Tax Traps for Property Settlements Involving the Allocation of Business Assets in a Divorce

This is the fifth post in the Frequently Asked Tax Questions in Family Law Cases series. This series is intended to answer questions family attorneys frequently ask us regarding tax issues.

Question: Husband is awarded the shares of the family corporation and the parties agree that Wife will take her Mercedes, which is owned by the corporation. What are the issues in awarding the car to Wife?

Answer: The transfer of the car from the corporation to the Wife will be a taxable event, even if it is part of a property settlement within a divorce. The challenge will be determining a way to reduce or avoid the tax impact of the transfer.

General Rule

In most cases, spouses do not recognize gain or loss on the transfer of property, or transfers between former spouses, if the transfer is pursuant to a divorce. (See IRS Publication 504) for examples of when this general rule does not apply, like when a spouse or former spouse is a nonresident alien).

Introducing a 3rd Taxpayer to the Divorce Settlement

The rules change when you introduce a third party, like a family owned corporation, into the transaction. Taxpayers often blur the lines between the company and themselves. They treat company assets as their own. This is a mistake. The corporation is a separate taxpayer and transfers from that taxpayer must be dealt with as a separate taxable event. Ignoring this distinction can create unexpected and unwanted tax obligations.

There are ways to transfer the car out of the corporation and incur minimum tax. The transfer could be a return of Wife’s capital in the business. It could be a repayment of a loan. It could be compensation to Wife, which would be income to Wife, but would create an equal deduction for the corporation. The impact of these and other scenarios can change depending on other factors including the form of the company, the parties’ ownership interest, the parties’ basis in their stock, or the parties’ position in the company. Each situation is unique, so you must determine the best way to transfer the asset from the company based on the existing circumstances. In all situations, you must treat the corporation as a separate taxpayer.

For more guidance on this issue, please refer to IRS Publications 535  and 15-B  which discuss the rules for the disposal of business assets and fringe benefits.