How to Protect Your Business in a Divorce
When people get married, they always hope for 'happily ever after,' but the sad fact is that 52 percent of all first marriages and 70 percent of second and third marriages end in divorce. Although divorces are always difficult for everyone involved, they can become that much more arduous when one or both spouses own a business.
Your business is probably the most valuable financial asset you own. You've spent countless hours and resources nurturing and growing it. But did you know that you might be unwittingly doing things that could put your business at risk in the event of a future divorce?
Depending on your individual circumstances, your spouse may be entitled to as much as 50 percent of your business in a divorce. Since it's probably safe to assume that you will not want your ex-spouse to remain in your life as a business partner, what can you do to protect your business?
This article will first explain the basic differences between separate and marital property and then provide you with a number of effective tools that could help protect your business against the possibility of a divorce. We will also discuss several ways to mitigate the damage if you are already heading for divorce.
Before we begin, please keep in mind the following critical piece of advice:
In order to be effective, these protective methods must be in place well before the thought of divorce enters anyone's mind. Obviously, something like a prenuptial agreement needs to be signed before the wedding (and please not the night before), but techniques such as transfers to an irrevocable trust need to be done years in advance. Depending on your state's fraudulent transfer laws, transactions can be voided up to seven years after the transfer. If you and/or your spouse are even slightly thinking about divorce, it's probably too late to take any protective measures.
OK, so let's begin with the basic differences between separate and marital property.
How to Protect Your Business in a Divorce: Separate vs. Marital Property
Although there are differences from state to state, in general, separate property includes:
- Property that was owned prior to the marriage
- An inheritance received by one spouse solely
- A gift received by one spouse solely from a third party (not from the other spouse)
- The pain and suffering portion of a personal injury judgment
Warning: Separate property can lose its that status if it is mixed or commingled with marital property or vice versa. For example, if you re-title your separately owned condo by adding your spouse as a co-owner or if you deposit the inheritance from your parents into a joint bank account with your spouse, then that property will most likely now be considered marital property.
All other property that is acquired during the marriage is considered marital property regardless of which spouse owns the property or how it is titled.
Marital property consists of all income and assets acquired by either spouse during the marriage including, but not limited to: Pension plans; 401(k)s, IRAs and other retirement plans; deferred compensation; stock options; restricted stocks and other equity; bonuses; commissions; country club memberships; annuities; life insurance (especially those with cash values); brokerage accounts – mutual funds, stocks, bonds, etc; bank accounts – checking, savings, CDs, etc; closely-held businesses; professional practices and licenses; real estate; limited partnerships; cars, boats, etc; art, antiques; tax refunds.
In many jurisdictions, if your separately owned property increases in value during the marriage, that increase is also considered marital property.
It is also very important for you to know if you reside in a Community Property State or an Equitable Division State. There are nine Community Property States: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. These states consider both spouses as equal owners of all marital property (a 50-50 split is the rule). The remaining 41 states are Equitable-Distribution States, which consider factors such as the length of marriage and the spouse's earning power and involvement in building the business when determining a settlement. Settlements in Equitable Distribution States do not need to be equal, but they should be fair (equitable).
You should fully understand this very important distinction between separate and marital property so that you do not inadvertently do anything that might cause your separate property to be construed as marital property.
How to Protect Your Business in a Divorce: Prenuptial and Postnuptial Agreements
So what is a prenuptial agreement? A prenuptial agreement (prenup) is a contract signed by both parties before their wedding that details what their property rights and expectations (including alimony) would be upon divorce. A well-drafted prenup can 'override' both Community Property and Equitable Distribution State laws and the courts will usually respect such agreements, making them a very powerful tool in protecting your business.
Having said that, prenups can be rather tricky, so it is really important that they are well drafted. To strengthen them, each to-be spouse should be represented by their own attorney. In most jurisdictions prenups should contain the following vital elements:
- The agreement must be in writing (No oral prenups)
- It must be executed voluntarily and without coercion (having your fiancé sign a prenup the day before the wedding is a good way to invalidate that prenup)
- There must be full disclosure (no hiding of assets) - this is another way to invalidate a prenup
- The agreement cannot be unconscionable (this is also another way to invalidate a prenup). For example, if you're making millions, don't expect to get away with only giving up the silverware in the divorce, even if that's what's in the prenup.
