Tax Reform Affects Divorce Settlements for Small Business Owners

How Tax Reform Affects Divorce Settlements for Small Business Owners

How does the Tax Cuts and Jobs Act (TCJA) affect divorce settlements? Changes in the new law may require divorcing individuals — especially those who own businesses and other investments — to take a different approach to splitting assets and setting maintenance payments than under prior law.

To illustrate, consider Pat and Chris, a hypothetical married couple who decided to file for divorce on Valentine's Day 2019. Here's an overview of several key issues they face.

Business Tax Issues

Pat is the family's sole breadwinner. During her 15-year marriage with Chris, Pat started a successful electrical subcontracting business. It's a C corporation with net profits of $300,000 and $450,000 in 2017 and 2018, respectively. Pat is the company's only shareholder.

Under the TCJA, tax rates for C corporations have been permanently reduced to a flat 21% for tax years beginning in 2018 and beyond. In general, this change would increase a C corporation business's future earnings and make it more valuable than under prior law.

Important: If Pat's business operated as a so-called "pass-through" entity — such as a sole proprietorship, LLC, partnership or S corporation — Pat might qualify for a deduction of up to 20% of qualified business income. This tax break is only available from 2018 through 2025, unless Congress extends it. It's not available for C corporation businesses.

There's more to the TCJA than just lower tax rates, however. There are some additional business friendly provisions, such as expanded first-year bonus depreciation and Section 179 depreciation deductions for qualified assets and elimination of the corporate alternative minimum tax (AMT).

There are also some provisions that can adversely affect business taxpayers, such as the new limitation on business interest expense deductions and elimination of deductions for business entertainment expenses and domestic production activities.

When valuing Pat's business, historical results may be less relevant under the TCJA. Projections of future earnings used in valuation will certainly require more than simply multiplying historical results by an expected growth rate. It's also important to fully understand how the TCJA affects Pat's company. The changes are sweeping. Some companies will come out ahead under the new law; others won't.

Investments and Real Estate

Pat and Chris have other valuable assets in their marital estate, including an investment in a private airplane, a primary residence and a vacation cottage. These assets also are affected by changes included in the TCJA.

Under the TCJA, tax-deferred Section 1031 like-kind exchanges are still allowed for real estate held for business or investment purposes. However, Section 1031 treatment isn't allowed for exchanges of personal property used for business or investment purposes (such as equipment, airplanes, vehicles and patents) that are completed after 2018. The change, which is permanent, could make these types of assets — including Pat and Chris's interest in a private airplane — less desirable when settling their divorce.

The TCJA also may have an impact on the perceived value of the couple's personal real estate, if they live in a high-tax state. Itemized deductions for all state and local taxes (SALT) are limited to only $10,000 for 2018 through 2025. New limitations have also been placed on itemized deductions for home mortgage interest expense for 2018 through 2025, with some exceptions.

Finally, standard deduction amounts have been nearly doubled (to $12,200 for singles and $24,400 for married couples who file joint returns for 2019). So, for 2018 through 2025, fewer taxpayers will itemize deductions and more will claim the standard deduction.

These changes may make principal residences and vacation homes less desirable when splitting up marital assets, because the ex-spouse who receives the homes may not be able to claim as many tax deductions as under prior law.

Tax Treatment of Alimony

Maintenance payments for alimony and child support are also common in divorce agreements, and they can be used to supplement asset splits to achieve an equitable overall settlement.

In our hypothetical example, Pat and Chris executed a prenuptial agreement before the marriage. In addition, they've agreed to share joint custody of their two minor children. Chris will be the custodial parent. Pat will pay Chris alimony and child support. Chris has agreed to pay for elementary and secondary school expenses, and Pat will cover the costs of post-secondary education. Each child has a tax-advantaged Section 529 account with a current balance of $50,000.

The TCJA doesn't change the tax treatment of child support payments. As under prior law, they are nondeductible for the payer and tax-free for the recipient. But for alimony payments required by divorce agreements signed after December 31, 2018, deductions are no longer allowed for the payer (Pat) and the payments are tax-free to the recipient (Chris).

The change in the tax treatment of alimony is permanent. In theory, for divorces settled after December 31, 2018, the payer (Pat) could challenge a prenuptial agreement that prescribed alimony payments based under the prior-law presumption that the payer was able to deduct the payments. This change to the tax law was arguably unforeseeable. And it would adversely affect the payer-spouse, because he or she would owe tax on the payments — and create a windfall for the recipient-spouse who wouldn't owe tax on the amount he or she received.

