Tax Planning for Business Owner Divorce

Tax Planning for Entrepreneurs During Divorce

If you are a business owner going through a divorce, it is prudent to have a tax adviser talk to you about the implications of the divorce on your business through the divorce. The purpose of this article is not to provide you with specific tax advice. We are divorce lawyers, not tax lawyers. However, we work regularly with tax professionals and attorneys to ensure our clients are best prepared for the road ahead. This article aims to highlight the need for a team of professionals to be on your team, if the circumstances call for them. You’ve worked too hard to get where you are in life not to plan and prepare for the next steps.

Strategize Tax Filing for the Year of Divorce

Your filing status is determined by your marital status on the last day of the tax year (IRC § 7703(a)). In community property states like Texas, you have two main options for the year of divorce:

1. Partition income for the entire year: File as if unmarried, claiming only your income, deductions, and withholdings. This is often the simplest approach.
2. Split community income: For the months you were married, claim half of your spouse’s income, deductions, and withholdings, and vice versa. This method may be financially advantageous but requires more coordination.

Consider the impact on various credits and deductions, such as:

• The Earned Income Tax Credit (IRC § 32)
• The Child Tax Credit (IRC § 24)
• Education credits (IRC § 25A)
• Itemized deductions (IRC § 63(d))

Ensure your divorce decree explicitly states how you’ll file taxes for the year of divorce to avoid future disputes. This agreement can be binding on the IRS if it meets the requirements of IRC § 6015(c)(3)(C).

Maximize Child-Related Tax Benefits

Understanding the IRS guidelines on claiming head of household status (IRC § 2(b)), child tax credit (IRC § 24), and the earned income credit (IRC § 32) is crucial. These can be valuable bargaining chips in divorce negotiations.

• Head of Household status: Generally more favorable tax rates and a higher standard deduction (IRC § 63(c)(2)(B))
• Child Tax Credit: Worth up to $2,000 per qualifying child under 17 (IRC § 24(h)(2))
• Additional Child Tax Credit: Refundable portion up to $1,400 per qualifying child (IRC § 24(h)(5))
• Child and Dependent Care Credit: Up to $3,000 for one child or $6,000 for two or more children (IRC § 21)

Only one parent can claim these benefits for each child in a given tax year. The IRS provides tiebreaker rules in Publication 501 for cases where both parents attempt to claim the same child.

Navigate Alimony and Spousal Maintenance

The Tax Cuts and Jobs Act of 2017 dramatically changed the tax treatment of alimony. For divorces finalized after December 31, 2018:

• Alimony is no longer tax-deductible for the payer (IRC § 215 repealed)
• Alimony is not taxable income for the recipient (IRC § 71 repealed)

This change can significantly impact negotiations and after-tax cash flow. Consider structuring payments as non-taxable property settlements instead of alimony if it benefits both parties. Be aware of the recapture rules under IRC § 71(f) for front-loaded alimony payments in pre-2019 divorces.

Leverage Tax Loss Carry-Forwards

Tax loss carry-forwards can be valuable assets in a divorce settlement. These allow you to offset future capital gains or ordinary income, potentially reducing your tax liability for years to come:

• Net Operating Losses (NOLs): Can be carried forward indefinitely for losses arising in tax years beginning after December 31, 2017 (IRC § 172(b)(1)(A)(ii))
• Capital Losses: Can offset capital gains and up to $3,000 of ordinary income per year (IRC § 1211(b))

Address the allocation of these tax attributes in your settlement. They can be especially valuable if you anticipate selling business assets or investments in the near future.

Plan for Retirement Account Impacts

Dividing retirement accounts requires careful handling to avoid early withdrawal penalties and other tax consequences:

• Qualified Domestic Relations Order (QDRO): A QDRO is used to split qualified retirement plan assets tax-free (IRC § 414(p))
• IRA Transfers: Can be done tax-free incident to divorce under IRC § 408(d)(6)
• One-time withdrawal option: Allows penalty-free (but not tax-free) withdrawals from a former spouse’s retirement account awarded in divorce (IRC § 72(t)(2)(C))

When comparing the value of retirement vs. non-retirement assets, consider the tax implications:

• Traditional IRA/401(k): Taxed as ordinary income upon withdrawal (IRC § 408(d)(1), § 402(a))
• Roth IRA/401(k): Potentially tax-free withdrawals if certain conditions are met (IRC § 408A(d))

Evaluate Investment Accounts and Capital Gains

Examine the cost basis of investments in any brokerage accounts:

• Long-term capital gains rates: 0%, 15%, or 20% depending on your income (IRC § 1(h))
• Short-term capital gains: Taxed as ordinary income
• Net Investment Income Tax: Additional 3.8% on investment income for high earners (IRC § 1411)

Consider these tax implications when negotiating asset division. Remember that the step-up in basis at death under IRC § 1014 doesn’t apply to divorce transfers, so keep accurate records of the cost basis of all assets received in the divorce.

