Divorce is tough. There’s no doubt about it. It can be particularly tough for individuals who own closely held or “family businesses”. In a divorce, an individual’s business can be divided by the court as a marital property asset.
During a divorce, the Court will divide the assets and liabilities of the parties in a “fair and equitable” manner. A business, or more particularly, the ownership interest in that business is considered property, which is subject to division by the court.
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. This article discusses the 7 things you need to know about divorce from a business owner’s standpoint.
1. Your spouse may have an interest in your business.
The characterization of property as either community or separate is usually determined by when a party first has a right of claim to the property by virtue of which title is finally vested. This is known as the “Inception of Title” rule or doctrine.
Generally speaking, if an asset was acquired during the marriage it is subject to division by the court in a divorce, which means your spouse may have an interest.
If an asset was acquired prior to the marriage, it is separate property and not subject to division by the court, which means your spouse may not have a claim.
Assets on hand during the marriage and upon its termination are presumed to be community property. In order to show that your business is not community property, you must present “clear and convincing evidence” that your business is separate property. In short, the court will put the burden on you to prove your business isn’t a marital asset.
This means that, if your business was established after you were married or if you can’t prove it was established prior to marriage, your spouse likely has an interest in that business. If your business was established prior to marriage, it can still be used to affect the disposition of the community property as we will discuss below.
2. You may be restricted from conducting business while the divorce is ongoing.
Often times, the court will issue orders to preserve the status quo while the divorce is ongoing. These orders usually prevent the parties from spending money, acquiring debt, making major purchases, making major sales, etc.
All of this is understandable, and usually unavoidable, when the parties do not own businesses. However, it is important to fight any of these restrictions when you are a business owner. Typically, business owners regularly acquire debt, make sales, make purchases, etc. in the operation of their business. If you don’t fight to have these restrictions lifted, you might find yourself in violation of them.
It is important to help the court understand why these restrictions might cause damage to your business and to make sure that the orders aren’t so restrictive that you are unable to operate.
3. Your business may be valued in several ways.
Valuing a business is a difficult task. There isn’t an easily ascertainable fair market value for businesses like there is for motor vehicles. Usually, a professional business appraiser is used to value a business. We’ll discuss below how to choose an appraiser.
Usually you will need to get your business financial statements and tax documents together to forward to the appraiser so they can make their valuation. The professional appraiser will know the proper method of valuing your business, but will generally choose one of the following:
- Market Approach – Usually arrives at the value of the business by comparing your business to other similar business that have recently sold.
- Income Approach – Usually arrives at the value of the business by valuing the reasonable expectation of continued economic benefits and places a value on those.
- Asset Approach – Usually arrives at the value of the business by valuing the assets and liabilities of the business.
4. Even if your business was established prior to marriage, it might impact the division of property acquired during the marriage.
The marital assets will be divided in a matter that is “just and right”. However, “just and right” doesn’t necessarily mean 50-50. The judge may order a 55-45 or 60-40 division of the marital property.
There are many factors that a judge can consider in the disproportionate division of the marital estate including the size of the community and separate estates. The size of the marital estate may affect the methods by which the court allocates the properties. As a general rule, the larger the estate, the closer the court will come to a 50-50 division of property. The approach to division of the community property may be affected by the nature and extent of the separate property owned by each party. The relative sizes of the community estate and the separate estates of one or both parties may be considered by the court.
In other words, even if your business was established prior to marriage AND you can prove it, it still might be used as a reason to grant your spouse a larger amount of the community estate.
The characterization of a business as community or separate can be very complicated and should be discussed with an experienced family law attorney.
5. Your goodwill might be subject to division by the courts.
Goodwill is the value of the business less the value of the tangible assets. There are two types of goodwill: “personal goodwill” (sometimes called “professional goodwill”) and “enterprise goodwill.”
Personal goodwill is the portion of goodwill associated with the person in charge of or owning the business. In Texas, personal goodwill is not marital property and cannot be “divided”. Rather, personal goodwill goes with the individual.
Enterprise goodwill is attached to the business itself. This would be the value which would remain if the person running the business left the business. This goodwill goes with the business and is subject to division by the courts. The following diagram may be helpful:
6. Different Types of Entities Mean Different Things.
The type of entity chose for your business may impact how the ownership interest in the business is treated for purposes of divorce.
Sole proprietorship is the simplest and most common form of business. However, the sole proprietorship is legally indistinguishable from the owner. This can lead to issues in divorce.
A sole proprietorship is likely to result in an inability to characterize the owner’s interest in it as separate because the assets can become comingled. This comingling of assets makes it difficult or impossible to trace which of the business assets were owned prior to marriage or traceable to assets owned prior to marriage.
Converting a sole proprietorship into a separate legal entity (i.e. corporation, LLC, etc.) prior to marriage, can maintain the client’s interest in the entity as separate property along with the assets of the business.
However, converting a sole proprietorship to a separate legal entity after divorce might conclusively make the interest a community property asset even if the sole proprietorship was established prior to marriage and the individual can trace the assets properly.
Partnerships, Limited Partnerships and Limited Liability Companies
Partnerships, limited partnerships and limited liability companies are separate legal entities under Texas law. The owners of the entity do not own the assets of the entity, but rather, the owners own an interest in the entity. A divorce court cannot award specific partnership assets to the other spouse but can award a portion of the value of the interest to the other spouse.
The character of a person’s interest in the entity will depend on the nature of the assets contributed in exchange for the interest itself. If the assets to purchase or obtain the interest are separate property, the interest should be separate property. Additionally, any undisbursed proceeds in the entity are an asset of the partnership rather than income to the individual spouse.
Non-liquidating distributions by the entity to the owners generally take on a community character like ordinary cash dividends distributed by a corporation to its shareholders.
7. Choose a qualified appraiser
Usually, this will be done at the recommendation of your attorney. However, you’ll be much safer if you look for appraisers who hold either the Certified Business Appraiser (CBA) or Accredited Senior Appraiser (ASA) credentials in business valuation. There might be lots of individuals who are willing to value your business, but they lack the rigorous requirements that a CBA or ASA appraiser must meet. Look for a CBA or ASA appraiser at these organizations: Institute of Business Appraisers (IBA) & American Society of Appraisers (ASA).
It is important to understand these issues if you are considering divorce or if your spouse has filed for divorce. Going through a divorce, even if you're the one filing, can seem catastrophic at the moment. Keep your head up and keep seeking quality help and advice. You will get through this!
Our law firm is standing by to help and answer any questions you may have. Send us an email or call(713) 999-9398.
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