We will not mince words here: getting divorced can be a long, drawn-out, and complicated process — both personally and professionally. But since we are not therapists, we will be focusing on how to handle your taxes when both parties have a stake in a small business. Keep reading for advice on future tax implications, retirement accounts, and more from our experts at Core Group.
Equitable Distribution States vs. Community Property States
Every state has its own laws regarding the allocation of assets in a divorce. Your first step is to determine if your state is an equitable distribution or community property state.
Equitable Distribution States
Most states, including Oklahoma, adhere to "equitable distribution," a set of rules used for allocating assets in a divorce. In this approach, judges determine what constitutes a fair split, based on each couple’s unique situation, considering factors like: age, health, and the duration of the marriage and each spouse’s ability to support themselves.
Community Property States
In a minority of states, including Texas, judges abide by "community property" rules when dividing assets, which essentially just means splitting the couple's joint assets in half, without considering the factors listed above. They do, however, consider factors like age, income, and employment when alimony and child support are involved.
The Tax-Free Transfer Rule
Once you know which type of state you live in, you can divide many of the assets without paying federal income or gift taxes, which is known as the tax-free transfer rule. Fortunately, these asset gains will not immediately be recognized as new income in most cases.
So, who is responsible for future taxes on these assets? The spouse who officially owns them after the divorce. The same goes for the existing tax basis and holding period.
To take advantage of this tax-free arrangement, you must swap assets:
before the divorce
at the time it is finalized
after the divorce, but onlyif:they are designated as “incident to divorce,” either:
within a year of the marriage ending
within six yearsbutspecified in the divorce agreement
Future Tax Implications
Do not be fooled: tax implications for assets received tax-free in a divorce settlement will eventually catch up with you. The ex-spouse who receives an appreciated asset must recognize taxable gain when it is sold (unless an exception applies). Also, the owner of the appreciated asset must pay the built-in tax liability associated with it.
For Profit Sharing, Defined Benefit and 401(k) Plans
It’s important to include a qualified domestic relations order, orQDRO, in your divorce papers to be able to transfer retirement funds and avoid taxes. A QDRO is a judgment, decree or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent of a participant.
Although no QDRO is not necessary for IRAs, you must include specific language in your divorce papers to avoid taxation on money transferred to your ex-partner. You can only make a tax-free transfer when you use this exact phrase: “Any division of property accomplished or facilitated by any transfer of IRA funds from one spouse or ex-spouse to the other is deemed made pursuant to this divorce settlement and is intended to be tax-free pursuant to Section 408(d)(6) of the Internal Revenue Code of 1986.”
Tax Status Changes Immediately After Divorce
Your tax status is based on your status on the final day of that year. Even if you were married for most of the year but got divorced before December 31, your tax status will be single (or possibly head of household if you have children). Speaking of children, this also applies to your dependents. When parents divorce, only one of them can claim each child on their taxes, which drastically affects those who rely on the Earned Income Credit, Child Tax Credit, or the Child and Dependent Care Credit to reduce the taxes you owe.
Consult a CPA for Additional Guidance
As you can see, these matters are complex. In addition to hiring a divorce lawyer, it is wise to consult an experienced CPA ahead of or in conjunction with your divorce to minimize the tax implications — both personally and professionally.
Our experts at Core Group are poised and ready to help you come out on top. Book a discovery call to get started today.