When the owners of a business decide to dissolve their company, a married couple chooses to end their marriage, or an estate needs to be settled, significant assets will need to be divided, and agreements will need to be negotiated. During this time, tax implications can raise questions and cause substantial problems for all parties involved. The main financial concern for former business partners, married couples, or grieving families to consider and be aware of is embedded taxes.
What are embedded taxes?
In general, an embedded tax is a hidden cost that is built into the value of a product or service and is paid by the end consumer. In relation to a divorce, estate settlement dispute, or business dissolution, embedded taxes are unrealized tax liabilities associated with assets that could be subject to division, sale, or transfer. Assessing the potential embedded taxes that you could be liable for is imperative during the property division process, as failing to do so could lead to an inaccurate assessment of the asset’s true market value.
How do embedded taxes impact property division?
During settlement negotiations or the property division process, substantial assets, including stocks, real estate and other investments, will be distributed equitably. To accomplish this, the fair market value of the asset must be determined.
Embedded taxes can affect the division of stocks or investment properties by impacting the asset’s fair market value, as capital gains taxes will need to be paid at the time these assets are sold or transferred if they have appreciated in value. Therefore, the capital gains taxes will be included in the value of the asset in order to ensure the property is divided fairly among everyone involved.
With respect to divorce, I.R.C. Section 1041 provides that transfers of property incident to a divorce are non-taxable events. Thus, no tax is realized simply by virtue of division of an asset with embedded taxes pursuant to a decree of divorce. At the same time, Ohio Rev. Code Section 3105.171(F)(6) requires the court to consider tax consequence in its determination of an equitable division of property. Many courts, however, do not consider embedded taxes unless marital property will actually have to be sold under the terms of the decree. Under any circumstance, embedded taxes will be realized if, after the divorce, a party sells an asset awarded in the divorce decree.
Further, qualified retirement assets (IRA’s, 401k’s, etc.) are often equalized during a divorce. Again, the equalization, if done properly, will not generate taxes, but any post-divorce distribution from a retirement plan to a party will be treated as taxable income possibly subject to penalty depending on the age of the distibutee. Many people mistakenly equate the value of a retirement asset with another asset of equal gross value but very different embedded tax consequences. For example, $100,000 in a retirement account is not equal in value to $100,000 in a savings account. The money in the retirement account is subject to income tax immediately upon distribution and the money in the savings account is tax free.
Is it possible to avoid embedded taxes?
While embedded taxes may not be completely avoidable, negotiating parties in Ohio may be able to disregard embedded tasks when valuing property if they can come to a mutual compromise. This agreement can additionally provide benefits to those involved as it can prevent immediate financial difficulties or allow them to maintain possession of the assets for an extended period of time and defer the payment of potential taxes.
Property division is frequently the most contentious portion of the business dissolution, estate settlement, or divorce process, as emotions from everyone involved can begin to rise and boil over. Ohio residents who could be or are currently involved in a divorce, business dissolution or an estate dispute may want to consider speaking with a legal representative and a tax professional to ensure they adhere to all pertinent regulations and laws.