Could Divorce Force You To Liquidate?

If you think ahead, the end of your marriage won’t be the end of your company.

There are many unseen threats to the small business. One that is easily overlooked is the possible impact of divorce, which occurs in an estimated 40 percent of American marriages. Because stock in a closely held business is often the main asset of a married business owner and many businesses are owned jointly by married couples, how the divorce is handled has a great deal to do with the future of the enterprise. As in the death, disability or retirement of a company principal, the goal is to avoid having to dismantle the company in order to accommodate his or her need to liquidate some or all of his shares.

State law generally determines the rights and obligations of each spouse. Community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin and sometimes Alaska) require that all property of the marital “community” be divided equally. In common law states, courts supervise an equitable division of property. Factors include whether the property was acquired by purchase, by gift or inheritance, in exchange for marital or non-marital property, or acquired after a legal separation. Additional factors might include whether either spouse made contributions to acquire, augment or preserve the value of the property, contributions as a homemaker or contributions to the training and education of the other spouse.

If your marriage is ending, you need to consult both a divorce attorney and your business advisor. Among the first steps in establishing how your business interest might be divided, you need to consider the status of:

The Parties

• owner of the business versus non-owner spouse
• joint owners of the business
• child owner versus child owner’s spouse; and
• co-owner versus co-owner’s spouse.

The Property

• Which spouse will ultimately own the business and the assets used in connection with the business?
• How will the spouses transfer an interest in the business?
• Is there liquidity to buy out the other spouse’s interest?
• How will the business be valued?
• What about pension benefits from the business? Can they be divided without causing current income tax liabilities?
• Is the business interest subject to a buy-sell agreement or a pre-nuptial or post-nuptial agreement?
• Are trusts, including asset protection trusts, affected by or helpful in the event of a divorce?
• What are the tax consequences to the spouses and third parties as a result of a division or disposition of the business or its assets?

The obvious first step is to get all assets, including the business interest, valued. Typically, the parties engage an accredited appraiser. Because a valuation is expensive, rarely is more than one obtained, although in extreme circumstances, the parties can get “his and her” valuations, and negotiate from there.

When a privately held company is the subject of a gift or included in an estate, the base value is discounted for tax purposes to reflect the lack marketability of the shares and/or minority-interest status (controlling shares have more value). But it is unclear whether discounts are appropriate when valuing a business in a divorce. Some courts have allowed it and some have not.

Getting the spouses to agree on a value can also be a problem. When one spouse is in the business—and wants to keep it—that spouse wants a low value; the other spouse of course wants a high value. The valuation method that’s used, whether asset-based, income-based, or market comparables-based, as well as the discounts taken, can all be a matter of dispute. If the business is heavy on human capital and low on fixed assets, an asset-based approach will likely yield a low value. In contrast, if the business has been in an earnings slump, the income-based approach would yield a low value.

To avoid some of these problems, long before divorcing couples start valuing their family business, they should engage in other preventive planning: • Pre-nuptial or post-nuptial agreements that spell out whether a non-owner spouse has any right to the business in the event of a divorce and, if so, the manner in which the business would be divided. If the non-owner spouse does not fully release rights to the business, the agreement should, at a minimum, set forth a method for valuing the business. The agreement should coordinate with any buy-sell agreement regarding the business. The agreement also should specifically address whether potential appreciation from the time of the agreement to the date of a subsequent divorce will be considered in the business valuation. • A divorce-triggered buy-sell agreements can be very helpful. An agreement may provide that if any relative by marriage of X or Y (founders) is divorced from a relative by blood of X or Y, then any shares owned by such relative by marriage (or acquired pursuant to the divorce) will be offered for sale for a set price to a specified buyer. These agreements also can set forth the desired method of valuing the business.

TAXES

Once the parties decide what their assets are worth and how to divide them, the next consideration is the tax implications. Internal Revenue Code Section 1041 allows spouses or even former spouses to sell or exchange property with one another, free of income tax—if certain requirements are met. The transfer must be “incident to the divorce” and generally must take place within one year of the end of the marriage.

For purposes of determining basis, property transferred between spouses is treated as acquired by the transferee by gift, but tax issues get nettlesome when soon-to-be ex-spouses are paid off through stock or other assets of the business. The tax consequences—whether dividend or redemption—will depend on how the buy-out is structured.

STOCK REDEMPTIONS

If a spouse redeems stock to transfer the ownership asset, the IRS generally treats this payment as a distribution, rather than a dividend. A competent CPA or tax attorney can help the parties determine in advance, via written agreement, how they will handle such a distribution and what its tax treatment will be. The letter should stipulate that the agreement supersedes any other agreement.

RETIREMENT ASSETS

Sometimes, the only assets of the business available to transfer to the spouse are retirement assets (sometimes held by the business itself). To have a spouse or former spouse recognized as the participant in a tax-qualified plan, you will need a Qualified Domestic Relations Order (QDRO), which assigns ownership of or benefits from the retirement account. The spouse’s distribution is subject to federal and state taxes, but not subject to the 10 percent excise tax on premature distributions. The spouse receiving plan benefits pursuant to a QDRO may be able to defer tax by rolling over the entire distribution within 60 days of the distribution into another qualified retirement plan.

The transfer of an IRA, or part thereof, to a former spouse as part of a divorce is a non-taxable transaction and no QDRO is required. The transferee spouse is thereafter subject to income tax on the distributions from the plan, unless the distribution qualifies for rollover deferral.

Exit Stage Left

Marital exit strategies, like other exit strategies, require lots of juggling. Who gets the kids? Who gets the car? Who gets the business? Who bears the costs? All of these require planning and consideration of everyone’s needs, so that everyone can move on as painlessly as possible.

This story is adapted from a Trusts & Estates Magazine, July, 2005. Ms. Capassakis is a member of the Private Company Services, Personal Financial Services Practice of PricewaterhouseCoopers LLP, in New York.