- It must be executed by both parties, preferably in front of witnesses (or a notary)
Some attorneys even recommend having a judge witness the signing to make sure that no party was coerced.
By using a prenuptial agreement, the parties can decide in advanced what property will be considered separate property and what property will be considered marital property and how that marital property should be divided.
A prenup is probably one of the best and least expensive ways of protecting your business against a future divorce.
But if you don't get a prenup put in place, a postnuptial agreement may be an option. It is similar to a prenuptial agreement except that it is, as the name implies, entered into and signed after marriage. In order to be valid, a postnup should contain the same vital elements as a prenup.
Having said that, a number of states still don't recognized postnups and even when they do, postnups are challenged and invalidated much more frequently than prenups.
Here's why: Before marriage, the parties are entering into an agreement much like two business people entering into a contract and neither party has any legal family law rights on the other. Theoretically, if they don't like the contract, either party can walk away. However after marriage, the situation is very different. The married couple now have very well defined legal rights regarding support and property division and they are considered to be in a fiduciary relationship with each other, meaning each party has to act in the best interests of the other party. Therefore, any transactions between them will be viewed with caution by the courts. By negotiating a postnuptial agreement, one party will typically be giving up some of these rights and that's why postnups will usually be held to a higher standard of fairness than prenups (on the theory that individuals have less bargaining power once married).
Nevertheless, if you don't have a prenup, try to get a postnup. It's better than nothing. Just understand that a postnup is not nearly as ironclad as a prenup and you never know how the courts will act if one spouse decides not to abide by the terms of the postnup.
How to Protect Your Business in a Divorce: Using a Partnership, Shareholder, LLC and/or Buy-Sell Agreements to 'Lock-out' Your Spouse.
Partnership, shareholder and/or operating agreements should include various provisions that would protect the interests of the other owners if one of the owners gets divorced, including:
- A requirement that unmarried shareholders provide the company with a prenup agreement prior to marriage along with a waiver by the owner's spouse-to-be of his or her future interest in the business.
- A prohibition against the transfer of shares without the approval of the other partners or shareholders and the right, but not the obligation, of the partners or shareholders to purchase the shares or interest of one or both of the divorcing parties so that the other owners can maintain their control of the business.
How to Protect Your Business in a Divorce: Pay Yourself a Competitive Salary
This point is often overlooked. If you don't pay yourself a competitive salary and instead reinvest everything back into the business, your soon to be ex-spouse might claim that he or she is entitled to more money or a larger percentage of your business because he or she did not derive any benefit and all your money went back into the business instead of the household.
How to Protect Your Business in a Divorce: Think Twice About Involving Your Spouse in Your Business
As we discussed earlier, all or part of your business will probably be considered marital property. If your spouse was employed by you or your company, helped run the company in any way or even contributed business ideas during your marriage, then he or she may be entitled to a substantial percentage of your business. The more involved in your business your spouse was, the bigger that percentage would be. If you have partners in your business, then your spouse would own a percentage of your share.
How to Protect Your Business in a Divorce: How to 'Pay-off' Your Spouse
If for whatever reason you were not able to adequately protect your business and now your spouse is entitled to an ownership interest, here are some ways to pay him or her off (I'm assuming your don't want to be business partners after the divorce):
- Use your share of other marital assets including cash, stocks, real estate, retirement funds, etc.
- Property Settlement Note – this is a long-term payout (with interest) of the amount you owe your ex-spouse for the value of her share of the business.
- Sell the business and divide the sales price. This is obviously the least preferred method, but all too common. When the business represents the vast majority of all assets, there just may be no other way to pay-off the other spouse.
Disclaimer: This article is for information purposes only. The author is not an attorney and nothing contained in this article should be considered legal advice. Readers are advised to consult with their legal advisors before attempting to utilize any of the information in this article.
Jeffrey A. Landers is president and founder of Bedrock Divorce Advisors and Bedrock Wealth Management. He is a Certified Divorce Financial Analyst™, Chartered Retirement Planning Counselor™ and Financial Advisor. He can be reached at 917-602-6977 or firstname.lastname@example.org.