Most people do not know to ask the question how a 179 deduction impacts spousal benefits after a divorce. Let’s talk about this ever so briefly.
In 2018 the tax laws expanded the 179 deduction from $500,000 per year to $1,000,000 per year. This can provide a significant benefit for business owners who are going through a divorce. Let’s place this in context to a case study.
Imagine Mary and John have been married for 15 years. Mary owns a manufacturing business that generates over $10 million in revenue per year. The business is organized as a multi-member LLC (a limited liability company with more than one shareholder) where Mary has a 50% ownership interest in the business. In 2017, before the change in the tax laws, the business was eligible to deduct up to $500,000 of certain equipment that was purchased within any given calendar year. If the business incurred, say, $600,000 in equipment purchases throughout the calendar year, the additional $100,000 ($600,000-$500,000) could not be deducted on the tax return of the business. It had to be depreciated over the useful life of the equipment, assuming the equipment was not eligible for something special called bonus depreciation. The $100,000 may equate to an annual depreciation of ~$14,000 per year (i.e. a 7 year useful life). In other words, the business would not receive a tax benefit for the cash it spent over $500,000. It would receive the tax benefit over a 7 year period of time not immediately.
Let’s bring that 179 deduction into the personal tax return now. Since the business is organized as a multi-member LLC Mary would receive a K-1 from the business. The 179 deduction would be separately stated on her K-1. Assuming there were enough profits reported on the K-1 she would be able to reduce the profits by the amount of the 179 deduction reported through the K-1. The tax preparer would record $250,000 ($500,000 x 50% ownership interest reported on the K-1) on Schedule E. The $250,000 would directly reduce any taxable income reported on Mary and John’s joint tax return. Assuming the couple was in a 30% tax bracket this would translate into ~$75,000 in tax savings for that year. This also assumed they would file a joint tax return for the 2018 tax year.
Now let’s talk about the expanded 179 deduction created through the 2018 Tax Reform Act. The $500,000 179 deduction limitation has now grown to $1,000,000 (i.e. a $500,000 increase). But, let’s talk about this in context to a divorce. Mary and John decide they want to get a divorce. They start and finish their divorce in 2018. The divorce decree stipulates that Mary would keep the business and John would get other assets in the marital estate such as the vacation home, etc. They finalize and sign their divorce decree in 2018. Since they authorized their divorce decree before the end of 2018, they were not eligible to file married filing jointly or married filing separately. In essence, their tax profiles have now been separated. Unless the divorce proceeding is re-opened the terms of their financial settlement is what they will have to live with for the remainder of their lives.
Since they didn’t know what they didn’t know, they perceived the assets in their divorce were distributed in an equitable manner. Yet, as often is the case, there were a number of hidden assets that were not taken into account in their settlement structure. In context to this article we are only focused on the hidden marital asset created from the 179 deduction available to certain business owners. Now back to our story.
Later in life John finds out in 2018 the business incurred large equipment purchases that amounted to $900,000. Yet, during his divorce no one asked the question whether the business purchased any large pieces of equipment during the year. This placed John in a compromised negotiating position. Yet he didn’t know it. He left a lot of money off of the negotiating table. Let’s see what happened to his future wealth position as a result.
In 2019 John sees Mary driving a beautiful new car. She also moved into a much larger home and started to travel extensively too. He wondered to himself how could this be possible. He knew how much she made in terms of income. He also knew how the assets were divided according to their divorce decree. He said to himself that he could not afford to do what she was doing. So, how could this be possible?
Mary filed her tax return as a head of household. The tax benefit Mary received from the 179 deduction was not addressed in their divorce decree. This 179 deduction created a hidden asset on the marital estate that needed to be addressed in the settlement structure. In the case of Mary and John they never talked about who gets the tax benefit for the 179 deduction. How much did Mary benefit by not bringing this up in her negotiations? Let’s do the math.
The total amount of equipment the business purchased throughout the year was $900,000. She owned a 50% equity interest in the business. $900,000 x 50% = $450,000. This was the amount of the deduction that flowed through to her personal tax return. Since her share of the profits were higher than this amount she was able to deduct the full $450,000 on her tax return. This translated into $450,000 x 30% = $150,000 in tax savings on her personal return. In other words she didn’t have to pay the government that money. She could keep it for herself to use any way she wanted to as her discretionary earnings. John never benefited from that deduction and therefore lost at least $75,000 ($150,000 x 50%) in that silent negotiation.
The 179 deduction is one of many assets that hide in marital estates. These hidden assets are often not discussed during negotiations providing one spouse a benefit and the other one to lose that financial benefit. We call this hidden wealth-at-risk. Divorces involve a lot of hidden wealth-at-risk. It appears in many forms. Yet, it is often not discussed or managed during a divorce process.
If you are an advisor who deems her or himself as a true fiduciary then you will want to make sure all of the financial matters are handled properly during a client’s divorce process. Feel free to reach out to us and we will be happy to discuss the matter with you. If you are a person going through a divorce be careful how these matters are handled in your settlement discussions, you could be leaving large sums of money on the table and not know until it’s too late.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
If You Have a Question
If you have a question, feel free to contact me at [email protected] or 617-680-5222. The call is free. I will spend 30–60 minutes with you. I will provide you an honest assessment as to where I think you are positioned in your divorce process or answer any questions you have. I may provide you some guidance, insight or advice that you can take with you as you wish. There is no obligation to move forward. The phone call is designed to ease your fears, provide you some options to pursue and a potential road to run on that can lead you down a path to achieve a successful outcome.
About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
- continuously strive to provide a return on our services
- build balanced financial solutions grounded in evidence
- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
- provide mental clarity to make decisions
- reduce the total process time from start to close
- minimize the stress and unpleasant memories that can last a lifetime
As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.