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Divorcing Business Owners: Don’t Forget to Weigh the Tax Consequences

Posted by Concannon Miller on Tue, Feb 19, 2019

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Closeup portrait of man woman couple standing with backs together covering ears, closed eyes, not listening to each other isolated on white background. Negative human emotions facial expressionsLet's say divorcing spouses own part of the stock in a closely-held corporation. This may be one of their biggest marital assets, and often one spouse decides to buy out the other party's shares by transferring some assets in exchange for the stock. Before jumping headfirst into these transfers, it's important to consider the expected tax consequences.

As long as the transfer happens before the divorce is final, there are usually no federal income tax or gift tax consequences. This is because of the tax-free transfer rule that generally applies to transfers of assets between spouses.



READ MORE: Divorce and Family Business: Obtaining a Valuation and Other Financial Steps to Consider

When the Buyer is the Corporation, Things Can Get Complicated

The tax outcome is not quite so simple when a closely-held C or S corporation redeems, or buys back, an ex-spouse's shares in the same company. Such third-party divorce-related stock redemptions can fall into two situations, both of which have tax consequences:


Generally, sale treatment is preferred, because the selling ex-spouse can offset the stock redemption payment with his or her basis in the redeemed shares. In this situation, the seller bears all the tax consequences. For the other ex-spouse, the corporation's redemption of the stock has no tax impact.

Situation 2. The tables are turned. The actual transaction is still between the corporation and the ex-spouse redeeming the shares. However, for tax purposes, the deal is treated as if the other ex-spouse collected the redemption payment and then transferred it in exchange for the shares. So in this situation, the redeeming ex-spouse has no tax consequences while the other party bears all of the tax burden.


Which Situation Applies?

This is where it gets tricky. In a nutshell, Situation 2 applies if the corporation redeems a former spouse's shares to fulfill a binding legal obligation that the other spouse had to buy those shares under the couple's divorce agreement. In essence, because the corporation actually supplies the money to buy the shares, one spouse is taxed as if he or she received the money from the company and then spent it to buy the stock from the selling ex-spouse, as legally required by the divorce agreement.

READ MORE: Births, Deaths and Divorce: Seven Reasons to Update Your Will

Election To Reverse the Tax Results

Regardless of which situation applies, the former spouses can together elect to reverse the tax results. In other words, when Situation 2 would otherwise apply (meaning one party would bear all the tax consequences), the couple can elect to reverse the results and have Situation 1 apply instead.

The two parties may be willing to cooperate in making this election -- for example, because the redemption would be treated as a sale and one ex-spouse has a large capital loss that would offset the gain from the redemption. Needless to say, some paperwork is involved to make the election, and there are deadlines, so planning ahead is critical.

Equitable Settlements Factor In Taxes

Looking at it from an arm's-length perspective, a divorce is a major financial transaction. As such, it has important tax consequences for both former spouses. This is especially true when business ownership interests are involved. The ability to choose which ex-spouse will be taxed on a divorce-related stock redemption allows the couple to tailor the tax outcome to suit their respective circumstances.

Done properly, there's more left for the two to divide up, because the tax collector gets less. We can provide more information on planning ahead to arrange a tax-smart corporate stock redemption as part of a divorce property settlement. Contact us for more information.

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Topics: Individual tax planning, Business Valuation



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