Though the divorce rate has been falling for the past couple of decades,1 divorce proceedings have only become increasingly complex, particularly when there are business interests involved. In fact, the valuation and division of closely held business interests is one of the most complex and highly litigated issues in a divorce action. While matrimonial laws and procedures differ between states, most states adhere to general rules regarding divorce proceedings. This article outlines the general processes of divorce proceedings for business owners, including classification of marital property, valuation issues and distribution. Clients should consult with their state-specific advisors for a more detailed discussion.
The Marital Estate
A common misconception about the division of assets in a divorce is that title matters. Just because an asset is titled solely in the name of one spouse and kept separate from the other spouse does not mean it will be excluded from the marital assets subject to division in a marital action, known as equitable distribution. In fact, in most non-community property states, the assets subject to such division include all property acquired from the date of the marriage to the date of commencement of the divorce proceeding. In a number of states, the marital property subject to equitable distribution even includes premarital assets. However, property acquired by gift, bequest or inheritance is generally excluded from the marital estate.
Businesses that were started or acquired during the marriage will generally be included in the marital estate that is subject to equitable distribution. In addition, businesses that were started or acquired prior to the marriage but that appreciated subsequent to the date of marriage due to the active participation of one or both of the spouses will generally be included in the marital estate. Finally, businesses that are co-owned by both spouses will be included in the marital estate. When ownership of a business is shared between two spouses, the shareholders’ agreement, LLC or partnership agreement, or another agreement that governs that business’s ownership should specifically articulate what happens with the business interests in the event of a divorce or separation.
Once a determination amongst the parties or the court is made as to what constitutes marital assets and before any equitable distribution decisions are made, the parties and the court must agree on the value of the assets in the marital estate. Any closely held business owner understands the complexity involved in valuing his or her business. In addition to tangible assets, many businesses involve hard-to-value intangible assets, such as the business’s brand name, the reach of the customer base, an owner’s relationships with suppliers and other goodwill components. The business may also be subject to varying liabilities, have no useful comparables and be nearly or totally illiquid. Unfortunately, the complexity of these valuation issues is compounded in a divorce proceeding by the proceeding’s adversarial nature, where each party will have opposing goals in valuing the business. In some cases, three valuation experts are used – one for each spouse and a “neutral” expert – to assist the court in determining the business’s value. In order to obtain and assess the value of the business, the parties may have to engage in an extensive discovery proceeding during litigation, in which the business’s books and records will be subject to intense scrutiny. Therefore, any business owner should keep accurate, complete books and records and retain a highly skilled and reliable accountant. Doing so could potentially reduce the costs of the discovery and legal fees as well as streamline any valuation dispute.
After determining what assets are includible in the marital estate and what the value of those assets is, the court will decide how to allocate the assets between the spouses. There are a number of misconceptions about how assets are divided between divorcing spouses without a prenuptial or postnuptial agreement in place, the most common of which is that the assets will be split 50-50. While this may be partially true in the nine states known as community property states,2 in the vast majority of states, a process known as equitable distribution controls the ultimate division of property between divorcing spouses. Equitable distribution is a judicial division of property rights that is “fair” according to the court – not necessarily, and most commonly not, equal. Different states have a varying list of statutory factors that the court must consider in making its determination. These generally include:
- Duration of the marriage
- Age and physical and emotional health of the parties
- Income and property of each party at the date of the marriage and date of commencement
- Earning potential of each party
- Custodial parent’s need to occupy or own the marital residence
- Awards of maintenance
- Liquid or non-liquid character of the marital property
- Probable future financial circumstances of the parties
- Tax consequences to each party
- Any other factor that the court finds just and proper
The number of potential factors a court may consider give a judge near-total discretion in dividing the assets between the parties, making the outcome of any divorce proceeding nearly impossible to forecast. This is precisely why prenuptial and postnuptial agreements are so highly recommended for business owners – so that they may have some predictability in a divorce.
Whereas most spouses generally agree in their settlement agreements on how to divide assets such as investment accounts, real estate and retirement accounts, the division of business interests more often than not provides contentious points of dispute between divorcing spouses. While it is unusual for a settlement agreement or a court to award the non-titled spouse an ownership stake in the business itself, the value of a portion of the business must be awarded to the non-titled spouse by some other means. For example, suppose the business is valued at $30 million, and the court awards the non-titled spouse one-third of the value of the business. The court would not generally award a one-third interest in the business to account for this distribution but would instead award the spouse one-third of the business’s value, or $10 million, out of other assets, such as residences or investment accounts. If there are insufficient other assets to make up the $10 million, the parties would likely negotiate a payout schedule over a period of years to the non-titled spouse.
Nearly all of the issues presented in determining what constitutes the marital estate, valuation and division can be agreed to in advance in a prenuptial or postnuptial agreement. Such agreements generally exclude business interests from the marital estate because of the difficulty and complexity in valuing and dividing those interests. However, in exchange for the waiver of any rights to the business, it is common to give the non-titled spouse other assets in exchange. For example, a certain sum in dollars for each year of marriage or a specific asset, such as a residence, may be negotiated between the spouses in these agreements.
Without any agreement in place, divorce proceedings involving business interests will likely present an array of complex issues requiring the retention of several experts, extensive and invasive discovery proceedings, and hiring of counsel to untangle complex tax and other legal issues. Keeping accurate and complete books and records, remaining transparent with one’s spouse about the business and having frank conversations with business partners well in advance of the initiation of discovery proceedings will allow all parties involved to more efficiently approach and handle the complexity of the issues presented.
We encourage you to reach out to your Brown Brothers Harriman wealth planner should you need any additional guidance.
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1 Source: U.S. Census Bureau. https://www.census.gov/prod/2011pubs/p70-125.pdf.
2 These include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.