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Divorce issues and business succession planning.

A CPA can play an important role in divorce tax planning that involves a closely held business. This article identifies some common issues the tax adviser faces when a divorcing client or spouse owns a closely held business and discusses planning techniques.


Stock in a closely held business can be one of" a business owner's most dominant--and illiquid--assets. Similarly, in the event of" a divorce, the closely held business can also be the largest portion of the business owner's marital estate. This category also includes the marital home and retirement assets. Thus, for many business owners, the majority of their assets arc illiquid. Equally important for planning purposes, closely held business interests are both centrally important to the wealth of the family and key to its ability to generate future income.

Because spouses in the midst of a divorce are often consumed with stress and emotion that may impede rational thinking, it is incumbent on their advisers to assist them in taking the steps they need to ensure sound financial results. This article is a primer for some of the issues that a practitioner faces in advising clients in the event of (or in anticipation of) a divorce, when one of the divorcing (or potentially divorcing) parties has (or may have) an interest in a closely held business.

In a divorce, the parties' financial rights and obligations revolve around three basic concepts, any one of which can affect the business: alimony or spousal support rights, child support rights and property settlement rights. The most obvious and profound effect is when the "property" interests in the business must be divided between the spouses. This can be very problematic for a business owner with spoused or child support obligations; he or she often relies on the business as a source of funds to provide such support. (1)

Conflicts and Issues

"People" issues in a divorce arise when one or both of the divorcing parties manage a closely held business or, perhaps, neither party plays a part. To further complicate the picture, other people could be involved in the business, such as the owner's child or in-law. Emotional issues also surround a divorce and could have a huge effect on ownership sharing and management and, ultimately, the business's survival.

"Property" issues that commonly arise might include ownership rights, valuation disputes, division of the business, tax ramifications and the rights of' third-party creditors. The following discussion briefly covers these concerns and the ways a practitioner can resolve them.

Valuing the Business

For purposes of dividing marital assets, the obvious first step is to value them. Assets are usually valued at current "fair market value" (FMV), winch is generally defined as "the amount a willing buyer and a willing seller would exchange assets absent duress." (2)

The valuation of a closely held business is no easy task. One possible starting point is for one or both parties to engage an appraiser. The appraiser should be accredited in business valuation and be a member of an accredited organization, such as the AICPA, the American Society of Appraisers, the National Association of Certified Valuation Analysts, the Institute of Business Appraisers, Inc. or the Association for Investment Management and Research.

Once the appraiser has used a valuation method or combination of methods to determine a base value of the business, discounts are sometimes applied to arrive at a final value. Discounts, such as for lack of marketability or minority interests, are often used to value certain gifts and third-party sales. It is not clear whether they are appropriate for valuing a business in a divorce context)

Pre- and Post-Nuptial Agreements

The most obvious way for business owners to protect their business interests on divorce is to execute a pre- or post-nuptial agreement. Among other things, the agreement should discuss whether the nonowner spouse will have any right to the business on divorce, and, if so, the manner in which the business will be divided. If the nonowner spouse does not fully release any rights in the business, the agreement should, at a minimum, set forth a valuation method.

To avoid ambiguities requiring court intervention, a client's pre- or post-nuptial agreement should coordinate with any buy-sell agreement for the business. For example, if the buy-sell agreement requires the company to redeem the shares of an exiting shareholder, the pre-nuptial agreement should not require the other spouse to redeem the shares. The agreement should also specifically address whether potential appreciation from the time of the agreement to the date of a subsequent divorce will be considered in valuing the business.

If children of either or both spouses are active in the business or are expected to take it over, it may be prudent to ask for their input before executing a pre- or post-nuptial agreement. This may avoid conflict later.

Shareholder Buy-Sell Agreements

A buy-sell agreement is a contract governing the sale of a business interest for a specified price at a future date or on the happening of a future event. The sale typically negotiated in a buy-sell agreement usually takes one of two forms: "redemption" by the company or "cross-purchase" between shareholders?

Buy-sell agreements can provide for the possibility of divorce. For example, a buy-sell agreement may state that if any relative by marriage of X or Y (founders) is divorced from a blood relative of X or Y, any shares owned by the former (or acquired in the divorce) will be offered for sale for a set price to a specified buyer.

Buy-sell agreements can also set forth the desired method for valuing the business. Such valuation methods, although not binding on a court, are often considered in a divorce proceeding. However, as noted above, issues such as discounts, tax liabilities and business goodwill might be used in a third-party context, but may not be acceptable in divorce valuations. A separate agreement between the spouses may be able to clarify the appropriate factors and means to be used to value the business on a divorce.

