As if getting a divorce isn’t hard enough, there are financial ramifications to consider. Who gets the house? How do you separate your finances? These issues are compounded when a couple owns a business together. A divorce can bring about all kinds of tax consequences and anyone considering ending their marriage needs to think about all of them.
The good news is, some options help make a post-divorce tax situation better. It means doing your homework and looking closely at all of your assets, but with some hard work and thoughtful preparation, you can end a marriage without losing a small business.
Here we’ll look at three things to keep top of mind about divorce-related tax issues for small-business owners.
Tax-Free Transfer Rule
The good news, generally speaking, if you and your spouse are both U.S. citizens, you can divide up assets without incurring a federal income tax consequence. This is thanks to the tax-free transfer rule.
When an asset falls under this rule, whichever spouse takes over the asset becomes responsible for its tax basis (gain or loss) as well as its existing holding period (for short-term or long-term holding period purposes).
For example, a divorcing couple might exchange a primary residence for stocks, and that exchange would be tax-free, provided it meets certain requirements.
Federal tax law says that that certain property transfers must occur:
- Before the divorce
- At the time the divorce becomes final
- Or, occur post-divorce provided they are “incident to divorce”
What if you want to use the tax-free transfer rule after that? You can, provided it occurs within one year of the date the marriage ends or “A transfer of property is treated as related to the cessation of the marriage if the transfer is according to a divorce or separation instrument, as defined in section 71(b)(2), and the transfer occurs not more than 6 years after the date on which the marriage ceases.”
Qualified Domestic Relations Order
A Qualified Domestic Relations Order, also known as a QDRO, is a term that refers to a special court order that grants a right to the retirement benefits of a former spouse. Why should small-business owners care? Because while this might seem irksome to an ex-spouse who doesn’t want their former partner touching their retirement money, it can be a helpful tax tool.
When you include a QDRO in your divorce papers, it makes your ex-partner a co-beneficiary of your retirement account. Therefore, both you and your ex become responsible for any income taxes on the retirement benefits that either of you receives.
Fail to include these four magic words in your divorce and you’ll be wholly responsible for any taxable distributions while your ex enjoys a tax-free boon.
This can be especially bad if your ex pulls money out of the retirement account before the age of 59 ½. If that happens, prepare to pay an additional 10 percent early withdrawal penalty.
And as a final word of caution, be wary of transferring IRA money to your ex without a court order if you’re under 59 ½. As stated before, any early withdrawal will trigger a 10 percent penalty.
If you were counting on alimony payments being tax-deductible, think again. According to the IRS: “alimony or separate maintenance payments are not deductible from the income of the payer spouse, or includable in the income of the receiving spouse, if made under a divorce or separation agreement executed after Dec. 31, 2018.”
This change could be neither here nor there for some small business owners, but if you have a higher-income, you might need to find other opportunities post-divorce to limit your tax liabilities. One way to do this is to transfer these tax liabilities to your ex.
For instance, you could transfer a vacation home or mutual fund stock to a soon-to-be-ex and give yourself the closest thing you can get to what was previously an alimony deduction. By doing so, you’ll make your ex the responsible party for the majority of what was once your shared tax burden.
Divorce is a tough business. Hard choices will have to be made, but at the same time, small-business owners have to remember to protect themselves. It might feel easier to hand an ex everything they ask for in a divorce agreement, but the hard truth is that could come back to haunt an ex-spouse suddenly overwhelmed with a tax burden that they once shared.
It doesn’t necessarily have to be like that. By using the tax law to your advantage you can navigate divorce and still come out on top. When in doubt, reach out to an expert to find the best opportunities for you and your small business.