For many small business owners, their ownership interest is one of their biggest personal assets. What will happen to your ownership interest if you get divorced? In many cases, your marital estate will include all (or part) of your business interest.

Sometimes, divorcing spouses continue to participate in the business’s operations after the divorce settles, and then both spouses retain an ownership interest in the business. But, more commonly, former spouses are unable to effectively co-manage the business. So, one spouse retains a controlling interest and the other spouse 1) retains a passive stake in the business, 2) is bought out, or 3) is allocated other marital assets in a property settlement agreement.

How a marital estate is divvied up can have significant tax consequences. Here’s what you  need to know to get the best tax results.

State Law Is Key

How you must split up assets in divorce depends largely on where you live.

Community Property States

Community property states include:

• California,
• Texas,
• Washington,
• Wisconsin,
• Arizona,
• Nevada,
• New Mexico,
• Louisiana, and
• Idaho.

In these states, the general rule is that each spouse owns half of community property assets (those accumulated during the marriage) and owes half of the liabilities incurred during the marriage.

In contrast, assets that were owned by one spouse before the marriage, or that were received by one spouse as a gift or  bequest during the marriage, are generally considered to belong solely to that person. Therefore, those assets aren’t included in the marital estate and split up 50/50.

Equitable Distribution States

All the other states are so-called “equitable distribution” states. Here, the general rule is that you and your spouse must split up your assets according to “whatever is fair” in the eyes of the divorce court. This often works out to be a 50/50 split.

If you don’t want to be at the mercy of the court, you and your spouse can negotiate a settlement outside of court, and the court will generally go along with your agreement. This can be a smart option, because spouses may be emotionally tied to certain assets (such as Grandma’s jewelry or a vacation home that’s been in the family for decades). And business-owner spouses may want to retain 100% of their business in exchange for other nonbusiness assets (such as a personal residence or retirement funds).
Tax-Free Transfer Rule

In general, you can divide most assets, including cash and ownership interests in a business, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. When an asset falls under the tax-free transfer rule, the spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).

To illustrate how this works, suppose that, under the terms of your divorce agreement, you give your primary residence to your ex-spouse in exchange for keeping all the stock in your small business. This asset swap would be tax-free. And the existing basis and holding  periods for the home and the stock would carry over to the person who receives them.

Tax-free transfers can occur before the divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they’re made incident to divorce. Transfers incident to divorce are those that occur within:

• A year after the date the marriage ends, or
• Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.

In recent years, the IRS has extended the beneficial tax-free transfer rule to ordinary-income assets, not just to capital-gain assets. For example, if you transfer business receivables or inventory to your ex-spouse in divorce, these types of ordinary-income assets also can be transferred tax-free. When the asset is later sold, converted to cash or exercised (in the case of nonqualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.

Tax Implications of Tax-Free Transfers

Eventually, there will be tax implications for assets received tax-free in a divorce settlement. The ex-spouse who winds up owning an appreciated asset — where the fair market value exceeds the tax basis — generally must recognize taxable gain when it’s sold, unless an exception applies.

For example, if you qualify for the principal residence gain exclusion break, you can exclude up to $250,000 of gain from your federal taxable income, or up to $500,000 of gain if you file a joint return with a future spouse.

What if your ex-spouse receives 49% of your highly appreciated small business stock? Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex continues to apply the same tax rules as if you had continued to own the shares, including carryover basis and carryover holding period. When your ex ultimately sells the shares, he or she (not you) will owe any resulting capital gains taxes.

Important: The person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven’t appreciated. Always take taxes into account when negotiating your divorce agreement.

Splitting Up Qualified Retirement Plan Accounts

Many business owners set up qualified retirement plans, such as a profit-sharing, 401(k) or defined benefit pension plan. A percentage of the account balance or plan benefits may need to be transferred to your ex-spouse as part of the divorce property settlement.

To execute a transfer without owing taxes on amounts that go to your ex, you must use a qualified domestic relations order (QDRO). In effect, the QDRO causes your ex-spouse to become a co-beneficiary of your retirement account. The tax advantage comes from the fact that the QDRO also makes your ex responsible for the income taxes on retirement account money that he or she receives in the form of account withdrawals, a pension or an annuity. In other words, the QDRO causes the tax bill to follow the money.

