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.