Getting a divorce is terrible enough as it is. Getting divorced when you own a small business is even more terrible, considering that there’s a good chance the business you’ve worked so hard to build could be considered marital property and therefore be on the chopping block of assets to be divvied up between you and your ex-spouse.
But perhaps the worst part? If you’re not careful, you could end up getting slammed by extra taxes as a result of the transfer of assets that happens during a divorce. The last thing you want is to have to hand over some of your business property and then you end up paying the taxes when your ex cashes out.
Whether you’re in a community property or equitable distribution state, here are some of the federal tax laws that could make this whole process harder—and some tips to help you work around them.
Take Full Advantage of the Tax-Free Transfer Rule
The good news is, many of the assets you divide can be done without paying any federal income or gift taxes. It’s almost like the IRS recognizes that the situation is already bad enough.
The tax-free transfer rule allows most of the things you’ll be splitting up—including ordinary-income assets like business inventory or vested stock options that are earning dividends, capital-gains assets like equity in your business or property you own, and even plain old cash—to be done without any immediate taxes due. In other words, those asset gains won’t immediately be recognized as new income. (One caveat here is that if depreciated assets that were previously deducted as a business expense are transferred to someone who doesn’t end up using them for business, they may own recapture taxes.)
Better yet, future taxes on those assets—like capital gains taxes when stocks that were transferred are later sold—would be the responsibility of the spouse who winds up owning them after the divorce, not the original owner. In fact, both the existing tax basis (basically the value of the asset for tax purposes, usually used to determine tax gain or loss) and holding period (to determine if it’s a short-term or long-term capital gain) follow the asset and are the responsibility of the new owner. So, if your spouse gets shares of your company and later sells them, he or she will owe the capital gains taxes, not you.
All this asset-swapping can be done tax free before the divorce, at the time it becomes final, or after the divorce as long as they’re made “incident to divorce” (which means they’re either done within a year after the marriage ends or they’re done within six years after the marriage ends but were outlined in your original divorce agreement).
If you don’t follow these guidelines when making asset swaps, you may end up paying immediate income taxes on some of the things you received—or even being responsible for the tax burden for some of the things you had to give away.
Know That Retirement Accounts are a Little Different
Retirement accounts are one major exception to the tax-free transfer rule, and if you’re not careful you could end up paying income taxes on money going to your ex (and may even end up paying extra in premature withdrawal penalties). Obviously we want to avoid that—here’s how.
For Profit-Sharing Plans, 401(k) Plans, or Defined Benefit Pension Plans
You’ll want to make sure to include a qualified domestic relations order (QDRO) in your divorce papers before letting your former spouse touch a cent of those retirement funds. This language makes them a co-beneficiary of your retirement account, thereby making them responsible for the taxes on any income they receive from withdrawals, pension payments, or annuity. It also gives them the option of rolling over their share of the funds into their own IRA without paying taxes on it now, allowing for a cleaner separation of your finances.
For SEP Accounts, SIMPLE IRAs, Traditional IRAs, and Roth IRAs
While you don’t need a QDRO for these types of accounts, you still do want to make sure specific language is in your divorce papers to ensure that you are not taxed on money being transferred to your ex. That’s because you can only make a tax-free transfer of money from your IRA to an ex if that transfer is ordered by your divorce or separation agreement.
Specifically, you’ll want to make sure the following phrase appears in your decree of divorce or separate maintenance: “Any division of property accomplished or facilitated by any transfer of IRA funds from one spouse or ex-spouse to the other is deemed made pursuant to this divorce settlement and is intended to be tax-free pursuant to Section 408(d)(6) of the Internal Revenue Code of 1986.” Only once that phrase is included and the papers are signed can you make a tax-free IRA transfer.
Remember Your Tax Status Changes Immediately
Your tax status for the year is based on your status on December 31 of that year. So, even if you were married for the majority of the year, if you got divorced at any point during the year, your tax status for the whole year will be single (or potentially head of household if you have kids). It’s important to know this so you don’t file incorrectly and end up dealing with penalties down the road!
This also applies to your dependents. When parents are split, only one is allowed to claim each child on their taxes. This could majorly affect you if you’re relying on the Earned Income Credit, Child Tax Credit, or the Child and Dependent Care Credit to keep your tax bill lower. If at all possible, you’ll want to negotiate with your spouse to be able to claim at least one of your kids to prevent the tax impact from taking you by surprise.
Take the Time to Consult an Accountant
As you can see, the tax implications of a divorce can be complex—and we haven’t even really talked about how to take potential taxes into account when divvying up assets to ensure a truly equitable split.
So, while nearly everyone thinks to hire a lawyer when going through a divorce, very few think to consult an accountant, too—something I would strongly recommend! Yes, it’s a little extra hassle and cost during an already tumultuous time, but it could save you loads of money (and grief) in the long run.
Check out the IRS website for more information on filing status, dependents, alimony, property settlements in Publication 504, information for Divorced or Separated Individuals. As scary as it may sound, calling an IRS agent can also be incredibly helpful when trying to decipher our tax code.
Divorce is a sad fact of life, which can leave you feeling mentally exhausted, but it does not need to leave you financially drained if you follow the advice outlined above. Gather your support group and hold your head high knowing you did everything you could to amicably protect the financial interest in your business.