(Part 12 is continuation of series, links to all parts are provided at end of this blog post. This valuable series on Dividing Property In Divorce Tax Traps has been updated for the Tax Cuts And Jobs Act (TCJA) and the Cares Act. This series is provided by David Ellis of Ellis & Ellis CPAs in Pasadena, CA.)
D. Dividing Interest in S Corporations and Other Pass-Through Entities
A large percentage of closely held businesses are organized as “pass-through entities”. This means that the income, loss, special deductions, and the like are reported on the individual tax return of the entities’ owner rather than the businesses themselves. Common forms of pass-through entities that need to be allocated between spouses in a divorce situation include S Corporations, LLCs, and Partnerships. Trust and estates, typically being separate property bequest, would not generally be expected to cause separate property issues.
The division of interest in pass-through entities, is subject to the general rules of IRC Section 1041 (nonrecognition of gain/loss, carryover of basis, etc.). However, ownership of pass-through entities—especially in the form of a closely held business, can be a double edge sword. Issues that should be taken into consideration, include but are not necessarily limited to the following:
1.Does the transferee spouse have the necessary understanding of the business, especially in cases where his/her active participation may be required?
2. Ownership of a pass-through entity may result in “phantom income” wherein the shareholder of the entity receives income on a K-1, but not necessarily the corresponding cash. Although many pass-through entities will at least make an effort to distribute enough cash to cover the tax generated from the pass-through income, this is not always the case. This can put the partner, shareholder, or member in the potentially disastrous tax position of being taxed on income for which he/she does not receive any cash. It is critical the transferee spouse and his/her advisors be made aware of this possible tax and financial downside of owning an interest in an S corporation, LLC, or partnership.
3.Issues of basis should be closely examined and understood by the transferee. Negative basis as well as insufficient basis may result in taxable income at some point in the future from events such as liquidation, or distributions in excess of basis. Such situations could put the partner, shareholder, or member in a position wherein cash that was expected to be a tax-free distribution, turns out to be taxable. Also, limited basis may result in the transferee’s inability to deduct losses under the “at risk rules” as well as the “passive activity rules”.[1] Partners and LLC members may be called upon to provide additional capital to the business entity. The transferee spouse should understand any such provisions and have the financial wherewithal to meet them.
Have a question? Contact David Ellis, Ellis & Ellis CPAs.
(Next Post in Series, Part 13 Will Discuss Taking Basis Into Consideration When Dividing Property)
(This material is for informational purposes only and is not a substitute for tax advice from a qualified professional and the author assumes no liability whatsoever in connection with its use. No advisor/client relationship exists.)
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