Texas Business Dispute Blog

Friday, August 12, 2016

FAMILY LAW POST: Co-Owning a Business After Divorce? Your Ex-Spouse May Still Love You more than the IRS (When It Comes to Paying Taxes)

By Frances Ellenbogen (Houston) and Ladd Hirsch (Dallas)

Conventional wisdom is not always so wise.  In the case of divorce, conventional wisdom holds that the divorcing couple must divide all of their assets at the time of divorce.  When the couple owns a business together, however, splitting up their business in the divorce proceeding often leads to intense disputes over the value of the business, the  management of the company and the handling of key employees.  Therefore, one approach the divorcing couple may want to consider to avoid or lessen conflicts between them is to agree to remain co-owners of the business for some period of time after their divorce is final.  Spouses who remain business partners after divorce do need to be aware of another possible foe – the IRS.  This Post considers a recent U.S. Tax Court decision, which provides positive news for spouses who remain co-owners of a business after their divorce is completed.  See Belot v. Commissioner of Internal Revenue.[1]

It is not surprising when divorcing couples conclude that dividing the ownership of a private company during their divorce would be a bad business decision.  The advantages to continuing to co-own a business include all of the following: avoiding an expensive and time-consuming fight over the value of the company, allowing the divorce to be finalized more quickly and creating the opportunity for each spouse to obtain appreciation in value.  Down the road, a few years after the divorce is final, the couple may decide to end their business relationship for business or personal reasons, with one spouse transferring his or her interest to the other.  If the couple did not plan ahead for this “business divorce,” however, they may be (unhappily) surprised to find that the IRS is now seeking to collect a sizable tax bill based on the profits realized from the “sale” of the business interest from one spouse to the other.

Belot v. Commissioner of Internal Revenue – The Tax Court Deals with A Business Divorce Following a Marital Divorce

In June 2016, U.S. Tax Court decision addressed the issue of the tax due on the sale/transfer of interests between divorced spouses in Belot v. Commissioner of Internal Revenue.  During their 18 year marriage, the Belots owned/operated three businesses, and in their divorce settlement, they agreed to own/operate the businesses as equal partners.[2]  Not long after the divorce became final, Ms. Belot filed a suit to gain control, contending that her ex-husband had mismanaged the businesses.[3]  This led to a second settlement agreement, about 18 months after the initial divorce decree, in which Mr. Belot sold his interests to Ms. Belot for almost $1.6 million.[4]

The Tax Court had to decide whether Mr. Belot’s sale of his business interests to his ex-wife qualified for nonrecognition (no tax) treatment under IRS Code 1041.[5]  The IRS contended that Mr. Belot owed taxes on the profits of this sale because his transfer did not relate to the original divorce  and the second settlement resolved a business dispute unrelated to the divorce.[6]  The IRS pointed out that Ms. Belot’s lawsuit was filed in civil court, which typically handles commercial disputes rather than divorce actions and other family matters.[7]

Does the Sale of a Business Interest After Divorce Relate to the Cessation of the Marriage?

 Under IRS Code § 1041, a transfer between spouses or former spouses incident to divorce is generally not taxable.  In the Belot’s case, the Tax Court had to decide whether Mr. Belot’s sale of his interests to his ex-wife 18 months after their marriage ended related to the cessation of their marriage.  IRS regulations provide that a transfer relates to the cessation of the marriage if:  (1) the transfer is pursuant to a divorce instrument; and (2) the transfer occurs within 6 years of the date the marriage ended.[8]  Transfers that do not satisfy both conditions are presumed to be unrelated to the end of the marriage, but this presumption is rebuttable upon a showing that the transfer was made to divide property the former spouses owned at the time of the divorce.

Although the sale of Mr. Belot’s interests occurred 18 months after the first divorce settlement and was unrelated to the divorce decree, the Tax Court found that the transaction did qualify for nonrecognition treatment because it was made to “effect the division of property owned by the [Belots] at the time of the cessation of the marriage.”[9]  The Tax Court pointed out that neither IRS Code § 1041 nor the IRS regulations limit nonrecognition treatment to the first division of marital property or bar divisions of marital property accomplished through sales.[10]

Lessons Learned – Include a Corporate Pre-Nup in the Divorce Decree

The Tax Court’s holding in Belot is good news for divorcing spouses who take a businesslike approach to their divorce settlement, and agree to co-own a business after their divorce.  In this situation, the couple will want to take steps to avoid a future tax bill from a later transaction following their divorce. 

This tax avoidance result can be readily accomplished with help from counsel for the spouses in drafting the divorce decree.  Specifically, if the divorce decree includes addressing how and when a future sale of their business interests can take place, it will relate to the cessation of the marriage and therefore avoid being subject to any future tax.  As in all things, but particularly with regard to taxes, avoiding uncertainty is always a good business decision.

 

For more information on protective provisions that divorcing spouses should consider including in a corporate pre-nup, please see our prior Blog post: Negotiating a Business Divorce in Family Law Cases: 101.


[1] T.C. Memo. 2016-113. 

[2] Id. at 4.

[3] Id. at 5.

[4] Id. at 5-6.

[5] Id. at 7.

[6] Id. at 11.

[7] Id.

[8] Treasury Regulation 1.1041-1T(b), Q&A-7.

[9] Id. at 13.

[10] Id. at 11.


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