Consider a typical corner store partnership arrangement. There are two primary issues involved in the event of family breakdown. The first relates to the apportionment of the income stream pending a dissolution of the partnership. The second concerns the disposal of capital assets and trading stock.
APPORTIONING THE INCOME STREAM
On a separation, one party invariably takes full control of the partnership resources and income. The ousted (or ''exiting'') partner may call for an accounting of this additional income up until the time the partnership resources are officially allocated by agreement or by Court order. In reality, the controlling partner continues to control the cash flow. This is then either divided equally or, more commonly, a lesser sum is paid to the exiting party. This usually reflects the fact that the remaining partner bears the brunt of the work and wants to be compensated accordingly. The other party's allocation often takes the form of spousal maintenance and child support. This will be based on that person's actual needs rather than an equal share of the partnership profits. At the end of the financial year, or on dissolution of the partnership, the income is equally divided between the parties for tax purposes. T
he remaining partner would pay the tax assessed on the allocation to the exiting partner, which usually results in a better net return to both parties. Thereafter the remaining partner loses the benefit of income splitting. The resulting PAYG and direct tax burden needs to be factored into the settlement equation. In some cases (depending on the terms of the partnership agreement), it may be possible to divide the profits unequally in the year the parties separate in order to take into account changes in the parties' duties. This may allow an advantageous distribution to the spouse with a lower taxable income. Regardless of the outcome, differing tax liabilities between the parties must be taken into account. Remember that distributions of partnership income will almost certainly impact on the eligibility of the exiting spouse to receive a pension. The ultimate consequences of this must be carefully considered.
CAPITAL ASSETS AND TRADING STOCK
CGT may apply on dispositionsof partnership assets to a spouse. It is important to remember that CGT may apply to a disposal of goodwill even if the goodwill is not recognised in the partnership's balance sheet. However, rollover relief is available in the same manner as is explained above (in relation to real estate), ie there is an exemption for family breakdown. That rollover relief is automatic. In some instances, electing not to take advantage of rollover relief may be appropriate if there are capital losses in existence. This could be achieved by keeping particular asset transfers outside of court orders. The disposal of trading stock on breakdown of marriage is not in the ordinary course of business and is therefore deemed to be a fully taxable disposal by the partnership for market value. This could be evidenced by the values set out in the parties' respective financial statements filed in court proceedings. Any tax on the resulting profit should be paid by the partners. If rollover relief is available, tax on the profit on that stock should be paid by the transferee spouse.
The two options need to be carefully considered in each particular partnership to achieve the best possible net result for the parties. Depreciable assets are not subject to CGT but any excess of the value of those assets over their written down value may be subject to income tax. If depreciable assets remain with the controlling partner, rollover relief is automatic for transfers on marriage breakdowns. No tax accrues to the exiting partner and the remaining partner retains the rollover benefits. If certain depreciable assets are transferred out of the partnership to one of the spouses, tax consequences may flow and the individual circumstances of any such possibility should be examined. For example, tax consequences could arise from the transfer of plant because of depreciation rules. In structuring a spouse's exit from the partnership, the remaining spouse may prefer to bypass the operation of the family breakdown CGT rollover provisions and buy the exiting spouse out. For example, if the partnership is profitable and has grown in value, the remaining spouse may wish to obtain a cost base for the partnership interest acquired from the exiting spouse.
The remaining spouse will probably want to allocate as high a purchase price as is reasonable, in order to maximise the cost base of the partnership interest. By contrast, if the rollover provisions are invoked, the remaining spouse will acquire the exiting spouse's cost base which, if the major asset is goodwill, will usually be nil. On a subsequent disposal, the remaining spouse will pay CGT on the entire value of the business even though he/she may have only held the entire business for a short period of time. If the spouse's exit is structured as a buy-out, the exiting spouse will usually be subject to a CGT liability on the payout, although the capital gain will be subject to the general 50% reduction applicable to disposals after 21 September 1999. Further, if the family's business assets amount to less than $5 million, the potential capital gain may be further reduced, deferred or exempt under the small business CGT relief.
For example, under one type of small business rollover if the exiting spouse is under 55 the payout may be exempt from CGT if it is made directly into a superannuation fund for the benefit of the exiting spouse. The proceeds would remain "locked in" the superannuation fund until the spouse reaches the preservation age. Another possibility alternative is that any capital gain may be eligible for the 50% "active asset" exemption. The active asset exemption and the general 50% reduction are cumulative, so that if both apply, the exiting spouse would pay tax on only 25% of the capital gain.
INDEMNITIES WITH PARTNERSHIPS
Commonly, the exiting partner obtains an indemnity from the remaining partner for all tax liabilities that may arise from his/her involvement in the partnership. This may also extend to limiting the exiting partner's legal liability.
CAPITALISING INSTALMENT PAYMENTS
Situations frequently arise where one party can only pay the required capital sum by instalments. The recipient demands interest on that sum. Capitalising that interest means a tax-effective payment in the hands of the payee. The payer may negotiate a lower capitalised payment given that benefit. If payments of these capitalised sums are late, penalty interest (under the Family Court Rules being 11.3% as at 1 January 2002) could be written into the terms of settlement. This interest would remain taxable in the hands of the recipient.
This paper is intended as a guide only to when further expert tax or accounting advice is needed. Every case is different, and different fact situations can impact substantially on what otherwise might be a straight forward case. It is trite to say that our tax laws are complex. As indicated, what follows is designed to prompt you to take care in what you are doing when you restructure your client's assets during a divorce.
This is the third article in the series of articles from Peter Szabo's publication "Tax Issues in Family Law Property settlement" Other articles in the series:
1. Tax Issues in Family Law Property settlements: Distributing the Spoils -The Difference between hacking and carving;
2. Tax Issues in Family Law Property settlements: Real Estate and othe Assets held by individuals;
3. Tax Issues in Family Law Property settlements: Divorcing the Partnership;
4. Tax Issues in Family Law Property settlements: Divorcing the Discretionary Trust;
5. Tax Issues in Family Law Property settlements: Divorcing a Spouse from the Company;
6. Tax Issues in Family Law Property settlements: Other Aspects;
7. Tax Issues in Family Law Property settlements: Tax Considerations for Child Support;
8. Tax Issues in Family Law Property settlements: Advance Planning