When you are in love, you make joint plans for life, share happiness, sorrow, material property, and finances. The last thing happy newlyweds want to think about is divorce and its consequences.
Divorce and Business Ownership
Dissolution of a marriage affects all aspects of a spouse’s life, from child custody to splitting up a shared business. Protecting a business from divorce is often the first thought of entrepreneurs when filing with the court.
Dealing with divorce when you own a business together can be more complicated than meets the eye. After all, you will have to decide whether you want to run the business or exchange it for money. In this article, we will consider all the possible options for saving your business during a divorce and the best ways to divide it if you are facing the challenging issue of divorce and business ownership.
Marriage, Business, and Contract
Conclusion of a Contract
Many couples sign an agreement before getting married. The contract may include plans for business management and ownership and real estate or other valuable assets.
A marriage contract is a formal agreement. There are two types:
- a prenuptial agreement that was drawn up and signed before marriage;
- a postnuptial agreement concluded accordingly after the date of registration of the marriage.
The decision to terminate a marriage contract can help spouses avoid unnecessary problems and quarrels during divorce with a business involved. No matter how much you trust each other, the contract is your guarantee and proof in court.
Jacqueline Newman, divorce lawyer and author of The New Rules of Divorce: 12 Secrets to Protecting Your Wealth, Health, and Happiness, highlights the importance of contracting:
“When the divorce rate is around 50%, divorce and prenups should be normalized. At the end of the day, marriage is a legal business relationship, so we need to be practical, and getting a prenup can strengthen a marriage.”
The spouses can write down their recommendations on the business’s value or divide the assets between them. Besides, the marriage contract can include other aspects of the relationship breakup, such as the division of family property, alimony, and child custody.
The marriage contract is signed when both parties agree with the prescribed conditions. The contract is made in duplicate (one for each spouse) and certified by a lawyer. This document is non contested evidence of the spouses’ agreement. If needed, the petitioner or respondent can use it in court.
If the spouses choose not to enter into a prenuptial or postnuptial agreement, they still have a way to keep their assets during divorce. To do this, you need to take some steps.
Register yourself as the sole owner of your business. You should make sure that the company organizational documents clearly state that the business management remains with you in the event of a divorce. The second spouse can be paid monetary compensation.
Maintain a strict record of the sources of investment for the business. The documents should indicate whether money received before marriage was used or was taken from the family budget for renting premises, opening an office, hiring employees.
Andriy Bogdanov, CEO and Founder of Online Divorce, places particular emphasis on this point.
“Under any circumstances, you should not use the collateral in your home to invest in your business. You should always separate all assets. Subsequently, there will be less confusion later as to what belongs to whom.”
Separate your personal and business expenses. Mixing of funds can lead to confusion during litigation and misappraisal of each spouse’s contribution to business development. If your company has a cash component, you should ensure all cash transactions are well documented.
If your spouse also works for this company and is not a simple shareholder, you should pay them according to market standards. Otherwise, they may demand a higher percentage of the company’s value, arguing that the distribution of their contribution to the company’s value will be more equitable.
Discussions about the future of the potential division of assets and your business must be positive, respectful, and productive. Having a mutually acceptable formal or informal agreement should give you both peace of mind.
Dividing a Business in a Divorce
Suppose you have not entered into any agreements with your spouse regarding the business and are partners and co-managers. In that case, one of the following methods may be suitable for you to divide a private business.
The first thing spouses should do about divorce is to determine whether the business is considered a family asset or personal property of one of the spouses. The assessment depends on whether the company was founded in marriage or before it. It also considers the number of financial contributions and efforts made by the spouses to the business during the marriage. Also, note that the analysis of marital property differs from state to state.
Business interest assessments are often a major source of disagreement between spouses in a divorce. Private businesses often do not conduct their business on public stock exchanges such as the NASDAQ, so calculating a business’s value can be difficult. To facilitate the process of determining a business interest’s fair market value, spouses may contact a specialist.
It may be an Accredited Senior Appraiser (ASA), Certified Public Accountant (CPA) with an Accredited in Business Valuation (ABV) designation, or Certified Business Appraiser (CBA). Also, each of the spouses has every right to hire their specialist. But in this case, the judge will need additional time to determine which of the presented experts has a more reliable assessment.
