The unique impacts of divorce on business owners
By arming themselves with knowledge of what to expect, they can devise a strategy to protect their interests
It’s no secret that divorce disrupts not just family and personal life, but also financial stability. In the case of small business owners, these effects are often felt even more acutely.
As a Certified Divorce Financial Advisor (CDFA), I work with clients and their attorneys to evaluate the short- and long-term financial and tax implications of proposed settlement options. I see firsthand how divorce impacts business owners and their companies — and it’s not always pretty.
When faced with divorce, business owners often feel caught off guard by the myriad ways that the process stands to impact their companies negatively. Fortunately, by arming themselves with knowledge of what to expect, and working with experienced financial and legal professionals, they can approach the process with a strategy designed to protect their interests. (Note: This commentary assumes that the couple will not continue to own the business together.)
The chances are that, in addition to comprising the majority of the marital assets, a business is also the primary source of household income. This is daunting because assets and income are usually two of the three main negotiating points in a divorce. (Children and the parenting plan are the third.) To make matters even more complicated, in many closely held companies, the line between personal and business assets is sometimes blurred. Similarly, separating earnings that are take-home pay from earnings that represent the owner’s return on capital can also be tricky.
Though motivated by factors other than facilitating the division of marital property, The Tax Cuts and Jobs Act of 2017 created some potential guidance here by defining two classifications of business owner income. These classifications create a potentially lower marginal income tax rate for a business owner’s income if she is an owner of a pass-through entity that meets the definition of a “qualified business.”
A qualified business may deduct 20% of “qualified business income” such that a maximum tax rate of 29.6% becomes the effective tax (80% of 37%) on total business taxable income. The 20% deducted is deemed a return on capital or “capital income.”
If a divorcing spouse/business owner has previously taken a defensible position that X dollars of her total reportable income were a return on capital rather than salary, it could be inferred that she has already drawn the line between the two sources of income. Thus, business owners choosing to allocate as much income as possible to the lower tax rate will implicitly increase the value of the business, and, in doing so, increase the value of the marital property to be divided.
As an offset, they will also reduce their “earned income” which could impact potential spousal and child support payments.
Like much of the Internal Revenue Code, the application and benefits of this tax liability calculation are dependent on many factors (use of capital in the business, total revenue of the business, household income if filing jointly to name a few) and are phased out as income increases. However, the U.S. economy is largely composed of small businesses, so time will tell if this part of the 2017 act will become a factor in making a blurry line somewhat less so.
Irrespective of income allocation, a certified business appraiser will be needed to determine what the business is worth. Carving out business expenses that could also be classified as personal, determining the worth of the business to a third party and figuring what, if any, discount should be applied for minority interests or lack of marketability are just a few of the many calculations an expert appraiser might produce.
Under the microscope
If finding the cash for a lump sum to buy out the spouse is not an option, there are several ways that a payout can be accomplished, such as promissory notes and structuring spousal support to avoid possible recapture of tax benefits at the state level.
The risk of the business owner/ex-spouse not surviving to meet this obligation can be offset with life insurance. Consider using a collateral assignment agreement to structure the ownership of the life insurance policies. The terms of the assignment can be flexible to allow the recipient to maintain ownership and protect their and the children’s financial interest. If a death claim or any other action is initiated, the carrier will inform all parties before money is distributed. The divorce decree can be cited in the assignment context.
Alternatively, an irrevocable life insurance trust can be used to provide a life interest for the ex-spouse for alimony and child support payments. Recipients’ interest in the trust would cease once the support obligation terminates, leaving remaining interests to the children.
The business owner’s income, along with other factors, will be used to determine spousal and child support. If the valuation effort described above used all of the earnings to assess the fair market price of the business, then counting them again to figure out support payments would be double-counting.
In many businesses, some of that income must be kept on the balance sheet for working capital or used to repay debt. It’s important to both parties to calculate the available income fairly.
While the business is under the microscope as part of the legal proceedings, financial records, shareholder agreements, buy/sell agreements and tax returns all need to be kept confidential. Even if the business is sold, making the inner workings of the business overly public can undermine the ultimate value to be realized by the separating spouses.
It is also imperative to consider both current and future tax consequences of the settlement on both parties. Often, recapture of tax benefits can prove a point of contention, as the spouse who receives an asset initially owned by the business may be left to face recapture provisions.
It is also important for business owners to be cognizant of embedded taxes, as business interest is determined without regard to unrealized taxes intrinsic to its value and courts may divide property without providing the business owner with assets to offset future taxes.
For example, if a business owner purchases property, such as office furniture or a company car, claiming an expense deduction, and the property is then transferred to the spouse and used for non-business purposes, the spouse will be left to bear the recapture provisions.
Many complex tax, financial and valuation issues arise during any divorce. Those involving business owners require an added degree of expert help.
Monica Ann McCarthy, principal at Northeast Divorce Settlement Consultants, a wholly owned subsidiary of Portsmouth-based wealth management firm Seascape Capital Management, can be reached at 603-812-0124 or firstname.lastname@example.org. This article was written with contributions by Chrissy Mason, senior wealth strategist at Seascape Capital.