Is an S Corp Considered Community Property?

An S corporation offers liability protection and “pass-through” taxation, which avoids the double taxation common to traditional corporations. Community property, a legal framework in some states, treats assets acquired during a marriage as jointly owned by both spouses. When an S corp is owned by a married person in a community property state, these concepts intersect, raising questions about ownership and value, especially during a divorce or after a death.

Determining the Property Character of S Corp Stock

Whether S Corp stock is community or separate property depends on state law. The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In these states, assets acquired during a marriage are legally presumed to be community property, belonging to both spouses equally. This includes property purchased through the skill or labor of either spouse.

Separate property includes assets owned before marriage or acquired during marriage through a gift or inheritance to one spouse. If an S corporation was started during the marriage with marital funds or effort, its stock is considered community property. This gives both spouses an equal interest, regardless of who is the named shareholder or who runs the business.

A business started before marriage is considered the owner’s separate property, but this can change. If community funds are invested into the business, commingling can create a community interest. The property’s character can also be changed through transmutation, a legal action that converts separate property to community property.

The labor an owner-spouse dedicates to a separate property business during marriage can also create a community interest. Value added through this participation may be considered a community asset. If the owner-spouse was not paid a fair market salary, the community may have a right to be reimbursed for that labor’s value, creating an interest in the business’s growth and profits.

Valuation and Division of the S Corp in a Divorce

If an S corporation has a community property interest during a divorce, it must be valued to determine each spouse’s share. This process requires a professional business valuator to analyze the company’s finances, assets, and market position to find its fair market value. After valuation, the couple must decide how to divide the community interest.

One method is an asset distribution buyout, where the spouse running the business keeps the S Corp stock. The owner-spouse then uses other assets, such as the family home, retirement accounts, or separate property, to buy out the other spouse’s share. This approach allows the business to continue operating without disruption.

A structured buyout is an option when other assets are insufficient for an immediate buyout. The owner-spouse agrees to pay the other spouse their share over time, formalized with a promissory note detailing the payment schedule and interest rate. The note is often secured by the S Corp stock, giving the non-owner spouse a claim to the stock if the owner defaults.

Selling the business to a third party and dividing the proceeds is another option. Co-ownership by ex-spouses after a divorce is also possible but rarely practical. This arrangement forces former spouses into a business partnership, which can lead to operational friction.

Key Tax Implications for Community Property S Corps

The community property status of S Corp stock carries specific tax consequences. Since both spouses are considered equal owners, they each have a tax basis in the stock, even if only one is the listed shareholder. This basis is used for calculating capital gains or losses if the stock is sold.

Profit distributions from the S corporation are community income. If spouses file separate tax returns, each must report and pay tax on one-half of the income from the community-owned stock. This applies regardless of which spouse actually received the funds.

Under Internal Revenue Code Section 1041, transferring S Corp stock between spouses during a divorce is not a taxable event. The transfer is treated as a gift, and the receiving spouse takes on the transferring spouse’s tax basis. This “carryover basis” means the recipient is responsible for all capital gains tax upon the eventual sale of the stock.

Upon the death of a spouse, a tax advantage occurs. The entire community property interest in the S Corp, including both the deceased and surviving spouse’s halves, receives a “step-up” in basis. The basis is adjusted to the stock’s fair market value on the date of death, which can reduce or eliminate capital gains tax if the survivor later sells the business.

Proactive Planning with Marital and Shareholder Agreements

Business owners can use legal agreements to override default community property rules. Marital agreements, such as prenuptial and postnuptial agreements, allow a couple to classify an S corporation as the separate property of one spouse. This contractually waives any community property claims the other spouse might have.

Through such an agreement, a couple can stipulate that the business, its appreciation, and its income remain the owner’s separate property. For the agreement to be enforceable, it requires full financial disclosure from both parties and must be entered into voluntarily.

Shareholder agreements, often structured as buy-sell agreements, are contracts between shareholders that control what happens to stock during events like death or divorce. The agreement can prevent an ex-spouse from becoming a shareholder by giving the corporation or other shareholders the right to purchase the stock.

Buy-sell agreements help maintain control over the corporation’s ownership. They often include a predetermined valuation method to set the buyout price, preventing disputes over the business’s value. This ensures a smooth ownership transition and protects the business from disruption caused by a shareholder’s divorce.