Abstract: The Tax Cuts and Jobs Act (TCJA) made sweeping changes to the tax law that must be considered when business owners file for divorce. This article explains how attorneys and clients may need to modify their mindset during settlement talks.
Critical tax issues for business owners in divorce
The Tax Cuts and Jobs Act (TCJA) made sweeping changes to the tax law that must be considered when business owners file for divorce. Here’s an overview of how you may need to modify your mindset during settlement talks.
Lower taxes, higher earnings
In general, tax reform legislation enacted under the Trump administration has been favorable for business owners. Starting in 2018, the TCJA lowers the corporate rate to a flat 21% for C corporations and personal service corporations. It also:
- Lowers the tax rates for owners of pass-through entities (including sole proprietorships, partnerships, S corporations and limited liability companies),
- Introduces a deduction for owners of pass-through entities of up to 20% of qualified business income,
- Repeals the corporate alternative minimum tax (AMT),
- Reduces the number of pass-through business owners subject to individual AMT,
- Expands first-year Section 179 and bonus depreciation deductions for qualified asset purchases, and
- Provides incentives to repatriate foreign income and operate in the United States.
These provisions (along with many other pro-business changes) are expected to lower business tax obligations. In turn, lower taxes mean higher future earnings and business values.
However, some TCJA provisions are unfavorable to businesses. For example, there are new limits on business interest deductions and net operating losses (NOLs). The law also eliminates the domestic production activities deduction (DPAD) and certain business expense deductions. When valuing a business, it’s important to have a comprehensive understanding of both the positive and negative effects of the TCJA on future earnings.
It’s all relative
Which marital assets are most desirable under current tax law? Various provisions of the TCJA may cause divorcing spouses to see private business interests in a more favorable light than under prior law.
For example, under the TCJA, tangible personal property held for business or investment purposes — such as vehicles or equipment used for business — are permanently ineligible for Sec. 1031 like-kind exchanges. Eliminating like-kind exchanges of tangible personal property could make these assets less appealing than under prior law, because owners can no longer defer any built-in tax obligations.
Real estate also might have less appeal under the TCJA. Although Sec. 1031 like-kind exchanges are still allowed for real estate held for business or investment purposes, the TCJA limits itemized deductions from owning a primary residence or vacation home. Plus, fewer taxpayers are expected to itemize deductions under the TCJA. These changes reduce the tax benefits of owning a home and may affect asset allocations.
However, when divvying up assets, it’s important to consider future tax obligations. For example, business interests typically incur capital gains tax when they’re sold. Capital gains happen when an asset’s value exceeds its tax basis. By comparison, a spouse’s personal residence is subject to a home sale gain exclusion of $250,000 (or $500,000 for a married couple who files a joint tax return).
New treatment for alimony
Another critical issue to consider in divorce settlements is alimony. For divorce agreements signed after December 31, 2018, the recipient is no longer required to include alimony payments as income, and the payer can no longer deduct the payments. That’s a major change that will likely cause the parties to pay more taxes overall (assuming the payer has a higher marginal effective tax rate than the recipient does) than under prior law.
Also, be aware when calculating alimony payments that courts in some states don’t allow “double-dipping” — that is, allowing a spouse to benefit twice from a former spouse’s future earnings. In these jurisdictions, spouses who receive alimony payments shouldn’t in theory be credited for half of the business’s personal goodwill (if applicable).
If you’re drafting or revising a divorce agreement, a business valuation expert can be a valuable resource. When hiring an expert, be sure to ask how the TCJA is likely to affect your specific case.