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Tax implications of divorce – what business owners need to know

By RJP LLP on 21 June, 2016

Companies which are run by couples can be very successful and there are plenty of examples where the trust and complementary skills shared between spouses has proved beneficial. There are many ways in which such a working partnership can operate, from each spouse having equivalent executive positions – one technical and one marketing for example, to one spouse taking the lead and his or her spouse supporting the business in an administrative capacity. Whether you are embarking on a new business venture, in a rocky relationship and pondering the future, or considering whether to award shares in your existing company to your husband or wife, couples are wise to understand the practical ramifications and likely tax implications of divorce on joint shareholdings.

Tax advantages of jointly owning company shares

Shares in privately owned companies are frequently split between husband and wife, and this can be advantageous for tax purposes. Although one shareholder may have the largest strategic involvement in the company, their spouse may undertake a lot of operational responsibilities which entitles them to receive a salary. If they have a shareholding in the company, this also entitles them to receive dividends, and these can be a tax efficient form of income, even though the rate of tax payable on dividend income has recently increased. Sounds like a win/win situation.

 

Tax issues if a relationship sours

However, if the couple separates with a view to divorcing, this can cause a number of problems. There are obvious issues to be addressed, such as the ongoing day to day running of the business, but beyond this there is the larger question of whether the couple actually wish to remain in business together. It may not be viable for the couple to continue working together or to remain as joint shareholders and an agreement may be reached that one party will cease to be a shareholder. In this case, the parties will need to agree the value of the shares to be transferred, which is likely to involve appointing an outside valuer; and of course, the spouse who is transferring their shares will also be losing the dividend income they receive from the company. For these reasons, shares are frequently used as a bargaining tool by a shareholder seeking the best possible divorce settlement.

Once negotiations have been settled however, the capital gains tax (CGT) implications of any share transfer will also need to be considered, and these will vary depending on when the shares are transferred. The general rule of thumb for tax purposes, is that the quicker you can reach an agreement about the division of jointly owned assets, the less complicated the tax situation, although practically this can be very difficult to achieve where business assets such as shares are concerned.

 

Worked example: capital gains tax implications of divorce


The following example highlights the different scenarios couples can find themselves in and the tax implications:

Tim and Julie are joint shareholders in a company and have an 50/50 shareholding which was worth £10,000 each at the time of incorporation and is now worth £100,000 each.

  • Scenario 1: They separate and Julie agrees to transfer her shares to Tim during the tax year in which they permanently separate, and before they divorce. Irrespective of the amount Tim pays for the shares, no CGT is payable because this is a transfer between husband and wife in the year of separation. Tim acquires the shares at Julie’s original base cost of £10,000 and will pay CGT on the excess sale proceeds he receives over this amount when he eventually sells the shares. Julie has no CGT liability.
  • Scenario 2: They separate but do not agree on the distribution of assets until well into the next tax year. CGT will need to be considered on the share transfer because the shares are not transferred in the tax year of separation, when Tim and Julie can still be treated as married for CGT purposes, but are transferred in a later tax year, during which they are still legally married. In this situation, Tim and Julie are treated as ‘connected’ for tax purposes and irrespective of the consideration actually paid by Tim for the shares, HMRC will substitute the market value of £100,000. Therefore, a capital gain of £90,000 will arise in Julie’s hands. If no further action is taken, CGT will be payable by Julie at her marginal rate of tax; if she is a higher rate taxpayer this will be at the rate of 20%. Julie may be able to claim entrepreneurs’ relief - if she has a minimum 5% shareholding and voting rights, and is an officer or employee of the company, and in this case she will pay CGT at the rate of 10%.

 

Ability to claim holdover tax relief

Where an individual gives away business assets or sells them for less than they’re worth, they can claim gift hold-over relief. This means no CGT is payable when the assets are transferred, and the person they are given to pays CGT when they sell the shares. This is however a claim that must be made jointly between both parties. Therefore, if Tim and Julie jointly agree, and make a claim, Julie can claim holdover relief and avoid the CGT liability. In this case, Tim will pay CGT when he sells the shares, based on the excess sale proceeds he receives over £10,000. The result is therefore the same as in scenario 1, but there are tax reporting requirements and the necessity to make a joint claim, in order to arrive at this position.

  • Scenario 3: Tim and Julie do not agree the share transfer until after their divorce (decree nisi) is granted, or the transfer is made as part of an agreement reached under Court Order. Once the decree nisi is granted, Tim and Julie are no longer connected for tax purposes and the actual consideration paid by Tim for the shares will be the amount which determines the capital gain arising in Julie’s hands. If the shares are transferred for no consideration, or for less than they are worth, Tim and Julie may be able to make a joint holdover election.
  • Scenario 4: The couple divorce but agree that both will remain as shareholders. This will give Julie an ongoing entitlement to dividends voted by the company. This scenario can be desirable in the case of an amicable divorce and working relationship and where ongoing income is required.

In summary, every situation is different, but where matters can be agreed between the parties quickly, the tax considerations and reporting burdens are likely to be minimised; where they cannot be agreed quickly, it pays to be aware that there may well be tax implications, and these can often be overlooked.

If you are thinking about offering company shares to your spouse or possibly wondering how to proceed with getting existing shares back and require tax advice, please contact Lesley Stalker by emailing las@rjp.co.uk.

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