend it.

But a family business owner may prefer to retain his or her business interest and, therefore, be willing to trade his or her spouse’s share of the business for cash. Spouses also may have emotional ties to homes and personal property, such as family heirlooms and jewelry, which they may be willing to trade for cash.

How do taxes affect value?

Emotional issues aside, tax consequences can significantly affect an asset’s perceived value. Discuss each asset’s tax consequences before agreeing on how to split up the estate. In general, when spouses transfer assets to each other, there are no federal income tax or gift tax consequences as long as the transfer happens before the divorce is final, under Internal Revenue Code Section 1041(a).

This tax-free treatment even extends to private stock buyouts that occur within six years after a divorce, provided they’re done per the terms of a divorce property settlement. One spouse generally takes over the other’s tax basis and holding period for the stock purchased. It’s essentially as if the buyer had always owned the shares and the selling spouse has no taxable gain or loss on the deal.

However, it’s important to realize that, if a business interest transfers between spouses tax-free, the spouse who retains it eventually will incur taxes on any gain when it’s sold in the future. So, receiving a business interest with significant built-in gains isn’t the same as receiving a lump sum of cash, unless adjustments are made to reflect the tax liability.

How are corporate redemptions taxed?

The tax consequences are more complicated when a C or S corporation redeems a spouse’s business interest, because the redemption usually triggers a gain or loss upfront. If the corporation redeems the shares to fulfill a spouse’s obligation to buy those shares under the couple’s divorce agreement, the deal is treated as if the spouse who will retain an interest in the business (the buyer-spouse) collected a redemption payment and then transferred it in exchange for the shares. The spouse who’s redeeming his or her interest (the seller-spouse) has no tax consequences; instead, the buyer-spouse bears the tax burden.

However, the parties may also opt to structure the sale strictly between the seller-spouse and the corporation. Depending on the circumstances, the seller-spouse may be able to treat the redemption as a sale of stock back to the corporation or as a corporate dividend. This deal structure is often preferred, because the seller-spouse can offset the stock redemption payment with his or her basis in the redeemed shares. In this situation, the seller-spouse bears all the tax consequences — and the other spouse bears none.

How can clients avoid surprises?

Arriving at an equitable distribution of a couple’s marital estate is a juggling act. To ensure that you don’t drop the ball, hire a valuation advisor who understands how taxes factor into the cash-equivalent value of assets held in a marital estate, especially when private business interests are at stake.

 Sidebar: Other financial considerations in divorce settlements

Like private business interests, real estate and other investments may create taxable gains when they’re sold. In some cases, divorcing spouses decide to sell these assets before the divorce is final to eliminate any uncertainty about future tax obligations and take advantage of the higher home-sale gain exclusion on the principal residence, which is $250,000 for a single taxpayer and $500,000 for a married couple (if they meet certain use and ownership tests).

On top of taxes, the couple should consider the liquidity and risk associated with owning noncash assets. For example, real estate and private business interests (especially minority interests) take time and effort to sell. The spouse who receives them also bears the risk that values could change in an uncertain economy.

To further complicate matters, maintenance payments and tax deductions for such items as dependents, mortgage interest and attorneys’ fees may become valuable bargaining tools in settlement talks. In general, alimony is taxable to the recipient and deductible for adjusted gross income for the payer, as long as the payments meet the requirements of Internal Revenue Code Section 71. However, child support, noncash transfers and payments for the use of property are never taxable (or deductible to the payer). Property settlements should also be carefully scrutinized to determine whether the transaction itself is a taxable event.

Michael Lehner

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.