When a marriage involving owners of a flow-through entity is on the rocks, the intertwining of personal and business finances can create significant tax complications. This is especially true when one spouse is more involved in the business operations than the other.

There are more than just tax issues to consider in divorce. But taxes are often one of the largest expenses and they do present obstacles and tax planning opportunities in divorce. The recent Veeraswamy v. Commissioner, T.C. Memo. 2024-85, case provides an opportunity to consider this question. It involves a couple that owned an S corporation and how to allocate the income and expenses from that entity leading up to and during the divorce process.

Before getting into this case, it’s important to note that significant differences apply in community property states, such as Texas and California. This article focuses on common law states, as the Veeraswamy case does not involve a community property state. We have other articles on this site that address those topics, such as this article on innocent spouse relief and this article on the election process for S corporations, among others.

Facts & Procedural History

In this case, the taxpayer-wife and her husband formed an S corporation in 2000. They each owned a fifty percent interest in the business. The business’s primary asset was an apartment complex purchased in 2005, which had about 70 tenants, including three commercial units.

As their marriage deteriorated, the husband began to isolate the taxpayer-wife from the business operations. By 2011, the taxpayer-wife had moved out and filed for divorce. In 2013, the husband filed for Chapter 11 bankruptcy protection on behalf of the business. He represented to the bankruptcy court that he was the sole owner.

In 2014, the business’s primary asset, the apartment complex, was sold for $7.6 million, resulting in a substantial gain. After paying the business’s debts, there was a nearly $2 million surplus. The taxpayer-wife, believing she was no longer a shareholder, did not report any of this income on her tax return. In fact, she did not file a tax return for 2014.

The husband then died in 2019. After his death, the taxpayer-wife discovered corporate documents proving her continued fifty percent ownership interest in the business. She used these records to file an amended proof of claim in her late husband’s bankruptcy case, asserting her right to half of the business’s surplus funds from the 2014 sale.

In 2022, the bankruptcy court approved a settlement that paid the taxpayer-wife $486,038 to satisfy her equity claim in the business, along with $480,000 in domestic support. However, she didn’t report these amounts on her 2022 tax return.

The IRS then audited the taxpayer-wife‘s income tax returns and, given that no tax return was filed for 2014, prepared a “substitute for return” for her. The IRS’s substitute return determined that the taxpayer-wife owed taxes on her fifty percent portion of the business’s 2014 income, including half of the $1.9 million capital gain from the sale of the apartment complex.

The case ended up in the U.S. Tax Court. The primary issue was whether the taxpayer-wife was a fifty percent owner of the business in 2014 and, thus, liable for the taxes on her share of the company’s income for that year.

Flow-Through Taxation

Let’s start with the concept of flow-through taxation. Flow-through entities, such as partnerships, S corporations, and certain trusts, generally do not pay taxes at the entity level. Instead, the income, deductions, and credits “flow through” to the owners, who report these items on their individual tax returns. This tax treatment applies regardless of whether the owners actually receive distributions from the entity.

We can see this in the Veeraswamy case. In the Veeraswamy case, the business elected to be an S corporation. As the owner of an apartment compelex (and probably engaged in tax planning for real estate), the S corporation likely had rental income, depreciation expenses, mortgage interest expenses, and property management costs. These items would be reported by the business owners of the S corporation. The owner would then report their share of these items on their individual tax returns, regardless of whether they received any actual distributions from the business.

Tax Filing Status for Divorcing Couples

This gets into questions about the tax-filing status for the couple. This is one of the preliminary tax decisions that divorcing couples have to make and other tax implications build off of this decision.

Leading up to and during the divorce process, many taxpayers choose to file as married filing separately. By filing as married separately, each spouse agrees to pay tax on just their income and deduct their expenses. If the parties can work together, they can usually find ways to reduce their combined income tax liability. For example, they can agree on who is to claim children on their tax returns as dependents, for child tax credits, etc. when the custodial parent is not able to benefit from these tax attributes on their own return. They may also agree to different allocations of income and expenses.

This type of tax planning is often not possible given the spouse’s positions in the divorce proceeding or acrimony, and the impact that these decisions can have on the outcome of property awards or divisions during the divorce proceeding. In these cases, the default is often that the spouses have their accountants exchange notes, with each reporting fifty percent of the items of income and expense.

In other cases, one or both spouses just don’t file income tax returns at all pending the divorce. This wait-and-see approach leaves the spouses on the hook for substantial late filing penalties and late payment penalties. We saw that approach in the Veeraswamy case. In the Veeraswamy case, the taxpayers eventually filed separately, but the husband apparently was not sharing information about the business with the wife. As a result, she did not file returns and did not report her share of the income from the business. This left the IRS in a position to go back and make adjustments later, which they did. Had the taxpayer-wife filed her returns, even without complete information, she could have started the assessment statute running and it may have prevented the IRS from making later adjustments to her income. It may have also helped her avoid having to pay significant tax penalties to the IRS.

