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.

What is Family Code 2640

Family Code section 2640 provides that in the event of a Family Law Action, contributions from separate property to the acquisition or improvement of community property, or the other party’s separate property, will be reimbursed to the contributing party without interest or adjustment for change in value.   

Reimbursement and Divorce

Did you contribute money that you earned prior to marriage to property that was acquired during marriage? If so you could be entitled to reimbursement. 

Reimbursable separate property contributions to community property are defined in Fam C §2640(a).

If you make downpayments, payments for improvements, and payments that reduce the principal of a loan used to finance the purchase or improvement of the property, you could be entitled to reimbursement at divorce.

Please note that Fam C §2640(a) does not include payments of interest on the loan or payments made for maintenance, insurance, or taxation of the property.

A party who makes such contributions to the community will be reimbursed if the contributions are traced to a separate property source, unless he or she has waived the right to reimbursement in writing or has signed a writing that has the effect of a waiver. Fam C §2640(b). 

If you have a reimbursement issue If you are drafting a premarital agreement and have questions,  you can contact me at Amanda@gordonfamilylaw.com for more information.