The QDRO also allows your ex to withdraw his or her share of the retirement account balance and roll the money over tax-free into his or her own IRA (to the extent such withdrawals are permitted by your plan’s terms). The rollover strategy allows your ex to take over management of the money while continuing to postpone taxes until funds are withdrawn from the rollover IRA. When your ex withdraws funds from the rollover IRA, he or she (not you) will owe the related income taxes.

Warning: Without a QDRO, money that’s transferred from your qualified retirement plan account to your ex-spouse is treated as a taxable distribution to you. So, your ex gets a tax-free windfall at your expense. To add insult to injury, you may also owe the 10% early withdrawal penalty tax on money that goes to your ex before you’ve reached age 59½.

Splitting Up IRAs

You don’t need a QDRO to obtain an equitable tax outcome when you turn over IRA funds to your ex under your divorce agreement. This includes money held in SEP accounts, SIMPLE IRAs, traditional IRAs and Roth IRAs. QDROs are only relevant in the context of qualified retirement plans.

However, with IRAs, you still must be careful to avoid getting taxed on money that goes to your ex. The key to a tax-free transfer is to specifically order the transfer in your divorce or separation instrument. For this purpose, the tax code narrowly defines a divorce or separation instrument as a “decree of divorce or separate maintenance or a written instrument incident to such a decree.”

A transfer that meets this requirement can be arranged as a tax-free rollover of the applicable amount from your IRA into an IRA set up in your ex-spouse’s name. Your ex can then manage the money in the rollover IRA as he or she sees fit and can continue to defer taxes until withdrawals are taken. Any future income taxes are paid by your ex (not you).

Important: When it comes to IRA transfers, don’t jump the gun. If you voluntarily give your ex-spouse some IRA funds before it’s required under a divorce or separation instrument, it will be treated as a taxable distribution to you. If a taxable distribution occurs before you’re 59½, you also may be hit with the 10% early withdrawal penalty.

New Treatment for Alimony Payments

Allocating marital assets is just one part of settling your divorce. Deciding on maintenance payments is another critical component.

The Tax Cuts and Jobs Act (TCJA) permanently disallows deductions for alimony payments required by divorce agreements signed after December 31, 2018. Such payments are federal income-tax-free to the recipient. Under prior law, payers could deduct alimony, and recipients had to include alimony in their taxable income.

This recipient-favorable change should be taken into account when negotiating divorce agreements — and when drafting prenuptial agreements in the future.

Minimizing Taxes

Like any major life event, divorce can have major tax implications, especially if you own a private business interest. Your tax advisor can help you minimize the adverse tax consequences of settling your divorce under today’s laws.

The IRS announced that it is providing expanded penalty relief to certain individuals whose  2018 federal income tax withholding and estimated payments fell short of their total tax liability for the year. (Notice 2019-25)

The IRS is now lowering to 80% the threshold required to qualify for this relief. Under the relief originally announced January 16, 2019, the threshold was 85%. The usual percentage threshold is 90% to avoid a penalty.

This means that the IRS is now waiving the estimated tax penalty for taxpayers who paid at least 80% of their total tax liability during the year through federal income tax withholding, quarterly estimated tax payments — or a combination.

Why Did Some People Not Have Enough Withheld?

The U.S. tax system is pay-as-you-go. By law, it requires taxpayers to pay most of their tax obligation during the year, rather than at the end of the year. This can be done by either having tax withheld from paychecks or pension payments, or by making quarterly estimated tax payments.

The expanded relief will help many taxpayers who owe tax when they file, including taxpayers who didn’t adjust their withholding and estimated tax payments to reflect an array of changes under the Tax Cuts and Jobs Act (TCJA), which was enacted in December 2017.

“We heard the concerns from taxpayers and others in the tax community, and we made this adjustment in an effort to be responsive to a unique scenario this year,” said IRS Commissioner Chuck Rettig. “The expanded penalty waiver will help many taxpayers who didn’t have enough tax withheld. We continue to urge people to check their withholding again this year to make sure they are having the right amount of tax withheld for 2019.”

The revised waiver computation will be integrated into commercially-available tax software and reflected in the forthcoming revision of the instructions for Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts.

What If You Already Filed?

