Divorce and the Closely-Held Business
A divorce can become extremely complicated when it involves a closely-held business. This article provides an overview of options for dealing with a business in divorce.
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A business typically provides income for the family and is also considered property, which may be divided between spouses in a divorce. In other words, both spouses may have ownership rights in a family business, and they will likely fight to get their share when the marriage ends.
How to Resolve a Business Ownership Divorce Dispute
There are a wide variety of closely-held businesses, including professional practices (for example, medical, dental, law and tax) and retail businesses, such as groceries, specialty shops, internet businesses and restaurants. While each business will have its own set of problems and complications, there are basically three methods of dealing with a business during divorce.
With co-ownership, both spouses continue to own the business after the divorce. If spouses remain amicable, it may be possible to work together after a break-up. But this is not for the weak of heart; it will require a solid working relationship or high level of trust in the other’s management skills. If there is a great deal of rancor, continued co-ownership is a recipe for disaster and not really a viable solution.
Sell the business and divide the profits
The pros of this option are that both spouses may profit from a sale of the business and can use the proceeds to invest in their own business ventures. Plus, spouses can avoid additional financial ties to their ex-spouse. The downside is that this could take some time; many businesses can’t be sold easily and it may be months before a buyer is found.
Buy-out the other spouse’s interest
In a buyout, one spouse keeps the business and buys (pays for) the other spouse’s interest. A buyout may be the best option assuming there are sufficient assets to complete the transaction. This can be accomplished if the buying spouse has enough cash or liquid assets available to pay off the selling spouse. Alternatively, the spouses could offset the selling spouse’s portion of the business with other assets, for example:
- The equity in a home.
- IRAs or 401(k) plan assets - however, these should be calculated at their estimated after-tax value in order to compensate for the eventual tax on withdrawals.
- Securities outside of qualified plans may be the most desirable in offsetting the value of a business because there is little to no tax liability associated with these accounts.
- If the business comprises most of the couple’s net worth, the spouses may have to enter into a “property settlement note” or “structured settlement,” which will be paid out over time to the selling spouse. A property settlement note is similar to a note at a bank - it should have a reasonable rate of interest, a definite term, and a principal amount.
Example: Susan and Steve have two significant assets: $100,000 equity in their home ($50,000 each) and the value of their business - $350,000 ($175,000 each). In order to keep the business, Steve will need to come up with $175,000 for Susan. He can give Susan his $50,000 equity in the home and provide her with a property settlement note for the remaining $125,000. Assuming a 5% rate of interest, Steve could pay Susan approximately $1,350 per month for ten years, thereby keeping the business undivided and assisting Susan with cash flow for ten years.
Business Valuation for Divorce
If you decide you can’t co-own the business with your ex, you’ll either need to sell to a third party or complete a buyout. To do either of these, you’ll need to determine the value of the business and how much each spouse owns.
Community versus separate property
In Texas, a business started during the marriage with joint funds is “community property” – meaning it’s owned equally between the spouses (50/50).
A business created before marriage, or founded with “separate property” funds (money earned before the marriage or by gift or inheritance) is a separate property business (owned by one spouse).
The key elements to determine community versus separate property are:
- the date of the marriage and date the business was founded
- the source of funds used to start the business, and
- the financial and labor-related contributions of each spouse to the business during the marriage.
Separate property businesses may (and usually do) have community components that will need to be valued and accounted for. Community interests may derive from:
- joint funds used to expand or invest in the business
- any appreciation in value attributed to joint financial contributions during the marriage, and
- the spouses’ contributions to the business, if those contributions played a role in the operation or growth of the business.
Thus, following the example above, if Steve started a business before marriage with separate property funds, but Susan managed and grew the business during the marriage and contributed community property funds, which resulted in an increase to the business’ value, there will be significant community property interests in the business. In a divorce, Susan will be entitled to one-half of the community interests in the company.
The characterization of a business as community or separate can be very complicated and should be discussed with an experienced family law attorney.
Determining the business value
Valuing (“appraising”) a business is a very complex task, which usually requires a professional business appraiser. The appraiser must be skilled in identifying relevant information for the particular business and applying the appropriate valuation methods. Relevant information generally includes quantitative data, such as financial statements and business tax returns. The appraiser will also select the appropriate valuation method based on the type of business and the availability of relevant information. There are three generally accepted valuation methods:
The market approach estimates the business value by comparing the subject business to a similar one that has been recently sold.
The income approach estimates the value of the business by converting expected economic benefits, such as profits or cash flows into a value. This can be based on historical information regarding past and current profits.
The asset approach is based on the values of the assets and liabilities of the business. These assets include both tangible and intangible assets.
Goodwill value is essentially the total value of the business minus the total value of the company’s tangible assets. Texas courts often require that the value of business goodwill be split into two types for divorce purposes: “personal goodwill” (sometimes called “professional goodwill”) and “enterprise goodwill.”
Personal goodwill is the portion of goodwill directly associated with the person running or otherwise working in the business. For example, if the spouses run a law practice, and one spouse is a well-known, very successful and sought after divorce attorney, a judge may find that the divorce lawyer-spouse has a lot of personal good will. In Texas, personal goodwill is not marital property and its value cannot be “divided” – it goes with the individual.
In contrast, enterprise goodwill is attached to the business itself, even if for example, the divorce lawyer-spouse were to leave the law practice. Texas courts typically treat enterprise goodwill as marital property that is subject to division between the spouses.
Choosing an appraiser
Choose an expert business appraiser. You’ll be much safer if you start your search by looking for appraisers who hold either the Certified Business Appraiser (CBA) or Accredited Senior Appraiser (ASA) credentials in business valuation. Earning either of these credentials requires the applicant to pass a highly technical exam and submit appraisal reports proving they are competent. The process is rigorous and the pass rate is low. Other appraisal certifications exist. They may look good on paper, but they lack the rigorous requirements that a CBA or ASA appraiser must meet. Look for a CBA or ASA appraiser at these organizations:
Most skilled business appraisers offer more than one level of appraisal service. The price typically ranges from $3,000 to $12,000 or more and depends on the business itself and the level of appraisal services (amount of detail in the analysis and the report) the client requests. In order to save time and money after you hire an appraiser, make sure to gather and organize your business documents, and provide a full set to your own lawyer and business appraiser.
In a contested divorce (where the spouses don’t agree on divorce-related issues) spouses often obtain separate appraisals. Unfortunately, fighting this out in court will definitely increase the cost of the divorce. In a “collaborative divorce” the couple uses only one appraiser who works for the couple and is far more likely to produce a fair, independent valuation. This can save a lot of money and help yield a comfortable result for both spouses.