Identify How You Will Pay
There are various ways to buy out an ex-spouse’s stock. If the divorce has not been finalized, your spouse might get an off-setting amount of other marital property. For example, your spouse might get more of a retirement account while you take his or her stock in the closely held firm. This is often an easy way to divide equity in a business.
However, sometimes there is not enough marital property to offset the full value of the business interest. In this situation, our client might need to take out a loan to buy the stock. Getting approved for a loan is always difficult, especially in a down economy, but we have experience helping our clients accomplish this.
In other situations, the buying spouse might agree to make payments in installments over a number of years. However, in this situation, consideration must be given to the amount of interest to charge, which can increase the cost.
If the stock transfer happens while the couple is still married, then the transfer is tax free. This is the rule found in Section 1041 of the Internal Revenue Code, which states that transfers between spouses are treated as gifts.
Sometimes, however, the transfer will happen after the divorce has been finalized. Nevertheless, Section 1041 states that the transfer is still tax free so long as it happens within 6 years from the date of the divorce, if done pursuant to a divorce property settlement. This deadline is key if the buying spouse intends to use an installment agreement to purchase the stock.
The spouse getting the stock accepts it on a carryover basis, not a step-up basis. For tax purposes, this essentially means that it is as if the transferee spouse has always owned the asset. The spouse who is selling the stock has no tax liability.
Tax Issues when the Corporation Buys the Stock
Tax issues arise when an S or C corporation buys back the ex-spouse’s stock in the same company. This type of third-party stock redemption has tax consequences depending on how it is structured. Because company buybacks are popular for various reasons, we deal with two situations below to analyze who bears the tax burden.
In one situation, the redemption occurs between the ex-spouse who is selling the shares and the corporation that buys them. The other spouse has no federal tax consequences. The spouse who sells might be able to classify the redemption as a dividend paid by the company or as a sale.
If treated as a sale, the ex-spouse who is selling can sometimes offset the payment with their basis in the redeemed shares. The seller will bear all tax consequences.
In the second situation, the ex-spouse redeems the shares. However, tax-wise, the deal is construed as if the buying spouse collects the redemption payment before exchanging it for the shares. In this type of arrangement, the ex-spouse redeeming the shares has no tax consequences whereas the other ex-spouse bears the tax burden.
This arrangement occurs when there is a binding agreement that the spouse buy these shares. The corporation, in effect, only supplies the money, which the spouse uses to buy the shares from the ex-spouse who is selling them.
Of course, spouses have the power to elect to reverse the tax results under this second situation. However, they will need to agree to do so. They also will need to draft appropriate paperwork to make this election effective. This can be a bargaining chip when it comes to negotiating a property settlement agreement.
Protecting the Value of Your Business
Tax issues can dramatically lower the value of a business, so any time there is a stock transfer, particular attention must be given to structuring the transaction in the most favorable way. The federal and state tax codes are complicated, so hiring the right attorney can make a substantial difference in the value of your company exiting the marriage.
At Lawrence Law Office, we have helped entrepreneurs and other business owners divide their marital estates as part of a negotiated settlement. We can also litigate this issue in divorce court. Please contact us today.