Divorce - Divorce-Related Corporate Buyout

        The importance of properly structuring the transfer of the business owned with your spouse cannot be overestimated. When one spouse winds up with the family business as the result of a divorce, who bears the tax cost and what that tax cost will be is completely dependent on how the transaction is accomplished.

        Frequently, in these situations, the first place a couple looks for funds for the buyout is the corporation itself. In other words, one spouse's stock will be redeemed by the corporation. Normally, redemption of an individual's entire stock interest is fairly straightforward - the difference between the amount paid by the company and the individual's stock basis (usually what the individual originally paid for the stock) is a capital gain or loss. However, complications arise with divorce-related redemptions.

        Specifically, the spouse who keeps the company may face a big tax bill on account of the redemption of the other spouse's stock. The flip side is that the redeemed spouse may be able to escape paying any tax on the redemption.

        The complication arises from interplay of the redemption and divorce rules. In general, divorce-related property settlements are not treated as taxable sales. For example, one spouse gets the primary residence and the other spouse gets the vacation home and investment property. Neither spouse is treated as having made a taxable sale to the other spouse.

        But it is a totally different situation when the spouse being bought out is having his or her shares redeemed by the company in exchange for cash from it. In a case involving this type of situation, the spouse who was bought out (who happened to be the wife) got the court to agree that she did not have to pay tax on the redemption. A key fact was that the divorce instrument required the wife to transfer her stock to the corporation in exchange for cash. The wife was treated as transferring her stock to the husband in a tax-free transaction. While only the wife's tax was before the court, under its reasoning, the husband would be considered to transfer the stock to the corporation and would be hit with ordinary income on this deemed transfer.

        Obviously, this type of result is good for the redeemed spouse and bad for the spouse who winds up with the business. The best solution would be to structure the buyout so that neither spouse is taxed. One way to do this is to have the spouse who is to end up with the company transfer other marital assets to his or her spouse in exchange for the stock.

        If company funds absolutely have to be tapped, the spouse who will get the business should insist that the divorce agreement not obligate the other spouse to transfer his or her shares. There can, however, be a separate redemption agreement between the spouse who is being bought out and the corporation. If these steps are taken, the gain on the redemption will be taxed to the redeemed spouse who will have cash from the redemption to pay the tax. However, because of the tax, the redeemed spouse may be justified in seeking a higher price or a greater share of other assets.

        Please do not hesitate to contact us to help you develop appropriate planning for your situation.

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