When you are a shareholder in a business, how will divorce affect your stake? Here is an overview of what owners and investors can expect during the asset division process.
The Importance of Planning Ahead
The most opportune time to consider the implications of divorce on business ownership is before marriage. If you already have a proprietary interest in a business, any increase in value of that interest during marriage that is due to the active efforts of either spouse will be marital property, subject to equitable distribution in divorce. For this reason, a premarital agreement addressing the valuation and disposition of the proprietary interest in the event of divorce is a valuable planning tool. A premarital agreement can take into account any existing business agreements, and the possibility of amending business agreements to take the marriage into account can be addressed at the same time.
If you start a new business after you are already married, then the entire value of your ownership interest will be marital property. In this case, planning the new business venture should include assessing the potential impact of divorce, however remote you may imagine that possibility to be. If you are starting the business with your spouse, with other business partners, or with other business partners and your spouse, a well-drafted shareholder or partnership agreement can address the risks of divorce down the line. All too often, the scarcity of capital during start-up leads new business owners toward discount services and other corner-cutting options. Relying on standard buy-sell provisions and other “form” agreements that do not address your specific situation can lead to problems down the road, whether you ultimately end up dealing with a divorce or with a serious disagreement with another partner or shareholder. Addressing potential resolutions ahead of time instead of waiting until tempers are flaring and logical thinking is compromised can prevent major disruption or collapse of the business. The business planning stage is also a good time to consider the need for a post-nuptial agreement that coordinates with business agreements.
Issues to Discuss with Your Attorney When Divorce is Imminent
Whether you have planned ahead or not, once divorce is on the horizon, there are specific points that a business principal, partner, or major shareholder needs to consider and review with a family law attorney as soon as possible. These include the following:
Fiduciary Responsibility and Confidentiality Concerns:
Divorcing spouses owe each other complete transparency regarding all financial matters. Business partners, officers, directors, and majority shareholders are also generally bound by fiduciary obligations to other partners or shareholders. There is no point in expending financial resources resisting disclosure or discovery of information you have a duty to disclose. In fact, any such resistance can subject you to financial penalties. At the same time, if you are involved in a business that owes a duty of confidentiality to clients, you may be concerned about whether or not you need to take steps to protect those clients by redacting certain information. Talk to your attorney about your fiduciary responsibilities and consider any need for protective orders from the court.
Business valuation can be a major issue in divorce. New Jersey courts have permitted three main methods of valuation: an income or capitalized method, a market method or a cost approach method. The most appropriate method for your particular business will depend on the specific nature of the business. Regardless of the method chosen, the unpredictability of various factors impacting any ongoing business means that a business valuation is always, at least to some degree, an estimate. It is never wise to accept the valuation offered by someone with an opposing interest at face value; two different appraisers could arrive at and defend substantially different valuations for the same business.
An important aspect of business valuation in New Jersey is the use of the “fair value” standard. Fair value does not include certain discounts that are included in “fair market value,” such as a discount for the length of time necessary to find a suitable buyer. Conceivably therefore, a business could be assigned a very high monetary valuation and yet have almost no value at all on the open market due to a lack of interested buyers. This can be a strong negotiation point. Discuss business valuation issues with an attorney early in your divorce case.
The extent to which each spouse actively contributed either to the value of a marital business or to the post-marital appreciation of a separately owned business is often a critical issue. You will need to discuss with your attorney not only how to build your arguments regarding fair distribution, but also which spouse has the burden of proof under various circumstances.
In New Jersey, the division of business value in divorce is rarely 50/50, unless the business was started after marriage and both spouses are equally involved. It is important to understand that business “involvement” can take many forms. For example, if you were the principal of the business and your spouse did not work in the business at all, you may believe that you are entitled to virtually all of the business value, but if your spouse took on the lion’s share of responsibilities in the home to permit your heavy involvement in the business, then your spouse was contributing actively to the growth of the business as well, albeit indirectly, and not necessarily equally.
If you brought your business interest into the marriage as separate property, or you inherited it separately, you may be able to argue that part of any increase in value was not due to active efforts by either of you but was instead “passive” appreciation—due to market forces, return on capital, or efforts of a third party. Any appreciation in the value of a separately owned business due to such passive forces remains separate property and is not subject to equitable distribution at all.
Alimony and Child Support:
In New Jersey, business valuation usually involves capitalization of the income stream. This means that the same income stream used to determine a business’s fair value will also be used to determine appropriate amounts of alimony and child support. If a dependent spouse will be receiving substantial amounts of alimony and/or high child support amounts, this can be the basis for an argument in favor of reducing the spouse’s distributable share of the business.
Practical Concerns Regarding Sale, Buy-Out, or Ongoing Co-Ownership:
Each of these options has different implications, including different tax consequences. Selling a business is frequently not a viable option. Often the main concern of both spouses is ensuring that the business continues to function as a major source of income, necessitating either a buy-out or ongoing co-ownership. Ongoing co-ownership after divorce is usually the most emotionally challenging option, but financially, it may actually be the most appealing. If you still trust one another financially and are able to define separate roles in the business, then you may be able to continue operating the business together. Talk to your attorney about whether or not and how this might work in your particular case.
Negotiation or Mediating Out of Court:
Because business valuations and distributions can present multiple complex issues, there may be an assumption that these issues must be handled in court. This is not necessarily the case, and in fact, negotiation or mediation can be far more cost-effective. This is another aspect of your divorce case that you should discuss with your attorney as early as possible.
Do you have other questions about valuation or equitable distribution of a business interest in divorce? Our powerful team of attorneys can guide you in protecting your business. If you would like assistance with either planning ahead or with identifying your current issues and options, please contact us to schedule yourinitial consultation.