What Is a Redemption of Spouse's Stock in a Closely Held Business?
A stock redemption occurs when a shareholder sells stock back to a corporation. Unlike a complete liquidation, the corporation generally continues to exist after the transaction. In a divorce context, if either spouse owns a closely held corporation, that business will probably be a part of the property division. Clearly, the business will be considered marital property if it was started during the marriage with joint funds. If the business was started prior to marriage or financed with separate funds, however, it is necessary to consult state law to determine the rights of the other spouse. And although the rules will vary from state to state, most states mandate that a portion of the business will be considered a marital asset.
For instance, the marital portion might be the amount of joint funds used to expand an existing business (plus the appreciation attributed to that contribution). Or, the nonowner spouse may have helped operate the business, and that assistance may have contributed to the growth of the business during the marriage. Because each spouse will probably have a stake in the business, it is typical, in divorce situations, for one spouse to buy out the other's share or to trade assets of equal value for that share.
If you're considering a stock redemption incident to your divorce, you should appraise the business, evaluate alternative methods of dividing the business, and become familiar with the tax consequences of stock redemptions and other methods of apportioning the business.
How Do You Value The Business?
Once you have determined the marital portion of the business, you need to determine the value of the business. Business appraisers and forensic accountants are qualified to place dollar values on businesses. Their goal is to establish a fair market value for the business (i.e., to fix the amount of money the business would bring if it were placed on the open market).
Appraisers use a number of methods. For example, they might total the value of the equipment, analyze the cash flow by reviewing the balance sheets and other financial documents, or compare the company to similar ones on the market. Although competent appraisers should come up with similar values, each spouse will often hire an expert appraiser to value the family business.
The date used to fix the business's value is important and can vary from state to state. In some states, businesses are valued as of the date of separation. In others, businesses may be valued at a settlement date agreed upon by the parties. A number of factors can cause fluctuations in the business's value, including the state of the economy, market forces, and perhaps the efforts of the spouse working in the business.
Finding an Appraiser
If you and your spouse are on good terms and are fairly sophisticated about business matters, perhaps you can agree on the business's value. If your business, for example, was recently appraised for purposes of getting a loan, you can use that figure. Otherwise, you might wish to consider hiring a certified appraiser.
A certified business appraiser is one who has been certified by the American Society of Appraisers. You can find the names of appraisers in your area by calling the Society at (800) 272-8258. Alternatively, you can get a referral to a competent appraiser by asking other small business owners, accountants, financial planners, and attorneys for recommendations.
Most appraisers typically charge an hourly fee, although some will charge a flat fee. The appraiser will send you an appraisal report when he or she has completed the valuation process. It should include the following information:
- The fair market value of the business
- The methods used to arrive at the value
- A description of the business appraised
- The name and qualifications of the appraiser
- The documents reviewed and the names of people interviewed
- A list of data analyzed, and how it was analyzed
- The appraisal techniques chosen
- An explanation of why those techniques were chosen
Methods of Appraising the Business
Appraisers use a number of valuation methods. The following are the most common methods:
- Adjusted book value--The business's adjusted book value consists of the firm's total assets (including depreciation) minus its total liabilities. This method is often used when a company has substantial capital investments in hard assets, such as machinery.
- Comparable sales--A business appraiser can get a rough idea of the value of your business by comparing it to the prices quoted in classified advertisements under the heading "Businesses for Sale." This value, of course, is only an estimate.
- Comparable values method--The appraiser surveys similar businesses and appraisers to establish a basis for buying or selling a particular company. Certain rules of thumb or "industry rules" exist. For example, experts generally believe that a retail business is worth one to two times its yearly earnings, and a sandwich shop is worth four to nine times its monthly average sales. In terms of a professional practice, an attorney's practice might be valued at the amount it would take to buy in as a partner in the firm. Like the comparable sales method, the comparable values method is merely a starting point in valuing the business.
- Capitalization of excess earnings--This approach combines the adjusted book value with the value of goodwill. By capitalizing excess earnings, the appraiser arrives at the goodwill. Any established business has a name and reputation which, by themselves, can be expected to generate a certain amount of income in the future. This intangible asset is called "goodwill." Along with name recognition, the goodwill of a business depends on the length of the company's existence and the extent of its revenues. Most states require that the goodwill of a business be included as part of the overall appraisal.
How Can a Family Business Be Divided?
As with assets in divorce, one spouse's interest in a business can be kept, sold, or exchanged for other property. Or, the entire business can be sold and the proceeds divided between the spouses according to their marital interests in the property.
One Spouse Keeps the Business
If one spouse wishes to keep the business, he or she can buy out the other spouse's share with cash, have the corporation redeem the stock, or trade assets of equal value. If there are no assets large enough to trade, a property settlement note can be drawn up, and the spouse can be paid over time.
Both Spouses Continue to Operate the Business
In a family business, both spouses may have enjoyed serving the public for many years, and neither spouse wants to stop working. If you have an amicable relationship, it's possible (though risky) to continue working as long as your financial rights in the business are well documented. Or, you may decide that while you'll both own the business, only one spouse will run it. In such cases, you'll need to consider the following questions:
- What constitutes a reasonable salary for the spouse who runs the business
- When will profits be paid
- How will profits be divided and taxed
- What role will the nonmanaging spouse play in decision-making
- Do both parties have a right to enter the premises and inspect the books, and
- What personal expenses or perks will be allowed the managing spouse?