Address Estimated Tax Payments

If you make quarterly estimated tax payments, determine how much has been paid for the current and prior year. Overpayments could be considered community assets to be divided.

Ensure you’re meeting your estimated tax obligations post-divorce to avoid underpayment penalties (IRC § 6654). You may need to file a new Form W-4 with your employer to adjust your withholding (IRC § 3402(f)(2)(B)).

Consider Business Valuation Methods

The method used to value your business can have significant tax implications:

• Asset-based valuation: May result in higher immediate taxes if you buy out your spouse’s share
• Income-based approach: Might lead to ongoing payments taxed as ordinary income
• Discounts for lack of marketability or control: Can reduce the taxable value of business interests (see Estate of Davis v. Commissioner, 110 T.C. 530 (1998))

Work with a qualified business appraiser and your tax advisor to understand the tax implications of different valuation methods.

Plan for Potential Business Restructuring

You may need to restructure your business as part of the divorce settlement:

• Buying out spouse’s interest: Could trigger taxable gain (IRC § 1041 doesn’t apply to transfers to third parties)
• Changing business structure: E.g., converting from S corporation to C corporation can affect how business income is taxed and may trigger the built-in gains tax under IRC § 1374
• Partnership to corporation conversion: May be tax-free under IRC § 351 if requirements are met

Consider the impact on:

• Pass-through taxation (IRC § 701 for partnerships, § 1366 for S corporations)
• Deductibility of business losses (limited for individuals under IRC § 461(l))
• Qualified Business Income Deduction (IRC § 199A)

Document Everything Meticulously

Keep detailed records of all business income, expenses, and asset values. This documentation is crucial for:

• Accurate valuations
• Tax reporting
• Potential future audits (the IRS can examine records going back several years)

Consider using accounting software that allows you to easily generate reports and track changes over time. This can be invaluable if you need to demonstrate the value of your business at different points in time.

Review Historical Tax Return Filings

Scrutinize your tax returns for each year of marriage, particularly the last seven years. The IRS generally has a three-year statute of limitations for audits (IRC § 6501(a)), but this can extend to six years for substantial underreporting of income (IRC § 6501(e)(1)(A)) or indefinitely in cases of fraud (IRC § 6501(c)(1)).

For business owners or those with complex investments, audit risk may be higher. Before agreeing to share responsibility for tax liabilities and refunds, consult a tax advisor about:

• Potential future audits
• Tax liabilities from previous years of marriage
• The impact of filing joint returns (joint and several liability under IRC § 6013(d)(3))
• Possible relief under innocent spouse provisions (IRC § 6015)

Engage Expert Help

Work with a Certified Public Accountant (CPA) or tax attorney specializing in divorce and business taxation. Their expertise can help you navigate complex tax issues and identify the most advantageous strategies.

Consider forming a team of experts, including:

• Divorce attorney
• CPA or tax attorney
• Financial advisor
• Business valuation expert

This team can ensure all aspects of your financial situation are considered holistically.

Consider the Timing of Income and Deductions

The timing of income recognition and deduction claims can significantly impact your tax liability:

• Cash vs. accrual accounting methods (IRC § 446)
• Accelerating or deferring income (Rev. Rul. 78-200)
• Timing of business expense deductions (IRC § 162)

Coordinate with your spouse to time income and deductions in the most tax-efficient manner possible during the year of divorce.

Address International Tax Issues

If your business has international operations or investments, be aware of additional complexities:

• Foreign tax credits (IRC § 901)
• Controlled Foreign Corporation rules (IRC § 951-965)
• Global Intangible Low-Taxed Income (GILTI) provisions (IRC § 951A)
• Transfer pricing considerations (IRC § 482)

These issues can significantly impact the valuation and division of business interests in a divorce.

Conclusion

Navigating a divorce as a business owner involves complex tax considerations that can have long-lasting financial implications. By understanding the relevant tax laws and planning strategically, you can protect your business interests and set yourself up for financial success post-divorce.

Start this planning process early, ideally before filing for divorce, and maintain open communication with your tax and legal advisors throughout the proceedings. Remember that while tax considerations are important, they should be balanced with other factors such as maintaining business operations and achieving a fair overall settlement.

With careful planning and expert guidance, you can emerge from your divorce with your business intact and a clear path forward for both your personal and professional life. The tax code is complex and ever-changing, so regular consultation with tax professionals is crucial to ensure you’re making the most informed decisions possible during this challenging time.