Complex Property Business Entities
Divorce is difficult. When children are a part of it, the process is even more stressful. But what if your baby isn’t a child at all; it’s your business. It’s the business you created, stayed up nights to help grow, and lost sleep thinking about what might happen to it and how to make it better.
Business entities, in the context of divorce, can be remarkably complex. Below are some basic ideas to keep in mind.
Businesses are regularly attacked in divorce. The way the owner has managed the operation of the business, including the capitalization and debt structure, can alter the value and, in some instances, even the character of part or all of that entity.
We have to identify the character of a business (is it separate or community property). If it’s one party’s separate property, then it doesn’t get divided. That spouse just gets it (though there may be claims for reimbursement). The inception of title doctrine says that the character of an asset, including a business, is established when ownership vests. If the husband started a corporation before marriage, that company is his separate property, even though the business may have grown and increased in value throughout the marriage.
If the business was started during the marriage, it will be considered, at first, to be a community asset. But if it was capitalized by one of the spouses’ separate property, that asset might quickly turn to a separate property item or perhaps a mixed character asset (part community and part separate).
Even if a business is the separate property of one of the spouses, the income from that business, including distributions of profits and dividends, belongs to the community and is subject to division. As distributions are taken and then put back into the business, the assets inside the entity start to become commingled, and the community estate may begin to develop an ownership interest.
If an entity is created, it stands alone. For instance, a corporation has its own identity. It can own assets, bank accounts, owe money and conduct business, all within the limits of its corporate shell. The parties to a divorce may own shares of stock in the company, but the entity still owns and operates inside of itself.
That corporate shell can be cracked. It often happens, particularly with closely held businesses, that the managing spouse uses the business like his or her personal checkbook. The cars are purchased through the business, along with the family boat. Vacations, meals, clothes, or any number of other items get paid for out of the business. The more corporate formalities are ignored by the business owner, the more likely the corporate shield will be ignored by the court.
Every case is different, but in general, courts avoid keeping people in business together after they divorce. That really leaves three choices: The wife gets the business, the husband gets the business, or the business gets sold. As an example, assume the wife started and runs the business, a corporation owned entirely by the community estate. The husband has had his own career and really doesn’t know the details of running the company. It’s not a comment on the husband’s intelligence, it’s simply a matter of having years of head knowledge in running this particular business.
Since the husband has his own job, he is less likely to be able to take over for the wife and run the business as successfully. A more attractive option might be for the wife to buy him out of his share of the business. So what’s his share of the business worth? That’s the million (or maybe several million) dollar question. The valuation of a business is an art form all its own. It’s far more than just multiplying the gross revenues by an industry acceptable factor. The ultimate question in valuating a business is “what will someone pay for that it?” If it’s a closely held business (for instance, owned entirely by the husband and wife), there may be a discount on the value due to the lack of a continuity of management after the business is sold. Is the wife’s personal goodwill a large factor in the success of the business? If so, it will be worth less if she is no longer around to run it. How long would it take to sell? The list of factors goes on. Professional forensic valuators spend years practicing their craft to give us the most accurate valuation possible.
A business owner may testify to the value of their company. It’s testimony which is, perhaps, more than a layperson’s, but not necessarily an expert’s. If it is the only testimony about value presented, then it will be the only evidence the court has to go on. But a strong valuation done by a forensic expert will also be considered, along with any incentive the court perceives the testifying owner may have to underestimate the value of the entity.
If a business is found to be the separate property of one of the spouses, the community estate may still be entitled to claims for reimbursement. If the owner spouse has under-compensated himself, the community might be able to get the value of reasonable compensation. If community property money or assets are put into the business to keep it afloat or make it grow, the community once again may be entitled to get that money back.
A separate property corporation may be sold and the money from the sale used to buy or start another business. So long as the money from the sale can be traced, with specificity, into the new business, that new entity can be preserved as the original party’s separate property.
If the company is publicly traded, the division generally becomes far less complicated. Publicly traded stock is valued on the exchange, and ownership of that stock doesn’t require any interaction between former spouses. The court may simply divide the stock.
Professional practices – law, medical, dental – may be valued and the value may be considered in the division of the community estate. But a non-professional can’t own a part of a professional practice. For instance, a medical practice can’t be owned, in part or in whole, by someone who is not a doctor.
Partnership agreements may limit the transferability of an interest in a company to a spouse. They can also fix the value of an interest in the entity and allow for the business to be bought by the other partners or shareholders in the event of divorce. Whether a court will allow such agreements to operate to the detriment of an unknowing spouse will depend, to a great degree, on what line of cases the court tends to follow.
The characterization, valuation and division of business entities is complex. It takes decades of experience to understand and master them. But with the right team, you can protect your baby.