Liquidity issues should be addressed before finalizing any marital settlement agreement. If the buyer does not have the cash for the purchase, it may be desirable for the business to sell assets to generate liquidity or obtain financing to redeem the spouse's shares. One solution is for the purchasing spouse to assign the right to buy the shares to a co-owner or to the business. Obviously, tax and other ramifications to the co-owners should be addressed.

Trusts and Asset Protection

Generally, "asset protection" describes a method, such as a trust, by which a property is preserved and protected from creditors. Creditors are often thought of as including suppliers, customers or perhaps the government. Sometimes, however, the biggest creditor (or potential creditor) is a divorcing spouse.

Typically, a person creates a trust in which to place assets for the benefit of his or her children or other descendants to accomplish normal estate planning objectives, as well as those arising from concerns over the family business and the possibility of divorce. Such trusts are often created when either the grantor's children are minors or other-wise incapable of managing the trust property, or the grantor wishes to name a trustee capable of making appropriate business decisions.

The grantor might also create a trust to hold business interests, to be certain that any property, given to a child is protected (1) from the child's wasteful habits (e.g., a spendthrift-type trust) or (2) if the child divorces. The child's spouse could be excluded as a potential beneficiary, so that the child would be protected. Of course, a divorce court, when making an equitable distribution of assets between divorcing spouses, may take into account the fact that a trust is in place for the child and, thus, allocate a larger percentage of the marital assets to the child's spouse to compensate. Also, courts have been known to attach trust assets to meet support obligations.

A more classic "asset protection" plan is a trust created for the benefit of the grantor, among others. In this situation, assets are transferred in trust; the trustee is given discretion, generally subject to the approval of a third party (often known as the "protector"), to make distributions to a class of people, including the grantor. Asset protection trusts may be created onshore (i.e., in the U.S.) or offshore. MaW factors need to be considered in choosing the appropriate jurisdiction for a particular client. A discussion of these factors is beyond the scope of this article.

For asset protection trusts to be deemed a viable alternative, the grantor cannot have creditors already in existence. In the divorce context, this probably means that the divorce or separation proceedings must not have already begun. However, even if no divorce proceedings are pending, other creditors may already exist. If assets are transferred while there are known creditors, such a transfer could be deemed a "fraudulent conveyance" and overturned by creditors.

Thus, in assisting a client in setting up an asset protection trust, it is important to understand why he or she is interested in asset protection, prepare a solvency analysis and conduct due diligence on the client, to ensure that there are no known or readily identifiable creditors. If there are, any persons assisting the debtor in defrauding them (e.g., an adviser with a deeper pocket) could be held personally liable.

Tax Issues


Sec. 1041 is the cornerstone of a system of tax-free treatment of inter-spousal transfers under the income, gift and estate tax rules. Under this provision, spouses or former spouses can sell or exchange property, with one another, free of income tax, if certain requirements are met. Sec. 1041 states: "[n]o gain or loss shall be recognized on a transfer of property- from an individual to (or in trust for the benefit of)--(1) a spouse, or (2) a former spouse, but only if the transfer is incident to the divorce." According to Sec. 1041 (c), a transfer is incident to the divorce if it occurs within one year after the divorce or "is related to the cessation of the marriage." Thus, it may not be a bad idea for property settlement agreements to recite that all property transfers between the parties are "related to the cessation of the marriage."

Notwithstanding the general rule, Temp. Regs. Sec. 1.1041-1T(b), Q&A-7, provides a rebuttable pre-sumption that "any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than 6 years after the cessation of the marriage is presumed to be not related to the cessation of the marriage. This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage." An adequate rebuttal would entail, for example, proof that an earlier property transfer was hampered by "legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and [that1 the transfer is effected promptly after the impediment to transfer is removed."

In the business succession planning context, an example would be an agreement between the divorcing parties to split the business's ownership; an impediment would be transfer restrictions imposed by a buy-sell agreement between the divorcing business owner and an unrelated business owner that would prevent transfer of the interest to the spouse. (5)

The tax adviser should keep in mind the following points:

* Under Sec. 1041, a spousal transfer of encumbered property will not result in gain recognition, even if liabilities exceed basis; see Temp. Regs. Sec. 1.1041-IT(d), Q&A-12. However, transfers in trust may result in gain recognition under Sec. 1041(e) (discussed below).

* Sec. 1041 does not apply if the transferee spouse is a nonresident alien or if the transferor is an executor of a will and makes a transfer to his or her spouse in a fiduciary capacity (as opposed to in his or her individual capacity). Under Sec. 7701(a)(1), the term "individual" does not include an executor.

