(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:
(Part 11 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.)
C.Transfers of Closely Held Businesses
In a divorce, it is often the case that the family business will be one of the most valuable assets in the marital community. Generally, the transfer of the stock in a closely held business will enjoy the protection of Section 1041 in the context of divorce. Likewise, the basis and holding period will carry over to the transferee spouse, thereby deferring the recognition of any gain or loss to him/her. However, the transfer of closely held stock can be accomplished through various means, under a variety of circumstances, with the resulting tax burden born in some cases by the transferor spouse, and at other times by the transferee spouse.
1. Cash Buyout
The simplest scenario in a divorce related transfer of a closely held business would be a cash buy out of one spouse by the other.
Example: Barney and Betty are in the process of divorcing. They own 100% of the stock in a granite quarry that they acquired during the marriage. The stock has an appraised value of $500,000. As part of the divorce agreement it is decided that Barney will buy out Betty’s interest for $250,000. The basis of the shares in total is $50,000. Barney proceeds to buy out Betty’s interest for $250,000. In accordance with IRC Section 1041, no gain or loss is recognized on the transfer. Barney’s basis in the stock is increased from $25,000 to $50,000.
2.Stock Redemptions for the Family Business