Will Your Business Survive a Divorce?
Pre- and post-nuptial agreements are increasingly common tools for protecting business viability.
The national divorce rate is approaching 50 percent. To anyone but divorce lawyers that's an unsettling statistic. To the family business owner, it can have a particularly unpleasant taste: Divorce and the resulting property division can force warring ex-spouses to become business partners. If they couldn't make the marriage work, how likely are they to succeed as business partners?
Pre- and post-nuptial agreements have become increasingly common as a way of ensuring the viability of a business. Although some people feel that dickering over property takes some of the bloom off love, they might be more realistic if they knew the consequences of not thinking the unthinkable.
In a divorce proceeding, the family business is generally considered marital property or community property. Courts have the power to divide the business between spouses in the settlement, and they do it all the time.
This may not be a problem if the business is a small part of the marital estate; the court can award it to the spouse most capable of running it, dividing the rest of the estate to achieve a balance. However, a business is usually a major asset.
Matters of domestic relations are controlled by state law. In many states an asset owned before the marriage is not considered marital or community property; only the increase in value during the marriage is regarded as property that can be divided between the partners. But even a business that has been in a family's hands for generations may be at risk if it has grown tremendously.
In community property states such as Idaho, New Mexico, or Texas you can be fairly sure that property will be divided equally between spouses. In these states your major concern should be to make sure that the court-determined value of the business is no more than 50 percent of your and your spouse's combined assets. If it is, ownership might then be divided. You have to do your best to prevent the court from setting a value on the business that is higher than what you believe it is worth.
If you live in an equitable distribution state such as Delaware, Georgia, Michigan, or New York you have to worry about much more than the business's value. In these states the courts may have the power to divide property unequally. Depending on the facts of the case, what is "fair" may turn out to be 8-20, 90-10, or even 100-0.
Big problems arise when a business is a large enough portion of the marital estate that the court feels it would be unfair to award the whole thing to one spouse, even if the other spouse gets all of the other property.
Let's look at a couple whom we'll call Al and Dora Cook. Al and his brother, Bob Cook, each own 50 percent of a family business, ABC Co., which they started six months before Al married Dora. At the time of their marriage, the business had liabilities that exceeded assets and had a negative cash flow. Al and Bob have no buy-sell agreement between them that might set a value on the business. Nor have they recently received any arm's length offers that might establish a floor price.
Al and Dora have no pre-nuptial agreement and now, two years later, their marriage is on the rocks. When the couple decides to divorce, Dora hires a good matrimonial lawyer and a good appraiser. Her appraiser values the business at $2.4 million, which would make Al's share worth $1.2 million. But Al looks at the liquidation, forced-sale value and says the depreciated assets have a book value of no more than $400,000. That would make his share worth only $200,000. Al and Dora have other property which they agree is worth about $300,000. If Al's assessment prevails and the couple's property is divided 50-50, he will be awarded his entire share of the business, free of any claim by Dora, plus another $50,000 from the non-business assets. Dora will receive the other $250,000 of non-business assets, and she and Al will go their separate ways.
But suppose the court finds Dora's appraisal correct. That would mean the estate is worth $1.5 million and each of the parties is entitled to $750,000. Brother Bob has no interest in buying Al out, especially at that price. This leaves Al with several choices, all unpleasant.
One alternative would be to divide up their half of the company, so that Al and Dora each own 25 percent. But that would leave Bob with a controlling interest, which Al doesn't want. Dora doesn't want this either, because Al and Bob would likely become allies against her.
Under these circumstances the court will probably award the business to Al, at a value of $1.2 million, and require him to pay Dora a hefty $450,000, so that each comes out with $750,000. That means Al may have to borrow against the business, which, if he's right about its true value, may not be easy. Further, Bob may refuse to encumber the firm to that extent.
The other option is to let Dora function, in effect, as the bank and have Al pay her $450,000 over the next nine years. If the court chooses that option, Dora will surely get interest for this delayed payment. At 10 percent interest, Al's yearly obligation is $55,00-$4,583 a month, none of which is deductible to Al.
Unfortunately, neither option is good for Al. Worse, he has spent thousands of dollars in legal and appraisal fees.
Now let's alter the facts slightly and assume that Al and Dora have a premarital agreement. The agreement establishes that Al's ownership interest in ABC Co. is separate property not subject to distribution in a divorce even if the business increases in value during the marriage. In addition, Al and Bob have a buy-sell agreement, entered into before any divorce litigation, which provides that, if one brother wants to get out of the business the other will buy him out at a fair price. They might agree that the buyout price will be the partner's share of the company's net equity.
Now when the couple divorces, if the premarital agreement was done right, the business will be fully insulated from the divorce court. The buy-sell agreement is an added safety net; if for some reason the premarital agreement is unenforceable and the worth of the business becomes an issue, the court may accept the value set by the buy-sell agreement. Al can thus avoid the expense-- and the devastation to the business — that may result from a battle between appraisers.
How common are pre- and post-marital agreements? In the experience of my law firm, they are more common in second marriages than in first marriages. This is not surprising when one considers that the divorce rate increases from 50 percent to 60 percent for second marriages. The second time around, moreover, people tend to be a little wiser.
Business owners should approach marital planning with the same pragmatic attitude that they do estate planning. More than the welfare of the spouses is involved when a divorce threatens to destroy a thriving business with many employees and other stakeholders. Some day business owners may regard such planning as a routine precaution that has nothing to do with love or sentiment.
Patricia G. Miller is head of matrimonial practice at Reed, Smith, Shaw & McClay, in Pittsburgh. She was named one of the country's leading matrimonial lawyers in The Best Lawyers in America, 1990-1991.
KEY POINTS OF A PRENUPTIAL AGREEMENT
To make sure that a prenuptial agreement will stand up in court, be sure to consult a good matrimonial attorney in your state. Here are some points to keep in mind:
- Do the premarital agreement as far in advance of the wedding as possible. When a bride is asked to sign such an agreement after the wedding invitations go out, the court may reasonably conclude that she was coerced or signed under duress.
- Don't hide anything. Premarital agreements require full and fair disclosure by both parties. Agreements have been set aside because one spouse has under-represented his or her net worth.
- Make sure that each party has legal counsel before signing the agreement. If Dora claims she wasn't given enough time to digest the terms, Al has a better chance of knocking down her claim if he can argue: "She had independent advice from a good lawyer. She was told what the terms meant."
- When planning to transfer assets to other family members, consider the stability of their marriages. If you sell shares to a son or daughter, they may be considered marital property, to which their spouses would have some claim in a divorce. In many states, a gift of stock or inheritance of ownership shares may not be considered marital property even when received during the marriage. However, the appreciation on that gift or inheritance may be included.
- If you're already married and didn't negotiate an agreement, consider asking your partner for a post-marital agreement. Your spouse may not be willing to give up all rights already acquired as a result of the marriage, and may insist on financial consideration for any he or she does relinquish. Nevertheless, you may be able to work out terms that protect the business if the marriage breaks up.
- An agreement signed by you and your partner that excludes "outsiders" from running or owning the business will not deprive your spouse of his or her marital rights in a divorce.