Taxpayers who have already filed for tax year 2018 but qualify for this expanded relief may claim a refund by filing Form 843, Claim for Refund and Request for Abatement and include the statement “80% Waiver of estimated tax penalty” on Line 7.  This form cannot be filed electronically.

If you have questions about withholding or the recently announced penalty relief, contact your Cornwell Jackson tax advisor.

 

Most businesses will owe less tax for the 2018 tax year than they would have under prior law, thanks to changes brought by the Tax Cuts and Jobs Act (TCJA). But have you done everything possible to lower your business tax bill for last year? Even though 2018 is in your review mirror, there are some possibilities for business owners to consider if your return for the last tax year hasn’t been prepared yet.

New QBI Deduction for Pass-Through Entities

Before the TCJA, net taxable income from so-called “pass-through” business entities was simply passed through to you as an individual owner and taxed at your personal rates. This includes sole proprietorships, partnerships, limited liability companies (LLCs) treated as sole proprietorships or partnerships for tax purposes, and S corporations.

For tax years beginning in 2018, the TCJA allows a new deduction for individual owners of pass-through entities based on their share of qualified business income (QBI) from those entities. The deduction can be up to 20% of QBI, subject to restrictions that can apply at higher owner income levels.

If you qualify, the deduction is claimed on your personal tax return. (See “Filing Deadlines for 2018 Returns” at right.) The IRS has issued regulations on how to calculate the QBI deduction, but they’re lengthy and complex. So, it’s important to discuss the details with your tax advisor.

Filing Deadlines for 2018 Returns

Tax Day varies depending on how your business is set up. Here are the basics.

For Sole Proprietorships and Single-Member LLCs

The 2018 filing deadline for an individual who operates a business as a sole proprietorship or as a single-member limited liability company (LLC) that’s treated as a sole proprietorship for tax purposes is the same as the deadline for filing their personal tax return. That’s generally April 15, 2019. However, for taxpayers in Massachusetts and Maine, the deadline is April 17, 2019, due to holidays. (April 15 is Patriots’ Day in Maine and Massachusetts; April 16 is Emancipation Day in Washington, D.C., where the IRS is located.)

Those dates are rapidly approaching. Your deadline can be extended to October 15, 2019. But you still must pay your tax liability by the April deadline.

To avoid penalties for the 2018 tax year, your payments from withholding and estimated payments (combined) generally must equal at least 80% of the current year’s tax liability or 100% of the prior year’s tax liability. Higher income taxpayers may be required to pay at least 110% of the prior year’s tax liability to avoid an interest charge penalty for inadequate estimated tax payments.

For Other Pass-Through Entities

For partnerships, LLCs treated as partnerships for tax purposes, and S corporations that use the calendar year for tax purposes, the 2018 filing deadline is March 15, 2019. But your tax advisor may have extended the deadline to September 15, 2019, to give you extra time to deal with changes included in the Tax Cuts and Jobs Act (TCJA).

When these types of pass-through entities use a fiscal year end for federal income tax purposes, returns are due on or before the 15th day of the third month after the fiscal year ends. The due date can be extended for six months.

For example, an S corporation with a March 31 tax year end must file or extend its return for the tax year beginning in 2018 by June 17, 2019, and the extended due date would be December 16, 2019. (These deadlines have been adjusted for weekends and holidays.)

For C Corporations

For 2018, the tax filing deadline for C corporations that use the calendar year for federal income tax purposes is generally April 15, 2019. It’s April 17, 2019, for calendar-year corporations registered in Massachusetts or Maine. The deadline can be extended for six months to October 15, 2019.

Generally, a corporation with a fiscal tax year end must file its return by the 15th day of the fourth month after the end of the tax year. However, a corporation with a fiscal tax year ending June 30 must file by the 15th day of the third month after the end of its tax year.

100% First-Year Bonus Depreciation

Under the bonus depreciation program, businesses are allowed to deduct 100% of the cost of certain assets in the first year, rather than capitalize them on their balance sheets and gradually depreciate them. This break applies to qualifying assets placed in service between September 28, 2017, and December 31, 2022 (or by December 31, 2023, for certain assets with longer production periods and for aircraft). After that, the bonus depreciation percentage is reduced by 20% per year, until it’s fully phased out after 2026 (or after 2027 for certain assets with longer production periods and for aircraft).

