Divorce is unpleasant. An unexpected tax outcome can add insult to injury. Generally, in a divorce, all the marital property is divided evenly. This can include cash, cars, homes, rental properties, boats, retirement accounts, and even your business ownership interests. If you’re a business owner, your business ownership interest is likely one of your biggest personal assets and, in many cases, your marital property will include all or part of it. As a side note, this is one reason why many businesses utilize buy/sell agreements to help value business interests upon specified triggering events including a divorce.
Additionally, certain states, such as Wisconsin, are known as Community Property states. This generally means you must split income, tax deductions, and tax withholdings in the year of divorce up until the date the divorce becomes final. This unique tax return reporting requirement is a commonly missed detail which results in filing amended returns and incurring additional tax preparation fees to file a proper return.
Tax-free property transfers
You can generally divide most assets, including business ownership interests, between you and your soon-to-be ex-spouse without any tax consequences. When an asset falls under this tax-free transfer rule, the spouse who receives the asset takes over its existing tax cost basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).
Let’s say that under the terms of your divorce agreement, you agree to give your house to your spouse in exchange for keeping 100% of the stock in your business. That asset swap would be tax-free. And the existing basis and holding periods for the home and the stock would carry over to the person who receives them.
Tax-free transfers can occur before a divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they’re made “incident to divorce.” This means transfers that occur within:
- A year after the date the marriage ends, or
- Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.
What happens when the transferred property is eventually sold?
Later there may be tax implications for assets received tax-free pursuant to a divorce settlement. The ex-spouse who winds up owning an appreciated asset — when the fair market value exceeds the tax basis — generally must recognize taxable gain when it’s sold (unless an exception applies).
What if your ex-spouse receives 49% of your highly appreciated small business stock? Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex will continue to apply the same tax rules as if you had continued to own the shares, including carryover basis and carryover holding period. When your ex-spouse ultimately sells the shares, he or she will owe any capital gains taxes. You will owe nothing.
The person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven’t appreciated.
That’s why you should always take taxes into account when negotiating your divorce agreement.
Going back to the earlier example of swapping business interest for the house. The spouse who took the stock may have larger capital gains to pay on the eventual sale but the spouse who took the home will likely have the gain exempt from tax under the “gain on home sale” exclusion.
In addition, the beneficial tax-free transfer rule is now extended to ordinary-income assets, not just to capital-gains assets. For example, if you transfer business receivables, depreciated assets, or inventory to your ex-spouse in a divorce, these types of ordinary-income assets can also be transferred tax-free. When the asset is later sold, converted to cash, or exercised (in the case of nonqualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.
Contact your CPA and plan ahead to avoid tax surprises
Like many major life events, divorce can have major tax implications. By contacting your CPA prior to a final agreement during the divorce proceedings, we can help you understand and hopefully minimize the adverse tax consequences of managing your divorce as well as identifying the year of divorce tax return (including filing status, claiming dependents, etc.).