* Under Secs. 71 and 215, alimony and separate maintenance are taxable to the recipient spouse and deductible by the payer spouse. Occasionally, the distinction between alimony and division of property is blurry.

* Under Sec. 2043(b)(1) (transfers for insufficient consideration), certain property is included in a gross estate to the extent of excess value over consideration received; relinquishment of marital rights is not generally deemed consideration.

Tax Liabilities

In the divorce arena, courts generally will not consider the tax consequences resulting from a marital property distribution, unless they are an immediate and a direct result of the divorce. For example, under NewYork law, a former husband's interest in a law firm could not be valued by deducting taxes that would have to be paid by his estate on the portion attributable to his income, because no taxable event (i.e., death) had occurred. (6) According to the court, "[i]n the absence of a showing that a taxable event is involved, a court is not required to consider tax consequences."

When distribution of the marital estate may have negative tax ramifications to the spouses, the parties may execute side (e.g., indemnity) agreements to make them whole. The parties should be sure that the transfers qualify for tax-free treatment under Sec. 1041.


Property transferred between spouses is treated as acquired by the transferee by gift under Sec. 1041(b)(1). According to Sec. 1041(b)(2), the transferee's basis in the property is the transferor's adjusted basis. These rules supercede the general gift tax rules for transfers between unmarried persons under Sec. 1015. The significant distinguishing factor is that the transferee spouse takes the transferor spouse's basis for all purposes, including determining loss for income tax purposes; see Temp. Kegs. Sec. 1.1041-1T(d), Q&A-11.

Sec. 1041 allows a spouse to take a loss when the property's basis exceeds FMV.

Example 1: A transfers ownership of the principal residence to his spouse, E. On the date of the transfer, the residence has a $100,000 adjusted basis and a $125,000 FMV. E sells the residence for $135,000. E recognizes $35,000 gain, the difference between the $135,000 sale price and the lesser of (1) FMV ($125,000) or (2) her carryover basis ($100,000). The same result applies under both Secs. 1015 and 1041.

Example 2: The facts are the same as in Example 1, except the FMV of the residence on the date of the gift is $90,000; E sells the residence for $85,000. When a donee's basis is. determined under Sec. 1015, he or she would recognize a loss equal to the difference between the lesser of basis or FMV on the gift date and the sale price ($90,000 FMV - $85,000 sale price = $5,000 loss). Under Sec. 1041, however, E's loss would lie $15,000 ($100,000 carryover basis - $85,000 sale price).

Example 3: The facts are the same as in Example 2, except E sells the residence for $96,000. She would recognize no gain or loss had Sec. 1015 applied, but would recognize a $4,000 loss under Sec. 1041 ($100,000 carryover basis - $96,000 sale price).

Under Sec. 267(g), Sec. 267 (which provides special income tax rules for transactions between related parties) does not apply to transfers subject to Sec. 1041(a).

Also, for Sec. 1041 to apply, the transfer must be between spouses. Thus, according to Regs. Sec. 1.1041-1T(a), Q&A-2, a distribution from a corporation owned by one spouse, to the other spouse will not trigger Sec. 1041.

Stock Redemptions

In a divorce, two common problems arise when spouses own interests in a closely held business--how to divide the property and the income tax consequences of the resulting division. Typically, the parties have resolved the first issue by negotiating a stock transfer or stock redemption in their divorce agreement.

General rule: Generally under Sec. 302(a)(1), when a corporation redeems its own stock and any one of the exceptions in Sec. 302(b)(1)--(4) applies, the redemption "shall be treated as a distribution in part or full payment in exchange for the stock." Under Sec. 302(b)(1), the redemption will fall within this general rule, if, inter alia, "the redemption is not essentially equivalent to a dividend"

If the redemption is deemed "essentially equivalent to a dividend" and does not fit within any of the other Sec. 302(b) exceptions, the amount received by the shareholder is taxed under Sec. 301 as a distribution "with respect to its stock" (potentially a dividend) from the company.

Normally, a complete redemption of a shareholder's interest in a closely held business will fall within the Sec. 302(b)(3) exception, and the exiting shareholder will be taxed at capital gain rates on the difference between the sale price and his or her basis in the shares.

Example 4: Brother B and sister S each own 50% of family corporation F.F has $50,000 cash and $50,000 in other assets. B and S each has a $10,000 stock basis. S retires; F redeems all of her stock for $50,000. B now owns 100% of F, worth $50,000. S has $50,000 and a $40,000 realized capital gain ($50,000 redemption value -$10,000 basis).

