Going through a Divorce while Owning a Business

When it comes to going through a divorce there are thousands of articles that discuss child custody, division of assets and even how to award pet visitations.  However, the prospects of negotiating a successful Business Divorce in a marital divorce action can be complicated.  As Mick Jagger famously sang the Rolling Stones song, “You can’t always get what you want, but if you try sometimes, well, you might find You get what you need”.

The most common Business Divorce scenario that arises in divorce proceedings is the transfer of one spouse’s ownership interest in a private company to the other spouse as part of the divorce settlement. It is rare for divorcing spouses to be able to continue working together in a business after a divorce. Even if they are not active in the business, the co-ownership of business interests by divorced spouses can often lead to conflict, which is why dividing the couple’s ownership interest in businesses is a typical part of the divorce settlement. 

If one spouse transfers an ownership interest in a private company in the divorce, it is vital to remember that the transfer of this ownership stake gives the company a seat at the table in the divorce.  The transfer takes place of an interest in a private company.  Both spouses need to address the following points:

1.        The transferee spouse (who receives the interest being transferred) needs to provide the transferor (who is transferring the interest) with a release of claims from the business, and not just from the spouse. The transferor spouse may have been quite active in the business before the transfer took place, and does not want to be subject to any future claims that are asserted by the business (at the direction of the transferee) after the divorce is final.

2.       The transferor should also seek an indemnity from the business for any future claims that are made against the transferor by third party creditors or others after the divorce. If the transferor is dragged into a lawsuit by a third party after the divorce, the business should indemnify the transferor against the claims, which covers both the transferor’s legal expense and any resulting liability. The transferee may insist on including a carve-out that eliminates the indemnity if the transferor is found to have acted in bad faith or was grossly negligent, which caused the lawsuit to be filed by the third parties.

3.       In the year after the divorce becomes final, the company may issue a K-1 tax document to the transferor, which is based on his/her ownership in company during the prior year. The transferor needs to secure a representation from the business that this K-1 will not include any “phantom income” that would require the transferor to pay taxes based on income that was not distributed to the transferor in the preceding year.

4.       Finally, the transferee needs to make sure that all rights, title and interests of every kind and character are transferred by the transferor in the transaction, and that there are no hold backs of any retained interest by the transferor in the company or any of its assets.

Another issue that business owners will want to address is the liquidity of the business.  The challenge arises when the company in the marital estate is highly valued, but the couple does not have enough other value in assets outside the business to allow either spouse to pay the other spouse one-half of the value of the business.   One spouse generally wants to buy the other spouse’s ownership interest in the business, but this spouse (the proposed buyer) lacks the funds necessary to purchase the interest and cash out the other spouse (the proposed seller).

In this situation where sufficient funds are not available at the time of the divorce to permit one spouse to buy the other spouse’s interest in the business, there is a creative solution we have presented that does work for some couples. We refer to it as the “kick the can down the road” strategy in response to this problem created by the liquidity crunch, and the elements of this approach are summarized below.

·         The spouses will continue jointly owning the company after their divorce, but one spouse will operate the business, and they will also receive an option they can exercise at a set point years down the road (usually 3, 4 or 5 years). This is known as a put/call option, with the operator spouse having the right to purchase the non-operator spouse’s interest in the business at the agreed point. The non-operator spouse will have a put right that, when exercised, requires the operator spouse to purchase the non-operator’s interest in the business at the agreed point.

·         Importantly, the spouses’ ownership interest in the business is not valued at the time of their divorce. Instead, the couple will adopt a specific, detailed valuation formula, which will be applied to determine the value of the ownership interest at the point at which they exercise the put/call option years down the road.

·         During the holding period before the put/call is exercised, the operator spouse will be required to provide full transparency regarding the operation of the business. This will require the operator spouse to issue regular financial reports and also require the operator to obtain/provide audits of the business at least on a yearly basis by independent auditors.

·         Also during the holding period, the non-operating spouse will have a set of veto rights regarding the operation of the company to protect him/her during this multi-year period. These veto rights do not permit the non-operator to micro-manage the business, but they protect the non-operator and ensure that the fundamentals of the business will remain the same. Some examples are that, without the consent of the non-operator, the operator spouse cannot declare bonuses for management, add new partners to the business, and require the non-operator to contribute capital or dilute the ownership interest of the non-operator.

Using the kick-the-can approach there are three attractive features:

1.       It avoids a fight about the value of the business during the divorce, which can be both time-consuming and very expensive.

2.       It gives the operator spouse several years after the divorce concludes to determine how to secure the funds necessary to purchase the interest of the non-operator spouse. This can be accomplished by finding another investor to take the place of the non-operator, by securing a loan or by selling the business, in whole or in part.

3.       The delayed division of the business does not have any tax impact – a division of the business within 3, 4 or 5 years is still regarded by the IRS as incident to the marriage and it is therefore is not deemed to be a taxable event.

The delayed division of ownership interests until a set period of years after the divorce only works, however, when there is some liquidity in the marital estate at the time of the divorce. The non-operator spouse can afford to wait for a buyout of his/her interest only when the couple does have some liquid assets to divide at the time that the divorce becomes final.

In some cases both of the spouses want to continue to maintain an ownership piece of the business.  This might be because the both enjoy working at the company and have a high compensation, they are receiving sizable annual profits from distributions or they believe the business has the potential for very significant appreciation and they want to realize the benefit in the future.

When couples continue to own a shared interest in a business, however, they will want to ensure they have the right to obtain a buyout of the interest they continue to hold in the business after the divorce. This will require that the spouses themselves, or other partners in the business agree to provide them with a buy-sell agreement that applies to their interest. Stated simply, a spouse who becomes a minority interest owner in the business will not want to be left holding an illiquid and unmarketable ownership stake in the company. The value of the ownership interest is not really relevant if the spouse has no way to ever monetize that value.

Divorcing couples might have many areas of disagreement and the dissolution of their marriage as well as their ownership interest in private companies will be no exception.  However, there are paths that can be provided to them that is can be mutually beneficial.

Having an attorney with the resources and knowledge to give you the best representation is vital to your interest and the interest of your family.  You also want to make sure they will exhaust all avenues and be willing to research, pursue and implement strategies to provide the best possible outcome.

Rob McAngus, Partner with Verner Brumley Parker, P.C., is Board Certified in family Law and his practice is devoted primarily to family law, including high conflict divorce, custody cases, and complex property issues. In addition to being selected on the Board of Directors for the Family Law Section of the Dallas Bar Association; he values your priorities as a parent and works with you to achieve the goals that will help transition your family to a new normal.  As both an adopted child and a member of a blended family, Rob can provide a unique perspective in the practice of family law.

Rob has been recognized in Super Lawyers as a Rising Star in 2016 through 2020, and recently The National Advocates recognized Rob as one of the Top 40 Under 40.  He can be reached by calling 214.526.5234 or email at rmcangus@vernerbrumley.com.  Mr. McAngus received his bachelor’s degree cum laude and master’s degree from Baylor University and graduated cum laude from the Dedman School of Law at Southern Methodist University.