What Are the Tax Concerns for Business Owners Who Divorce?

When you own a business and decide to get divorced, the company does not just stop operating until things are resolved. It can be even more difficult to move forward when you and your spouse both participate in the business. There are assets and liabilities to divide, and depending upon what your future roles are within the company structure, that division can affect the business.

There will also be certain questions as to how you may be affected by taxes whether one or both of you continue to operate the business once the dust of your divorce settles. Below we will look at some of the topics you will need to become educated on as divorcing business owners.

Making tax-free property transfers

Under the  tax-free transfer rule most of your assets can be divided between you and your spouse, to include your ownership interest in your business, without having to pay federal income or gift taxes on the transfer. The recipient spouse takes on the asset’s existing tax basis and holding period. For example, if you buy out your spouse’s interest in the business by giving up your interest in the marital home, you each then take on the tax basis and holding periods for the property of which you retain sole ownership.

If these transfers are made incidental to divorce, they can be made before the divorce, at the time the divorce is granted, or for up to six years after your divorce depending upon the terms of your divorce decree or separation agreement. Some of the assets that may be transferred tax-free include:

• Business inventory
• Vested stock options
• Equity in your business or property you own
• Cash

Bear in mind that a tax-free transfer does not mean you will permanently escape the payment of taxes on assets you receive in your divorce. It is important to speak with a tax attorney before agreeing to the exchange of certain property to understand the circumstances that will trigger payment, and whether there is a strategy that may net you more in your property settlement.

Dealing with retirement accounts

Different types of retirement accounts will be treated differently not only under the tax code, but also in the way the transfer will be accomplished. A qualified domestic relations order (QDRO) is one tool that is used  by divorcing spouses to split retirement accounts subject to the Employee Retirement Income Security Act (ERISA). Other “tools” can include domestic relations orders (DRO) and specific language contained within your property settlement agreement or order that spells out the rules of the transfer. The tools you use will depend on the type of retirement plan you have.

A QDRO is essentially a court order containing a legal directive to the plan administrator authorizing the release of funds from the owner’s account to the named beneficiary (known as an alternate payee), which would be your spouse. The QDRO provides the amount or percentage to be paid so that the alternate payee can withdraw the funds to be deposited into his or her own account.

As the original owner of the funds, you will no longer be responsible for paying taxes on the amount your spouse receives, provided you use a QDRO or other appropriate “tool.” If those funds are rolled over directly into an IRA or other appropriate retirement account, your spouse will also escape payment of taxes until such time as he or she takes a distribution.

QDROs are typically used for:

• Profit-sharing plans
• 401(k)s
• Defined benefit pension plans
• Defined contribution plans

Divorce decrees and property settlement agreements are generally used for the transfer of assets from various retirement plans including 401(k)s and IRAs; however, every case is different. A QDRO may be necessary in one case whereas no court order may be necessary in another.

There are many issues that you will need guidance on as a business owner when you choose to divorce. A spouse who may be entitled to a share of the business as a marital asset stands to benefit from having an attorney who understands how different assets are treated by the IRS. This knowledge will allow you to make more informed decisions when negotiating your settlement.

Concerned about the tax implications your impending divorce will have on the family business? Hartsoe & Associates, P.C. offers experienced counsel to family law and tax clients throughout the state. To schedule a consultation, please call 336-725-1985, or reach out to us through our contact page. We maintain offices in Winston-Salem and Greensboro.