Redemption as primary and unconditional obligation: Under certain circumstances, a redemption of stock owned by one shareholder could result in a constructive distribution to another shareholder, if the latter has a "primary and unconditional obligation" to purchase the former's stock. However, if the stock purchase right is assigned by the shareholder to the corporation before he or she incurs a primary and unconditional obligation, the redemption does not result in a constructive distribution to the shareholder. (7) When the redemption is treated as a constructive distribution, the remaining shareholder is taxed on it under Sec. 301 and, if it is a dividend, at applicable income tax rates.

"This 'primary and unconditional obligation' standard applies to all redemptions, including those involving stock of closely-held corporations by spouses or former spouses." (8)

Example 5: The facts are the same as in Example 4, except B has a primary and unconditional obligation to redeem S's shares. B is treated as if he received $50,000 as a constructive distribution from F--all of which is treated as a distribution under Sec. 301. S still has a $40,000 realized capital gain.

Post-Jan. 13, 2003 redemptions and transfers: On Jan. 13, 2003, Regs. Sec. 1.1041-2 came into effect, which should help divorcing parties plan the tax aspects of stock transfers and redemptions. The new regulation applies the case law principle of "primary and unconditional obligation" and the general principles of constructive distributions, to stock redemptions in the divorce context.

Under Regs. Sec. 1.1041-2(a)(1), if the redemption of the stock owned by the exiting shareholder spouse is not a constructive distribution to the remaining shareholder, the redemption's form will be respected and the exiting shareholder spouse will be treated; for tax purposes, as having redeemed the stock. The Sec. 1041 nonrecognition rules do not apply to the transaction; instead, the normal Sec. 302 redemption rules determine the tax consequences, under Regs. Sec. 1.1041-2(b)(1).

If, however, the transaction is deemed a constructive distribution to the remaining shareholder spouse, Regs. Sec. 1.1041-2(a)(2) provides that it will he treated as if it occurred in three steps: (1) the stock was transferred to the remaining shareholder spouse; (2) the stock was redeemed by the corporation; and (3) the remaining shareholder spouse transferred the redemption proceeds to the exiting shareholder spouse. In effect, Sec. 1041 will result in nonrecognition treatment on the transfer of stock between the spouses (step 1) and the transfer of the redemption proceeds between the spouses (step 3), but will not apply to the deemed redemption by (distribution to) the remaining shareholder spouse (step 2); see Regs. Sec. 1.10412(b)(2). Instead, the normal rules of Sec. 301 (distributions of property) and Sec. 302 (distributions in redemption of stock) will apply to the deemed distribution proceeds.

Recognizing that the primary and unconditional obligation standard had caused uncertainty among taxpayers, and acknowledging that flexibility is consistent with legislative intent in this area, the new regulation permits spouses to avoid questions as to the tax treatment of a redemption, by allowing them to have a written agreement that, in effect, defines the tax consequences. (9) Under Regs. Sec. 1.1041-2(c), the spouses can agree which of the two tax treatments should apply in an agreement that expresses both spouses' intent and provides that the agreement supersedes any other.

Under Regs. Sec. 1.1041-2(c)(3), the agreement must he executed before the timely filing date (including extensions) of the return of the spouse recognizing the distribution for the tax year that includes the redemption.

Other Tax Consequences

Transfers in trust under Sec. 1041(e): If the spouses agree that one of them will place property in trust for the other in lieu of, or in connection with, the division of business assets or interests, the transferor spouse may have to recognize gain under Sec. 1041(e). That provision states that when property is transferred in trust for the benefit of a spouse or former spouse incident to a divorce, the Sec. 1041 nonrecognition rules do not apply to the extent the sum of the liabilities assumed by the trust and the liabilities to which the transferred property is subject exceeds the transferred property's total adjusted basis. This result should be contrasted with Temp. Regs. Sec. 1.1041-1T(d), Q&A-12 (discussed above), which would not cause gain recognition if a spouse directly transfers encumbered property to the other spouse when liabilities on the property exceed basis.

In Letter Ruling 9230021, (10) however, the IRS did not apply Sec. 1041(e) when the transfer was to a grantor trust. In that ruling, the IRS held that the transferor was the owner of the property both before and after the transfer, so that no transfer took place for Sec. 1041 purposes.

Qualified plans: Under certain circumstances, retirement assets may be the only assets available to transfer to the spouse in lieu of a business interest, as part of a property settlement. To have a spouse or former spouse recognized as the participant in the plan for tax purposes, Sec. 402(e)(1) requires a qualified domestic relations order (QDRO), within the meaning of Sec. 414(p).