Important: The TCJA doesn't change the tax treatment of alimony payments made under divorce agreements executed prior to January 1, 2019, unless the agreement is amended to expressly adopt the new TCJA rules.

Under prior law, allocating maintenance payments between alimony (which was formerly taxable to the recipient) and child support (which was and is nontaxable to the recipient) was a major issue, especially when there was a substantial disparity between the former spouses' expected tax rates. This issue is no longer relevant under the TCJA.

In some jurisdictions, courts have ruled that there's a trade-off between receiving personal goodwill and alimony payments.

Under prior law, non-business-owner spouses sometime chose to forego alimony (which the recipient had to claim as taxable income) in exchange for receiving more of the business's value (which could be transferred tax-free). Conversely, the business-owner ex-spouse may have preferred to pay more in alimony to reduce his or her taxable income. This is no longer an issue for payments required by post-2018 divorce agreements.

The Double-Dipping Debate

When a divorcing couple's marital estate includes a private business interest, the value of goodwill may be a point of contention. Although this issue is most often associated with professional practices, other businesses can also possess some elements of goodwill.

The term "goodwill" is used to describe intangible value that exceeds the value of a business's identifiable assets, such as inventory, receivables, equipment, real estate, customer lists and patents.

Whether goodwill is included in the marital estate varies from state to state. In some jurisdictions, the value of the entire business (including goodwill) is included in the marital estate and subject to division just like other assets. In others, goodwill is carved out and specifically excluded from the marital estate.

More than half the states take this analysis one step further. They split up goodwill into two parts:

  1. Business goodwill. This is attributable to the business as the standalone entity. It includes the value of an established workforce, viable long-term contracts and recognizable brands.
  2. Personal goodwill. This is tied to the skills and reputation of an individual owner. It typically can't be transferred to a new owner if the business is sold without substantial continuing efforts from the former owner.

In jurisdictions that differentiate between business and personal goodwill, the former is included in the marital estate. Personal goodwill may be excluded from the marital estate if the non-business-owner ex-spouse receives alimony based on the business-owner ex-spouse's earnings.

The theory is that it's inequitable for a non-business-owner ex-spouse to benefit twice from the same asset — the other ex-spouse's future earnings capacity — by receiving both alimony payments and the value of personal goodwill. This concept, commonly known as "double-dipping," isn't universally accepted in all states. Contact a valuation professional to determine the appropriate treatment of goodwill in your case.

Child-Related Tax Issues

Under prior law, when both spouses shared custody of minor children, the right to claim dependency exemptions could be used as a negotiating tool in some cases. In general, the custodial parent was eligible for the exemption. But a noncustodial parent could claim the exemption if the custodial parent signed a release form.

The TCJA eliminates dependency exemptions for 2018 through 2025. So, this is no longer an issue over the short run.

However, a new negotiating tool has emerged: the expanded child tax credit. Under the TCJA, this credit has been doubled to $2,000 and the income threshold to qualify for it has been increased, making many more taxpayers eligible for it. In addition, older children and other nonchild dependents may qualify for a new $500 credit.

In general, the custodial parent (Chris in our example above) is eligible for these credits unless he or she signs a release that allows the noncustodial parent (Pat) to claim them. These changes are temporary; the old rules are scheduled to return after 2025, unless the TCJA changes are extended by Congress.

The TCJA also has expanded the benefits of Section 529 plans. It allows federal-income-tax-free distributions from Sec. 529 plans of up to $10,000 per year for an account beneficiary's tuition at a public, private or religious elementary or secondary school. This change could cause problems if a custodial parent (Chris in our example) takes distributions from a Sec. 529 account to pay for K-12 costs without telling the noncustodial parent (Pat) — especially if the noncustodial parent makes regular contributions that are earmarked to pay for college expenses.

When this happens and it's time to pay for college, the remaining balance in a child's account could be lower than the noncustodial parent expects. So, it's important for divorce agreements to specify how funds in a Sec. 529 account will be spent.

For More Information

As this hypothetical example shows, the TCJA has a major impact on divorce settlements. But every case is unique. The parties may own a variety of assets and have different income levels. Moreover, unlike business transactions, nonfinancial issues often factor into how assets are split between divorcing individuals. We understand these issues and can help divorcing couples customize agreements that work for their situations.

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