Bonus depreciation is allowed for both new and used qualifying assets, which include most categories of tangible depreciable assets other than real estate. This change will be a major tax-saving benefit on many 2018 business returns, including returns for sole proprietors and owners of pass-through entities.

Expanded Section 179 First-Year Depreciation Deductions

For qualifying assets (including expenditures for certain building improvements) placed in service in tax years beginning in 2018, the TCJA increased the maximum Section 179 first-year depreciation deduction to $1 million (up from $510,000 for 2017). The TCJA also expanded the definition of qualifying assets to include depreciable tangible personal property used mainly in the furnishing of lodging (such as furniture and appliances).

The definition of qualifying real property eligible for the Sec. 179 deduction was also expanded to include eligible expenditures for nonresidential real property:

• Roofs,
• HVAC equipment,
• Fire protection systems, and
• Alarm and security systems.

These favorable Sec. 179 deduction changes will deliver tax-saving benefits on many 2018 business returns, including returns for sole proprietors and owners of pass-through entities. However, the deduction is subject to several limitations.

Important: When both 100% first-year bonus depreciation and the Sec. 179 deduction privilege are available for the same asset, it’s generally more advantageous to claim 100% bonus depreciation, because there are no limitations on that break.

Generous Depreciation Deductions for Passenger Vehicles Used for Business

For new or used passenger vehicles that were  placed in service in 2018 and used over 50% for business, the maximum annual depreciation deductions allowed under the TCJA are as follows:

• $10,000 for 2018 (or $18,000 if you claim first-year bonus depreciation),
• $16,000 for 2019,
• $9,600 for 2020, and
• $5,760 for 2021 and thereafter until the vehicle is fully depreciated.

Under prior law, the 2017 limits for passenger cars were as follows:

• $11,160 for the first year for a new car (or $3,160 for a used car),
• $5,100 for the second year,
• $3,050 for the third year, and
• $1,875 for the fourth year and thereafter.

Slightly higher limits applied to light trucks and light vans. So, the TCJA limits are much more taxpayer friendly.

Favorable New Tax Accounting Rules

Starting with tax years beginning in 2018, the new tax law increases the gross receipts limit to $25 million for eligible C corporations and partnerships that want to:

• Elect the cash method of accounting (rather than the accrual method),
• Elect out of the requirement to use the percentage-of-completion method to report income from long-term construction contracts,
• Elect simplified alternatives for inventory accounting, or
• Avoid the complex uniform capitalization (UNICAP) rules that generally require producers and resellers of real and personal property to include in inventory direct costs and certain indirect costs.

The $25 million gross receipts limit will be adjusted annually for inflation after 2018. Whether it’s advantageous to use these accounting alternatives depends on your business situation — and there’s more to consider than just taxes.

For example, the cash basis method of accounting generally defers income recognition for tax purposes and allows greater tax-planning flexibility. However, the accrual method conforms to U.S. Generally Accepted Accounting Principles (GAAP) and, therefore, facilitates M&A due diligence and comparisons with public companies.

Deductions for Business-Related Meals

Under prior law, you could generally deduct 50% of business-related entertainment expenses. For amounts incurred in 2018 and beyond, the TCJA generally disallows deductions for business-related entertainment.

However, meal expenses incurred in connection with business entertainment (for example, meals at sporting events) and meal expenses to wine and dine customers, clients and prospects are still 50% deductible. Be sure receipts from vendors separate the costs of meals from the total bill, rather than providing just a combined total.

SEP Plans

If you own a small business and haven’t yet set up a tax-favored retirement plan for yourself, you can establish a simplified employee pension (SEP). Unlike other types of small business retirement plans, a SEP can be created this year and still generate a deduction on last year’s return.

In fact, if you’re self-employed and extend your calendar-year 2018 personal tax return, you’ll have until October 15, 2019, to take care of the paperwork and make a deductible contribution for last year. The deductible contribution can be up to:

• 20% of your 2018 self-employment income, or
• 25% of your 2018 salary if you work for your own corporation.

The absolute maximum amount you can contribute for the 2018 tax year is $55,000.

Important: You may not want a SEP if your business has employees, because you might have to cover them and make contributions to their accounts. That could be cost prohibitive.

