Nick and Estelle are divorcing and negotiating an equal property settlement. Their marital estate includes a home valued at $350,000, two cars worth $16,000 each, and other mis­cellaneous assets with a total value of $100,000. The two also jointly own all stock of a computer business, CompuStore. The business is operated through a closely held corporation and has been appraised at $800,000.

One recurring issue in divorce is how to divide the marital estate when the couple owns all of the stock of a closely held corpo­ration. This can be a daunting task, especially when the value of the business exceeds half of the value of all marital assets. Although the spouses can continue the business through joint ownership after the divorce, this often proves difficult.

Spouses (and former spouses if the transfer
is made pursuant to divorce) can transfer prop­erty to each other without incurring income or gift tax, so the easiest way to divide a marital estate is simply to split it between the spouses. This will not work, however, if the value of the business dominates the value of the entire estate. Thus, Nick and Estelle must look at other options.

Why Not Liquidate?

The easiest alternative may be to liquidate
the corporation. The proceeds then can simply be distributed between the spouses. There is a major potential obstacle to this solution, however: Both Nick and Estelle may not want to sell. Even if both are willing, this method is often still undesirable, because the business will usually be worth more as a going concern (especially if it’s a service business), and finding a buyer may be difficult.

Redeem the Stock of One Spouse

If only one spouse wishes to continue the business, the best alternative may be for the corporation to redeem the stock of the other spouse. For example, if Nick wanted to con­tinue the business and Estelle wanted to liq­uidate her interest, the corporation could redeem her stock at its fair market value. Estelle would walk away with $400,000 in cash. 

From a tax perspective, the goal is to have the transaction treated as an exchange to take advan­tage of capital gains tax rates, which are lower than ordinary income tax rates. The tax consequences of a stock redemption in this context, however, are unclear. Interpret­ing the interplay of several tax provisions, a court might classify the redemption of Estelle’s stock as a dividend to Nick. As a dividend, it would be taxed at the higher, ordinary income rates.

Transfer Stock and Pay Alimony

To avoid the tax uncertainty of a redemption yet still equalize division of the assets, Estelle could transfer her stock to Nick pur­suant to a written agreement. Nick would then pay alimony to Estelle, which would include an amount equal to the value of the stock. He would make payments over a num­ber of years until the full amount was paid. Nick would also be able to deduct the pay­ments. Payment for Estelle’s stock as ali­mony would result in ordinary taxable
income to her, but it could be structured so that the parties would share this additional tax liabil­ity.

If properly structured, this divorce-related transfer of property would not result in tax­able gain or a taxable gift.

Split the Business

If the corporation consists of two separate and distinct lines of business or specialties, the couple might wish to divide the company into two businesses. The corporation could transfer the assets and liabilities of one of the businesses into a new corporation.

For example, if CompuStore consisted of a consulting division and a repair division, and Nick wished to retain one side and Estelle the other, they could transfer the assets and liabilities of one division into a newly created subsidiary corporation. The corporation could then distribute the stock of the subsidi­ary solely to Estelle in exchange for her stock in CompuStore. With proper planning, they could execute this strategy  tax free, and Nick and Estelle would each control his or her own business.

Consider All Options

The estate and gift tax aspects of divorce normally involve a number of complex issues. When a closely held business is part of the mix, however, the complications increase expo­nentially due to the many planning options available. You must plan care­fully to
avoid potential adverse tax consequences that may accompany the use of some of these strategies.