By Richard Bell
The names have been changed to protect the innocent. This is a real life situation with some facts altered. If you have questions, consult our firm or your attorney.
Our CPA firm represents a large number of first generation small businesses which were started by a 2nd mortgage on their house or maxing out all credit cards.
Sometimes in establishing these companies, the parents use labor called children to work in the business. Most businesses start off as proprietorships and summary of income and expenses show up on Form 1040 Schedule C for several years till the business gets off the ground. When the business turns profitable, usually year 3 to 5, mom and dad want to share the fruits of their labor with the son or daughter who may or may not have a spouse. A parent will consult their attorney and transfer the asset/liabilities to a new corporation or limited liability company, which is now owned by mom, dad, brother, and sister in some percentage amounts. The company continues to grow, brother and sister now have brought precious goods called grandchildren into the world, and all is blissful in the Garden of Eden, i.e. the corporate business. Things then go awry, the brother or sister and their spouses split up and file for divorce. The spouses ask for all prior year tax returns and financial statements on the family business and a demand is made on the brother or sister by the ex-spouse to be that the share of stock or LLC interest is now or will be owned by the ex-spouse, unless the company or child is willing to buy out the ex-spouse interest, under state law, which states that except for gift or inheritance, the stock certificate acquired during marriage is marital property and is split down the middle 50/50. The parents and children usually will have no desire to be partners or owners with exes, so it is down to the bank to make a loan to redeem the ex’s share of the stock or interest, which depletes the equity and working capital of the business, and is paid with after tax dollars.
While our CPA firm does not handle marriage counseling as a service, we could have recommended and insisted that the parents file gift tax returns at the time that the proprietorship was changed to a corporation or LLC. This would have put all future stakeholders on notice that the ownership was obtained by gift. The attorney for the child, who owned part of the business, could have argued then that the stock was not marital property.
Often times we do not go the extra step to cover all bases, especially when we are broke, and starting a new business.