Divorce is difficult, messy and expensive.
This is often doubly so for business owners, who are often faced with the prospect of having to carve out a portion of the value and assets of their businesses to give to their spouse in a divorce settlement.
“Fortunately, courts are cognizant of the fact that a business co-owned by a divorced couple is a terrible idea,” said Tom Banks, family lawyer and litigator with Straw-Boone, Doheny, Banks, Bowman & Mudd PLLC in Louisville. “But for many business owners, their business comprises the majority of their assets. If you don’t get your ducks in a row before you make the decision to divorce, you could be faced with automatic buyouts, liens and garnishments just to pay out an equitable portion of the business’ value to the other spouse. Divorce, for business owners, can be complex.”
According to the latest statistics from the Centers for Disease Control & Prevention, in 2016 there were 827,261 divorces in the United States – about 3.2 per thousand people. Kentucky’s divorce rate is a little higher at 3.8 people per thousand. While the number of divorces is down from its peak in the 1990s for most age groups, the rate has doubled since then for people over the age of 50 – an age when many people have amassed the most assets and may have successful businesses.
Kentucky is a “no-fault” divorce state; the court is required to find that a marriage is “irretrievably broken” but not why this is the case. Decrees are issued usually only after all issues of property, children and any support responsibility have been resolved, either agreed to by both parties beforehand or through negotiation (which happens in more than 95 percent of divorces) or by the court in a trial.
Property, assets and debt obtained after marriage by either or both members of a couple are subject to equitable distribution. This doesn’t include property owned before marriage, gifts, inheritances and anything excluded by legal agreement, such as in a prenuptial contract.
Few people think of the impact of potential divorce when they are in the exciting stages of starting a business or getting married, sources said. But those who do, and draw up agreements early, will benefit most. They will avoid many of the common business pitfalls divorce can bring.
These business pitfalls are pretty well understood by those in the legal community who handle divorce.
Pitfall 1: Failure to get a prenuptial agreement
A prenuptial agreement is a contract entered into before a couple is married, designating how assets are to be valued and divided amongst the partners in the event of divorce.
“Prenups are much more common these days, and don’t have nearly the stigma that they used to have,” said Susan Kennedy, family law attorney at Fowler Bell in Lexington. “People of all different income levels are getting them, especially if they are marrying later in life and bringing assets into the marriage. It’s simply a matter of agreeing whose property is whose, before a marriage, and who will retain what marital assets afterward. And as long as it’s fair, and equitably divides up any other assets besides the business, most people will sign it.”
Will the nonbusiness-owning spouse be entitled to a portion of the value of the company after a divorce? How will the business asset be valued? Will the nonbusiness-owning spouse be entitled to a bigger portion of the couple’s bank account and investments in return for giving up their share of the company’s value? Will they get the profits from the sale of a home, cars or rental properties? All these are common questions that, if answered in advance, can prevent a lot of legal bills and heartache later.
If a couple is already married when a business is started, “postnuptial” agreements can be entered into as well, which would do much the same thing, Kennedy said.
Many prenuptial agreements for business owners designate the business a spouse brings into the marriage as “nonmarital” property, meaning it cannot be divided in case of divorce, thus protecting the business.
Pitfall 2: Failure of business to have defined divorce clauses in its bylaws
For larger businesses, especially those with multiple partners, having divorce clauses can be crucial to the smooth running of the business. “It’s very important for businesses to have certainty around their ownership,” said J. Michael Cloyd, partner at Cloyd & Associates PSC in Lexington. “We often recommend that companies stipulate that in the event of a divorce, the company automatically has to buy the divorcing partner out for their share in the company. This document also has to be very clear about how their share will be valued.
“This will allow the divorcing partner to pay out to their (marriage) partner without any interruption in the business. And, it can be written in that the partner will have the ability to buy back the shares, if they desire. Many companies have clauses like this for bankruptcy or death; why not for divorce?”
Pitfall 3: Failure to understand how your company will be valued at the time of a divorce
In every divorce that involves business ownership, the overall value of the business has to be determined so that fair compensation to the other spouse can be determined. The method used to make that determination is critical, our sources say.
“There are three ways to value a company,” said David Guarnieri, divorce attorney for McBrayer, McGinnis, Leslie & Kirkland PLLC in Lexington. “A market approach, where a company like say, a McDonald’s franchise, is valued based on what price it would bring if it was sold on the open market. Then there’s an asset approach, where a company might be valued based on the cost of its inventory, equipment and physical plant.
“Then there’s the income approach, where a company is valued on its past and potential for future earnings,” Guarnieri said. “This is often used for companies in the service business, where they look at the last five years or so of earnings, average them out and project what earnings going into the future might be, and come up with a total value number from that. How your company is valued has a whole host of implications, and business owners are sometimes surprised at how high the valuation is.”
The goal is usually to give the business-owning spouse the entirety of their business in the divorce. However, sometimes business owners don’t have enough other assets to give a spouse what would make up for the value of a half stake in the business. In that case, sources say, business owners often have to give over all their bank accounts, profits from property, investments and still have to pay back the other spouse in installments over the course of years.
Understanding how your business would be valued and what that valuation might be is critical to making an equitable divorce settlement.
Pitfall 4: Thinking last-minute efforts to devalue a company will work
Though they don’t see it often, our sources say company owners who make last-ditch decisions to devalue a company in the wake of a divorce ultimately fail.
“Sometimes, business owners will suddenly start spending money in ways that are hard to trace or hard to split – like giving all the employees big bonuses, or borrowing against the equity of buildings, or finding other ways to carry a lot of debt on their books, so the value of their company will go down when it is valuated,” said Courtney Hampton, an associate at McBrayer.
“If it can be shown that the business behavior that led to those decisions is unusual or premeditated to deprive the spouse of a settlement, then the court will value the business as if none of those financial moves had ever been made,” Hampton said. “In short, you’ll still be on the hook for the settlement, as well as those financial decisions you made.”
Pitfall 5: Rushing into it
If there’s no prenup in place, and you don’t have any idea what kind of number might come up in a corporate valuation, it is probably better to wait until you have a valuation done before you start trotting out divorce papers, Banks said.
“For instance, you could own a financial advising business that makes $200,000 a year, but the valuation comes up at $1.5 million,” Banks said. “People who are going through a divorce are often the worst versions of themselves, and in a pressure cooker of stress.
“You have to think about not only what it’s going to cost you financially and emotionally, but how it is going to impact your productivity and the future of your business. Consult an attorney, and perhaps even a good CPA before you go down this road. It’s a big decision.”
Susan Gosselin is a correspondent for The Lane Report. She can be reached at [email protected]