After evaluating the joint business, the spouses need to define what should happen to the business interests after the marriage dissolution. There are three options for resolving the interests of a private business in a divorce:
- One spouse buying out another spouse assets;
- Selling a business; and
- Remaining co-owners.
Buying Out the Other Spouse
One spouse buying the other spouse’s share of the business is the most popular method of solving private business problems in divorce cases. But it is worth considering that only a licensed spouse can own a business in some professional services areas.
Usually, a spouse’s purchase of the other spouse’s business share is not considered a sale for tax purposes. Property transfers between spouses resulting from divorce are generally not subject to income tax under IRC §1041.
The transfer is a tax-free, non-recognition event. A transfer is considered part of a divorce if the transfer occurs within one year after the dissolution of the marriage, is related to the termination of the marriage, and the divorce or separation instrument requires the transfer and occurs within six years after the dissolution of the marriage. If the transfer occurs more than six years after the dissolution of the marriage, there is a rebuttable presumption that the transfer is not related to the divorce.
If the purchase of a spouse’s share is not considered a sale for tax purposes, then the buying spouse will receive the same basis of ownership as the selling spouse. In this case, the selling spouse will not be required to pay any taxes on the business interest sale.
It is crucial to consider the tax consequences of a buyout during the marriage dissolution process because the purchasing spouse could owe more in taxes if they eventually sell the business interest to a third party down the road.
A common problem with business buyouts is that this is only possible if there is sufficient cash or other liquid assets, such as stocks and bonds, from the buying spouse. Often the buying spouse can obtain funding from a third party lender or commercial bank to create enough liquidity to acquire the other spouse’s share.
Borrowing can be a tax-efficient strategy given low-interest rates. Selling personal stocks for capital gains or withdrawing funds from a retirement account, on the other hand, can lead to income taxes and a 10 percent penalty.
Chris Porteous, co-founder and CEO at Framestr, offers an alternative. During a divorce, the buying spouse may propose a non-pro-rata division of other marital assets instead of cash. For example, the second spouse may retain full ownership of the family residence and other assets equivalent to a part of the business value.
“You may be able to hold onto 100% of your business if you give your ex-spouse a higher, or the entire portion of, one or more of your other assets. Perhaps the family home is more important to them than it is to you and could be used as a settlement tool to secure your ownership of your company.”
Besides, a divorced couple may agree to a structured settlement, which means paying installments instead of one lump-sum payment. A structured settlement is considered a non-taxable division of property in a divorce. The selling spouse will not have to pay taxes on receipt of the principal payments but will be taxed on interest.
Selling the Business
If a business buyout is not a possible or affordable solution for both spouses, selling it and sharing the income between the spouses is the second most attractive option. Usually, the sale method is also applied to the division of the rest of the family property. But if one of the spouses insists on managing the business, its sale may not be possible without a court decree.
Selling a private business can be problematic even if both spouses have agreed. It is not an easy and fast process. It can be challenging for spouses to find an independent third party interested in buying a business. It can take several years to find a buyer. Therefore, spouses need to think about how and who will run the company until it is sold.
Besides, a couple may disagree with the price offered by the third-party buyer. The third-party buyer often offers a price lower than an independent valuation prepared for divorce proceedings.
Another option for dividing the family business is to continue the joint ownership after the divorce. Spouses do not often choose this option since not all couples break up peacefully. And for many, there are also emotional and psychological problems that will affect the quality of work. Alternatively, the spouses can agree that one party undertakes to fulfill all management responsibilities for running the joint business. The other party will receive a percentage of the business’s profits. Depending on the business’s success, each spouse will receive more or fewer assets while maintaining joint ownership of the business.
Spouses rarely choose to remain co-owners when divorced because many couples can not maintain a warm working relationship after a breakup. It is vital that they stay friendly, respectful, and trust each other. It is just as crucial that the spouses sign a formal written agreement to deal with their future business relationship as if they were unrelated before.
During a divorce, the main thing is to stay calm and do everything in a planned manner. The methods described above are the most common ways of maintaining and dividing a business. But this process can be complicated if there is debt or the company is also owned by third parties. Therefore, the best way to keep the business going during the divorce process is to agree with your spouse and find the best option that would work for both of you. To do this, each spouse should seek advice from a lawyer, wealth manager, or tax adviser to agree on further actions.