It's no secret a divorce affects more than the two people calling it quits. Children, in-laws and friends find that nothing is quite the same afterward. The same goes when the divorcing couple owns a business--almost certainly, they won't be able to keep doing business as usual.
"There are some rare cases [I've seen] where the parties don't get along in marriage but can in business," says family law attorney Gregg Herman of law firm Loeb & Herman Service Corp. in Milwaukee. In those cases, Herman arranges for each ex-spouse to retain 50 percent of the ownership, then makes sure they have a very good shareholder's agreement with a buyout provision in place, in case it doesn't work out. But that's the exception. "More commonly," he says, "you have to do two divorces: first the marriage, then the business."
U.S. divorce law is based on a concept called "marital property." Whether it's a house, a car or a business, anything acquired during the marriage most likely counts as marital property, which is subject to equitable distribution. In the case of a business, it doesn't really matter whether the husband or wife was a partner or shareholder in the business. Even if it was a sole proprietorship with one spouse at home raising the children, the law assumes the survival and growth of the business can be attributed in part to the support of the stay-at-home spouse. So while the spouse who is active in the business will most likely be the one who keeps it after the divorce, the ex-spouse is entitled to a share of the value of the business--often half.
Among the exceptions to the marital property rule, depending on the state, are property either spouse owned before they married, and property and gifts inherited by one spouse during the marriage. Suppose the wife founded the business five years before she got married. The value of the business at that time is hers alone, but any growth in the business since the marriage counts as marital property. The court would call on appraisers to determine the value of the business at the time of the marriage and its value at the time of the divorce. The difference, declared marital property, must be divided fairly.
When husband and wife are equal partners but unwilling to remain in business together, which one retains ownership becomes a matter for negotiation. Perhaps one will get the business, while the other gets the house and the retirement plan. Or one keeps the business but has to pay the other half its value. That arrangement can pose serious cash-flow problems. "The company may not be liquid," says William S. Friedman, a family law attorney with law firm Friedman and Babbitt Co. LPA in Columbus, Ohio. "Suppose the court goes on fair market value and requires one [spouse] to buy out the other. That's scary."
Even determining fair market value can be tricky, notes Columbus family law attorney Robert Wistner, because professional appraisers practice an inexact science. He tells of one case in which he represented a husband who had purchased a company. When the man and his wife divorced, two appraisers valued the company, one at $5 million and one at $5.5 million--surprisingly close for independent appraisals. Nine months later, the ex-husband sold the entire company for $25 million.
In a case like that, what seems to be a generous settlement can turn out to be less so. "Divorce for an entrepreneur is very complicated," Wistner observes.
To manage a buyout, the partner retaining the business may have to make payments to the ex-spouse over time. That can create a long-term drain on income--especially if the nonworking spouse is also entitled to spousal support (formerly called alimony). "Years ago, the husband would keep the business and pay alimony," Friedman says. "Now the spouse who owns the business can end up dividing the business with a nonworking spouse, plus have to pay spousal support from monies generated by the business."
When Complications Arise...
Not completing a buyout can be disastrous, too. In some states, Friedman says, a judge weighs the relative contributions of each spouse and awards unequal shares of the business--say, 60 percent to one and 40 percent to the other. That makes the latter a minority shareholder, with a sizable investment in the business but no say in management and no ready market for the stock.
Often, contested divorces take several years to settle. That can put everything regarding the business on hold at a time when the owners may need to make major business decisions, Wistner notes. Suppose the divorce court issues a restraining order to keep the owners from selling the business until the divorce is final. An opportunity might come along to sell the company at a premium price, but the owners' hands are tied until the opportunity is long gone. Then both parties have lost out.
A divorce can also lead to unexpected expenses for the business while it's still reeling from the cost of buying stock from an ex-spouse and perhaps paying spousal support from its income. Suppose the husband was the primary business manager while the wife did the books and answered phones. Most likely she performed these services free of charge to help build the family business. "Typically, the spouse who gets the business will have to hire someone to do all that--[and that person] won't do it for free," Herman says.
At the same time, Wistner notes, the corporation might be getting a tax deduction by paying for the owners' house, utilities and vehicles. If the wife was drawing a salary, that's tax deductible, too. "When the owners divorce, all that ends," he says. "The husband loses all those tax deductions, and the sweetheart deal on the home front is over." Accordingly, personal expenses increase not only from the cost of setting up two households but from expenses formerly covered by the business.
When the business has additional partners--say, several brothers--things get even more complicated. A judge can order only the divorcing owner's share to be divided, not the share belonging to the other partners. But having to come up with the cash to buy out the owner's ex-spouse can strain relationships within the partnership.
"A divorce is a substantial economic event even without a business," Friedman says. "The smartest [business owners] start with financial planners to figure out how this is going to work before they bring in the divorce lawyers." Sometimes, he says, the CPAs, business lawyers and divorce lawyers work together to forge the best possible agreement, then present it to the judge for approval. "The court doesn't have time to finely craft a solution," he notes.
It's easier when there's a partnership, shareholder's or LLC agreement in place ahead of time that includes formulas for how to value the business and how to arrange a buyout in the event of the death or withdrawal of an owner. The same goes for prenuptial agreements, which are more common these days. Most people contemplating marriage don't want to think about divorce, but a prenuptial agreement could save your business.
"Hire good lawyers," Herman advises. "Negotiate and resolve, and maybe you can avoid your business becoming a casualty of divorce."
Steven C. Bahls, dean of Capital University Law School in Columbus, Ohio, teaches entrepreneurship law. Freelance writer Jane Easter Bahls specializes in business and legal topics.