What Business Owners Need to Know About Divorce
by Jennifer Hargrave and Jim Mueller
There is no doubt that divorce can have serious implications for a closely held business that is part of the marital estate. With wise counsel, and a team of trusted advisors, the negative implications of contested divorce can be minimized for the business owner. Several key principles apply to virtually any closely held business interest that is part of the marital estate.
Character counts. It is critical to determine whether the business interest is community or separate property because a court cannot divest a party of his or her separate property interest. The income generated from the business will generally be community property, even if the underlying business is separate property. If, however, the compensation received by the community is inadequate, the non-owner spouse may be able to recover on a claim for reimbursement for the spouse’s time, toil and talent. The business owner needs to know that capital contributions and retained earnings of a corporation or partnership (not a sole proprietorship) are considered property of the business, and cannot be characterized as separate or community property.
Entity interests. In a sole proprietorship, the business interest will consist of all the business property, minus any liabilities for the business. In a corporation, limited liability company or partnership, the “business interest” represents the right to receive a share of the profits and surpluses from the business. The corporation, LLC or partnership is deemed to “own” the business property—not the shareholders or partners—and the assets of the corporation or partnership are not characterized as community property or separate property. Unlike professional goodwill, business goodwill is an asset that belongs to the business, and will be valued as such. In the case of a professional practice, such as a law firm, much of the goodwill, if not all, will be deemed to be professional in nature.
Core values. Valuation of a closely held business interest for tax or estate planning purposes is different than valuing a business in a divorce. The measure of value will be the price at which the property would change hands between a willing buyer and a willing seller. The business owner must ensure that the expert retained or appointed to value the business has the proper qualifications to value the specific business and is skilled at presenting complex calculations to judges who possess varying degrees of business training and experience.
Taxing concerns. While transfers incident to divorce may be nontaxable in most instances, that does not mean that transfers incident are without tax consequences—especially for the owner of a closely held business interest. The transfer must fit squarely within the IRS rules and regulations. While property transfers between spouses are generally treated as a gift, with the transferee taking the transferor’s basis, the parties have an opportunity to negotiate between them who will bear the greater tax burden based on the transferred basis of the divided assets.
Formality fundamentals. When the owner of the business has disregarded the corporate formalities, and used the business assets for personal purposes, the non-owner spouse may persuade the court to treat the business as the “alter ego” of the owner spouse. The consequences for doing so can be detrimental to the business owner who thought his or her business was protected from divorce court. Nobody knows more about the business practices of the owner of a closely-held business than his or her spouse. A complete lack of trust in the spouse’s business dealings often results in more community property funds being spent to track down witnesses, compel production of relevant records, and retain experts to trace and track transactions. Therefore, business owners who do not want the court to treat the assets of the business the same as all the other assets of the marriage are wise to observe the formalities of the corporate entity, keep corporate and individual property separated, and to ensure that the corporation is not used for personal purposes.
A business owner who desires to keep business operations out of the public courtroom is well served by ethical counsel, discreet transparency and good faith in the discovery and negotiation process. It is important for the business owner to keep in mind that they often have many more options in negotiating a division of the marital estate than does a court in dividing the interests of the parties. When confronting divorce, it is imperative that the business-owner spouse secure legal counsel who understands the sensitive financial, emotional and business issues facing the business owner.