A DRO, or "domestic relations order" is defined in Sec. 414(p)(1)(B) as any "judgment, decree, or order (including approval of a property settlement agreement)" that "relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant" and "is made pursuant to a State domestic relations law (including a community property law)."

Under Sec. 414(p)(1)(A), a QDRO is a domestic relations order that "creates or recognizes the existence of an alternate payee's right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits payable with respect to the participant under a [retirement] plan" To be a QDRO, Sec. 414(p)(2) and (3) provide that the DRO must also state certain facts and may not alter retirement benefits in certain proscribed ways. The spouse receiving plan benefits under a QDRO may be able to defer tax by rolling over the entire distribution within 60 days, under Sec. 402(c).

IRA offsets: The transfer of an IRA, or part thereof, to a former spouse under a written instrument incident to divorce is a nontaxable transaction between the parties. The transferred IRA is thereafter treated as that of the transferee spouse under Sec. 408(d)(6); no QDRO is required. The transferee spouse is thereafter subject to income tax on plan distributions, unless the distribution qualifies for rollover deferral under Sec. 402(c).

Property distribution: There are several considerations when business assets are used to satisfy a marital property settlement. First, will the business be able to continue without those assets or are the assets replaceable? Second, caution is warranted if the assets used to satisfy the settlement consist of appreciated property; the distribution of such assets may trigger gain or cause other tax ramifications. Third, if the parties decide to split off certain business assets or distinct operating businesses between them, they should consider the tax consequences and other costs of liquidating the corporation. They might consider a Sec. 368 corporate reorganization, which would result in nonrecognition treatment to them under Sec. 354 or 355.


CPAs can complement the role of legal and other advisers to ensure that a divorcing client's interests in a closely held business are fully represented. As a result, the client will have a more complete understanding of the financial and tax consequences of divorce and, perhaps, some "peace of mind" during a difficult time.


* When a closely held business is involved, divorcing couples often dispute ownership, valuation, division, taxation and third-party creditor rights.

* The tax adviser has to consider how divorce transfers and transactions affect tax liability and basis, including stock redemptions, transfers in trust, qualified plans and property distributions.

* The CPA can complement the roles of legal and other professional advisers to ensure that the divorcing client's interest in the closely held business is fully represented.

Editor's note: Ms. Capassakis is the immediate past Chair of the AICPA Tax Division's Trust. Estate and Gift Tax Technical Resource Panel.

Author's note: The author is grateful for the contributions of Lisa Barbieri and Anne Marie Guglielmo in the preparation of this article.

(1) State law generally determines the rights and obligations of each spouse as to marital property. This article does not address the laws of any specific state, but merely touches on state law concepts as they pertain to the overall discussion.

(2) See Christians v. Christians, 732 So.2d 47 (FL Dist. Ct. App. 1999).

(3) See Haymes v. Haymes, 298 AD2d 117, 119 (NY App. Div., 2d Dep't 2002) (court allowed discount in valuing a husband's business properties, which were equitably distributed to the parties pursuant to a divorce judgment, to reflect his minority interest and lack of control in the company). But see Brown v. Brown, 792 A2d 463 (NJ Super. Ct., App. Div. 2002) (court found no extraordinary circumstances warranting marketability or minority discounts in valuing a husband's 47.5% interest in a closely held floral business--with 47.5% and 5% owned by the husband's brothers--for purposes of equitable distribution in a divorce action).

(4) For a general discussion of buy-sell agreements, see Jackson and Maloney, "Buy-Sell Agreements--An Invaluable Tool," Part I, 34 The Tax Adviser 200 (April 2003) and Part II, 34 The Tax Adviser 284 (May 2003).

(5) See also IRS Letter Ruling 9123053 (3/13/91) (payments made more than six years after cessation of marriage were tax free when made to effect the division of community property. Cash payments were made to the wife in 60 installments (one-half of the value of employment benefits)).

(6) Harmon v. Harmon, 173 AD2d 98 (NY App. Div., 1st Dep't 1992).

(7) See Rev. Rul. 69-608, 1969-2 CB 42; William Sullivan, 363 F2d 724 (8th Cir. 1966), cert. den.; William Wall, 164 F2d 462 (4th Cir. 1947); and Mary Ruth Hayes, 101 TC 593 (1993).

(8) See TD 9035 (1/14/03).

(9) See the preamble to TD 9035, id.

(10) IRS Letter Ruling 9230021 (4/28/93).

Evelyn M. Capassakis, J.D., LL.M.

Wealth Transfer Solutions Principal

PricewaterhouseCoopers LLP

New York, NY
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Author:Capassakis, Evelyn M.
Publication:The Tax Adviser
Date:Dec 1, 2004
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