Disputes as to Business Ownership

While parties or the family law court may decide who owns a business after divorce, determining responsibility for taxes prior to divorce can be complex. In common law states, the actual owner(s) of the business is responsible. But who exactly is the owner? This was the primary issue in the Veeraswamy case.

In Veeraswamy, the husband had shut the taxpayer-wife out of the business and had represented that he was the sole owner of the business to the bankruptcy court. The taxpayer-wife did not believe that she had an ownership interest in the business prior to the time her husband and then ex-husband died. The taxpayer-wife discovered her ownership and was able to claw back a distribution of the sales proceeds from the business in bankruptcy, but, as the tax court found, this resulted in her being an owner and liable for the flow-through income for 2014.

This fact pattern raises the question of whether the taxpayer-wife abandoned her interest. Put another way, did she acquiesce in the transfer of ownership of the business to the husband such that she abandoned her interest in the entity (and could she have abandoned the interest and then re-acquired it)? The taxpayer-wife did not raise the issue, but the tax court did on her behalf.

There is case law that says one can in fact abandon an interest in a business. These court cases generally say there has to be some overt act of abandonment, and no hope of recovering the asset. In this case, the tax court said that the taxpayer-wife’s pursuit of her distribution in the bankruptcy showed that she had not abandoned her interest.

For someone in the taxpayer-wife’s position, there’s a cost-benefit analysis to consider: Is the potential income from a distribution worth more or less than the potential tax liability on omitted flow-through income? This analysis can be particularly challenging in cases where the business hasn’t sold a significant asset, potentially leaving flow-through tax liability higher than any cash the spouse might receive.

Records of Business Income and Expenses

Since the tax court found that the taxpayer-wife was a part owner in the business, she was responsible for paying tax on half of the items of income and expense for the business. This in turn raises the question as to how would she report these amounts if she did not track these amounts each year?

The husband did not share this information with the taxpayer-wife. How is the taxpayer-spouse to know that the husband reported the amounts correctly–or if he reported them at all? The facts could have been different in that the husband may not have filed a Form 1120S for the business. That is a common scenario in divorce proceedings. This situation compounds the problem as the spouse who does not have records of the business income or expense has no basis for even knowing how to report the income and expense from the business on their tax returns. This usually needs to be addressed through the family law court, and in some cases, the non-business spouse may need to file a return reporting an estimate with the intent of filing an amended return later to correct the estimate.

The other records issue in the Veeraswamy case involved the tax basis in the S corporation. Tax basis is generally the investment in the entity. It is a floating number that changes from year to year as contributions and distributions are made to the business. This is important, as it was in this case, as the tax basis represents already taxed money. Thus, on the sale of the business, like in this case, this amount is not taxed a second time.

Couples going through divorce or who are negotiating divorce terms may not be willing to share information to be able to accurately report this amount. In the Veeraswamy case, the taxpayer’s lack of documentation about her basis in the S corporation complicated her tax situation when the IRS determined she was still an owner. The IRS auditor appears to have accepted the number provided by the husband before he died, but this number may have been understated and the absence of knowledge may have put the taxpayer-wife in an unequal bargaining position and a position where she ended up paying tax on already taxed money.

This shows how important it is for the spouses to share and obtain records for several years prior to any divorce even being filed. As in this case, without this information, a spouse may end up in an unequal bargaining position or paying tax on already-taxed money.

Tax Planning or Mitigation Options

Given these issues, it is often helpful if the couple can work together, at least minimally, to reduce their combined tax liabilities. The divorce process does create some interesting tax planning opportunities.

The Tax Cuts and Jobs Act eliminated the alimony tax deduction which used to be at the heart of this type of tax planning, but, even then, opportunities still abound. This can range from simple planning involving QDROs for retirement accounts, to disporportionate distributions from S corporations, to strategic S corp conversions and terminations, to distribution of appreicated assets, to more involved income-shifting strategies.

For example, separating or divorcing spouses can often come to an agreement on how business income and losses will be reported during the separation and divorce process. Given the circumstances and that the IRS is likely to get involved, this type of agreement should be in writing and may need to be incorporated into your divorce settlement.

There are other planning opportunities too. Even those with outstanding tax balances can often find ways to use the process to cut their tax liabilities. One possibility might be to plan to take advantage of the innocent spouse relief rules. This could entail filing joint income tax returns, knowing that one spouse is going to take steps to qualify for this type of relief and the other spouse is going to discharge the tax liability in bankruptcy or with an offer in compromise.

Takeaway

The Veeraswamy case shows some of the challenges spouses face when divorcing and dealing with flow-through entities. Flow-through entities can make this very difficult. As this case shows, simply being excluded from business operations does not necessarily negate one’s ownership interest or tax liability for the business’s income. As with most things related to taxes, documentation is often key. This, plus some minimal cooperation between the spouses can go a long way in ensuring that the tax liability is correctly reported and, perhaps, minimizing the taxes as well.

Watch Our Free On-Demand Webinar

In 40 minutes, we’ll teach you how to survive an IRS audit.

We’ll explain how the IRS conducts audits and how to manage and close the audit.