Estate Planner Mar-Apr 1998
Jeff and Jessica are divorcing and negotiating an equal property settlement. The marital estate includes a home valued at $350,000, two cars worth $16,000 each, and other miscellaneous assets with a total value of $100,000. The two also jointly own all stock of a computer business, Computers ‘R’ Us. The business is operated through a closely held corporation and has been appraised at $800,000.
One recurring issue in divorce is how to divide the marital estate when the couple owns all of the stock of a closely held corporation. This can be a daunting task, especially when the value of the business exceeds half of the value of all marital assets. Although the spouses can continue the business through joint ownership after the divorce, this often proves difficult.
Spouses (and former spouses if the transfer is made pursuant to divorce) can transfer property to each other without income or gift tax, so the easiest way to divide a marital estate is simply to split it between the spouses. This will not work, however, if the value of the business dominates the value of the entire estate. Thus, Jeff and Jessica must look at other options.
Redeem the Stock of One Spouse
If only one spouse wishes to continue the business, the best alternative may be for the corporation to redeem the stock of the other spouse. For example, if Jeff wanted to continue the business and Jessica wanted to liquidate her interest, the corporation could redeem her stock at its fair market value. Jessica would walk away with cash of $400,000.
From a tax perspective, the goal is to have the transaction treated as an exchange to take advantage of capital gains tax rates, which are lower than ordinary income tax rates. The tax consequences of a stock redemption in this context, however, are unclear. Interpreting the interplay of several tax provisions, a court might classify the redemption of Jessica’s stock as a dividend to Jeff. As a dividend, it would be taxed at the higher, ordinary income rates.
Transfer Stock and Pay Alimony
To avoid the tax uncertainty of a redemption yet still equalize division of the assets, one spouse could transfer all of his or her stock to the other spouse, who then would pay alimony to the transferring spouse. Properly structured, a divorce-related transfer of property would not result in taxable gain or a taxable gift.
To take advantage of this planning opportunity, Jessica would transfer her stock to Jeff pursuant to a written agreement. Jeff would then pay alimony to Jessica, which would include an amount equal to the value of the stock. He would make payments over a number of years until the full amount was paid. Jeff would also be able to deduct the payments. Payment for Jessica’s stock as alimony would result in ordinary taxable income to her, but it could be structured so that the parties would share this additional tax liability.
Split the Business
If the corporation consists of two separate and distinct lines of business or specialties, the couple might wish to divide the company into two businesses. The corporation could transfer the assets and liabilities of one of the businesses into a new corporation.
For example, if Computers ‘R’ Us consisted of a consulting division and a repair division, and Jeff wished to retain one side and Jessica the other, they could transfer the assets and liabilities of one division into a newly created subsidiary corporation. The corporation could then distribute the stock of the subsidiary solely to Jessica in exchange for her stock in Computers ‘R’ Us. With proper planning, they could execute this strategy tax-free, and Jeff and Jessica would each control his or her own business.
Consider All the Opportunities
The estate and gift tax aspects of divorce normally involve a number of complex issues. When a closely held business is part of the mix, however, the complications increase exponentially due to the many planning opportunities available. Careful planning is required to avoid potential adverse tax consequences that may accompany the use of some of these strategies. We would be pleased to help you structure a property settlement to minimize the tax consequences and meet both spouses’ needs.
Why Not Liquidate?
The easiest alternative may be to liquidate the corporation. The proceeds then can simply be distributed between the spouses. There is a major potential obstacle to this solution, however: Both spouses may not want to sell. And, even if both are willing, this method is often still undesirable, because the business will usually be worth more as a going concern (especially if it’s a service business) and finding a buyer may be difficult.