What’s Right for Your Business?

This article just covers some widely available options for your 2018 business tax return. Your Cornwell Jackson tax advisor may be able to suggest others to consider, depending on your unique business situation.

The London Interbank Offered Rate (LIBOR) has served as the primary reference rate for various types of adjustable-rate financial products for decades. However, its role as the finance industry’s reference rate may soon diminish in favor of a U.S.-based alternative. What is LIBOR, and why might it disappear?

The Basics

Unlike fixed interest rates, adjustable rates vary depending on market conditions. These rates are commonly charged to individuals who buy homes, businesses that borrow from retail banks and even banks that enter complex derivative contracts. The market interest rate for these arrangements is typically a function of LIBOR, plus a risk premium.

There are many variations of LIBOR. In its simplest form, LIBOR provides a theoretical rate that a major bank might charge a competitor to borrow funds overnight.

It’s theoretical because, in the aftermath of the Great Recession, interbank borrowing is rare due to increasingly stringent capital requirements. So, LIBOR approximates the risk-free cost of borrowing, which serves as the foundation of variable interest rate financial products.

An Uncertain Future

LIBOR is compiled from voluntary submissions by banks. It’s not tied to real transactions. So, there’s a risk that it can be manipulated. In fact, in 2008, regulators uncovered collusion between banks to manipulate LIBOR to profit on the financial instruments supported by LIBOR.

Given the potential for abuse, the United Kingdom’s Financial Conduct Authority (FCA) recently announced its intention to make the submission of quotes to calculate LIBOR optional beginning in 2021.

But LIBOR may continue to be used as a market reference rate. While the FCA won’t require bank participation in deriving a rate, leading many to opt out of the process, some banks may continue to provide input.

Possible Replacements

One possible alternative to LIBOR comes from the Federal Reserve Bank of New York. The Secured Overnight Financing Rate (SOFR) addresses the shortcomings of LIBOR by using interest rates associated with repurchasing agreements, which involves a large volume of overnight lending activity.

These repurchasing agreements are secured by U.S. government securities, such as Treasury bills and bonds. So, SOFR closely approximates the risk-free rate.

Swapping SOFR for LIBOR minimizes the potential for market manipulation because, with SOFR, the Federal Reserve assumes responsibility for its aggregation and reporting, not a corporation. By comparison, individual companies assume responsibility for aggregation and reporting LIBOR.

Impact of Market Conditions

Using SOFR does have a potential downside: Because it involves the collation of real-world transactions, any volatility in the economy and the market for repurchase agreements could result in SOFR fluctuations. In turn, this volatility could cause frequent changes in the rates charged to consumers for variable-rate financial products. Right now, the use of SOFR as a reference rate is in its infancy. So, only time will tell how much market volatility will affect the rate.

If consumers experience frequent changes in interest rates and their associated debt payments, the market may shift to a market-adjusted SOFR. This alternative would reflect real-world rates while removing some of the market volatility.

Making the Switch

How can lenders and borrowers that currently use LIBOR prepare for the probable adoption of SOFR?

You’ll need to identify loans and other contracts that refer to LIBOR and revise them to reference the alternative market reference rate. In addition to updating documents, a robust communication plan must exist to explain the change in market reference rates and the implications for parties to a transaction. This process needs to be completed before the anticipated demise of LIBOR in 2022.

This isn’t as simple as finding and replacing one word in a contract. In some cases, it may also be necessary to adjust the risk premium that’s added to the new-and-improved market reference rate. LIBOR and SOFR (or another reference rate) may not be completely equivalent, so it’s important to make sure that the risk premium isn’t too high or low to compensate a financial institution for its risk.

To illustrate this point, let’s assume that the three-month LIBOR rate, expressed as an annual percentage, stands at 2.69%, and SOFR equals 2.39%. To arrive at the current rate for a traditional 30-year mortgage of 4.375%, an institution would need to add 1.685% to LIBOR and 1.985% to SOFR. While the end rate is the same, the risk premium differs.

For More Information

At this point, it’s unclear exactly which reference rate will replace LIBOR — or if LIBOR will somehow survive the FCA changes. Contact your financial advisor if you have questions about how these recent developments are likely to affect your organization and to devise a game plan to modify any existing or future market-based financial arrangements.