Business Is Sold
The spouses may sell the business and divide the profits according to their respective marital interests. The problem with this approach is that it may take years to find a buyer. In the meantime, you'll have to decide who runs the business.
What Are The Tax Implications of Property Dispositions, In General?
Property transfers between spouses during the marriage or incident to divorce aren't taxable, according to Section 1041 of the
Internal Revenue Code (IRC). But the tax effects of property dispositions can vary greatly, depending on whether you decide to transfer property immediately to your spouse, sell it to (or have it redeemed by) a third-party, or sell it to your spouse at some future time.
Transfer to Spouse Incident to Divorce
In general, neither spouse recognizes a gain or loss if one spouse transfers the title of property to the other spouse incident to a divorce. A transfer of property is viewed as incident to divorce if the transfer occurs within one year after the date on which the marriage ends or if the transfer is related to the ending of the marriage. Any transfer of property between spouses that is made pursuant to a divorce or separation instrument and that occurs within six years after the date the marriage ceases is presumed to be related to the cessation of the marriage.
You might, for example, want to use a promissory note to buy out your spouse's share in the family business. In such a case, taxation really won't be an issue. The buying spouse can't deduct the principal payments, and the selling spouse doesn't report the principal payments as income (the interest is income). Because the payments are being made to equalize a divorce settlement, the spouse buying the business gets the business's original tax basis.
The spouse receiving the property takes the basis of the transferring spouse. This result occurs even if the spouse who retains the property pays cash or other assets in return for the property and the transaction is basically a sale.
Example(s): Assume Mary sells her half ownership interest of their home to her spouse, John, for $85,000 as part of their divorce settlement. Because the property had initially been purchased for $80,000, Mary's basis was $40,000 and John's was $40,000. Mary doesn't recognize any gain on the sale to John because the sale was incident to their divorce. John's basis in the property will be $80,000.
Sale of Property to Third Party Immediately
Often, a piece of property will be sold to a third party as part of a divorce settlement, with the proceeds being split between the spouses. In such a case, both spouses will recognize their proportionate share of the gain on the sale, based upon their division of the sales proceeds (unless they qualify for a capital gain exclusion).
The parties might decide that the property will be sold at some point in the future. If sold later than six years from the marriage cessation date to the other spouse, the sale will not be incident to divorce. Thus, the seller will recognize gain or loss. (This is not to be confused with the promissory note arrangement.) In addition, a delayed sale may prove extremely risky, because during that period, the property will be exposed to the creditors of the spouse who continues to hold the property.
What Are The Tax Consequences of a Stock Redemption?
As a result of court decisions that have varied in different jurisdictions, the question of which spouse is taxed on a divorce-related stock redemption is unclear. However, a certain trend is apparent and is supported by a temporary IRS regulation.
It's clear that a transfer of ownership of a closely held business interest in divorce doesn't trigger recognition of gain or loss on the transfer if the transfer of that ownership is made directly between the spouses (e.g., one spouse pays cash to the other spouse in return for a release of all claims on the jointly owned stock).
In some cases, the spouses are financially unable to directly transfer ownership of a closely held business between themselves. In such cases, a stock redemption is often used. The corporation that redeems the stock is viewed as a third party in the transaction involving the spouses.
The general rule is that neither gain nor loss is recognized on transfers of property between spouses incident to a divorce. IRC Section 1041's nontaxable treatment is applied to transfers to third parties when:
- The transfer to the third party is required by a divorce or separation agreement or decree,
- The transfer to the third party is pursuant to the other spouse's written request, or • The nontransferring spouse consents to the transfer in writing, specifically references IRC Section 1041, and this statement is attached to the transferring spouse's tax return for the year of transfer.
A stock redemption on behalf of a spouse or former spouse is treated first as a transfer to the receiving spouse (governed by IRC Section 1041), followed by a transfer from the receiving spouse to the third-party corporation (not governed by IRC Section 1041). According to many courts (and the IRS temporary regulations), the first transfer is nontaxable, while the second transfer is not.
Example(s): Assume John and Mary are getting divorced and jointly own 100 percent of a small corporation. The stock is worth $100,000 at present, and Mary's adjusted basis in the stock amounts to $1,000. Pursuant to the divorce agreement, Mary will transfer her 50 percent interest in the company to John by way of a stock redemption. The corporation will redeem Mary's stock for $50,000. Since the transfer is incident to a divorce agreement, Mary's initial transfer of stock will be nontaxable to her under IRC Section 1041. For federal tax purposes, it is deemed that John received the stock from Mary and immediately retransferred it to the corporation in a complete redemption. The deemed transfer from John to the corporation lies outside the protective scope of IRC Section 1041. Thus, while Mary escapes taxation, John must recognize capital gain on the transaction ($50,000 value minus $1,000 basis).
Caution: Again, be aware that some tax courts have treated the taxation of stock redemptions differently. In fact, it's even possible that both spouses will avoid taxation of a stock redemption in accordance with IRC Section 1041. It is advisable to consult an attorney in connection with any divorce-related stock redemption.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.
The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.