Family Business in Divorce
Family Business in Divorce, Control, Date of Valuation, and the Buy out
When there is a family business involved, the divorce process can be even more daunting than normal. In some respects dividing the business is just one more piece of property to be valued and divided. On the other hand, a business is unlike any other piece of property. It represents income, assets, and stability.
A family business represents countless hours sweat and tears. A business can be an extension of the entrepreneur like no other career or item of property. Business owners face joy, pain, uncertainty and triumph in the years it took to build “the business.” Business owners pour themselves into the mission, vision and values of the company. When someone files for divorce, it can feel like a business owner stands to lose everything. If the business is owned by both spouses, decisions must be made regarding who will go on owning and controlling the business on a day to day basis and what role, if any, the out-spouse will have.
Who controls the business?
Typically, title of property doesn’t matter. Anything purchased during the marriage is community property and subject to division. That’s true of businesses, but the question of who has the right to control the business can be a serious issue when someone files for divorce.
As part of the divorce process, all of the assets and liabilities will have to be equitably divided between the parties. Essentially, a court will classify property as community property or separate property, place a value on the property, and then distribute amongst the spouses. In Arizona, all property acquired during the marriage is community property. Community property essentially gives each spouse a ½ equitable interest in the property, regardless of how it is titled.
The first step in determining who can control the business is to figure out the ownership structure. Here, we may run into a conflict between Title 25 (Domestic Relations and Divorce) and Title 10 (Corporations and Partnerships).
Let’s take an accounting business as an example, “Deborah Smith CPA”. Deborah Smith owns the business 100%. Her husband Kevin is not an owner of the firm and may be prohibited from owning more than 50% of the firm because he is not a CPA.
But let’s say Kevin has never owned a share of the business. If Deborah Smith’s firm was opened in Arizona during the marriage, her husband Kevin has a ½ equitable interest because the business is community property. In some ways this makes things easier. Kevin does not and never has had the ability to make decisions about how the company is run or operated on a daily basis. He is entitled to be “bought out” of his ½ interest in the firm if the Smiths divorce. The date of valuation will be the date that the petitioning spouse filed for divorce.
Let’s look at another example. If Kevin Smith and his wife Deborah had opened a restaurant during the marriage and they had both worked in the business and relied upon the restaurant for income and support, things would be trickier. If Kevin files for divorce, he doesn’t have the right to kick Deborah out of the restaurant. She has rights under Title 10 as a business owner to information, control and access to her business. Now they, a divorcing couple, must figure out how they will run their business while going through divorce proceedings.
Typically when we need an order on an issue pending a divorce, an attorney would file in court for a temporary order granting custody or control of a piece of property to one spouse. We see this happen with the marital home. It isn’t unusual for one spouse to be granted control and use of the home during the divorce proceedings. The spouse who doesn’t live there retains their ownership interest but loses the ability to control the home. When there is a business involved a judge may or may not enter a similar order regarding the temporary control and operation of a business.
Many judges, especially if the spouses are the only two owners, will enter an order giving one spouse temporary authority over the other spouse to operate the business or enter an order preserving the status quo. This is arguably within their authority since the business is community property. Other judges will not enter such an order. Their perspective is that Title 10 controls what happens to the rights of business owners. The family court judge should not or cannot divest an owner of his or her rights.
An operating agreement or the statutes in title 10 should control. In some ways this is a receipt for disaster! If the judge in family court refuses to enter a ruling regarding the divorce, the spouse must determine whether to file another court action in civil court regarding the business or continue daily operations.
Often times the LAST thing the owner needs is two lawsuits when his or her life is already in turmoil. One of the best things we can do is try to come up with a temporary agreement regarding how the business will be operated and how the funds will be used. In reality, many business owners use their business accounts inappropriately, spending out of the business account for personal purchases and taking withdrawals or distributions whenever they feel like it.
Protecting Against Sabotage
There are so many decisions that go into running a business. Sometimes a spouse will inappropriately use the operating account for attorney’s fees, cars, vacations or clothes. Other times, an owner will stop invoicing or stop working in order to push the value of the business down. Getting some sort of a temporary order or agreement in place while the divorce is pending is essential! Even if we have to file something in civil court or remove one spouse from the bank account, protecting the business has to be a top priority.
The Role of The Business Attorney
In hotly contested divorce cases with large businesses at stake, it is not unusual for the divorce attorney to consult with or involve a business attorney in the process. The business attorney will offer advice and counsel with regards to Title 10, the operating agreement or bylaws, and issues with regards to any third parties. Other potential issues for the business attorney could be related to debts, creditors, bankruptcy, or any breach of contract issues.
Valuing the Business
When generally determining the value of an item to be divided in the divorce, the value used will be the fair market value as of the date of separation. That means, we won’t look to determine how much it will cost you to replace the items, but how much will that particular item sell for today. For some items, the fair market value will be easy to determine. For instance, if we are talking about a car, we can look to a Kelly blue book value. For other items, valuation will be more complicated.
A bank account is an example of an easy item to value; simply look up the account balance as of that the petition was served. The date of service of the petition is the date the community terminates and the date of valuation for more items. The marital residence is fairly easy to value as well, parties can order an appraisal or agree to use the value as determined by a trusted realtor. On the other hand, placing a value on couples’ frequent flier miles or a qualified pension plan might prove more difficult.
One of the more difficult assets to value is a business interest
Separate v. Community
First we should discuss that there are factors that will determine whether the business interest is considered separate or community. If the business interest was acquired during the marriage, with joint funds, it is considered community property, and the value of the business will be equitably (usually equally) divided between the parties. If the business interest was owned prior to the date of marriage, or acquired with separate funds, it should be considered separate property.
There are several important factors that can help determine whether a business interest is separate or community. First, you will need to look at the date of marriage and the date the business interest was acquired. Second, you should look to the source of funds used to start the business, and finally, the financial and labor-related contributions to the business given by either spouse during the marriage must be considered.
Keep in mind, simply because the business interest was acquired prior to the date of marriage, it does not necessarily mean that the non-owner spouse can take no value from it. Let’s look at an example. If our previously mentioned Kevin Smith owns a restaurant before he gets married to Deborah, but then she works in the restaurant and together they grow the restaurant into a chain of restaurants, the business is still Kevin’s separate property but Deborah has an equitable interest in the growth. All of the work that Kevin and Deborah put into the restaurant is a result of their community labor. The community will have an interest in a portion of that growth. This can be a very complicated issue and is worth talking to an experienced attorney about immediately.
As you can see, the first step of determining whether a business interest is separate or community property can be complicated. This difficulty, however, only scrapes the surface of the complexity of business interest valuation.
Difficulty in Valuation
Once you have determined whether or not a spouse is entitled to a portion of the value of a business interest, how do you actually determine what that interest is worth?
Typically one spouse will continue to operate the business and will buy the other out. One spouse will argue that the value is very low and the other will argue it is very high. Imagine having to place a value on the restaurant business in the example above? The restaurant has equipment like tables, chairs, cash registers and cooking equipment, it is full of inventory, and earns a profit. Clearly, it would be difficult to place a dollar amount on the future interest of the community in the business.
Let’s begin by noting that in situations where the business interest is clearly a minimal asset, the parties may be able to easily agree on an amount and move forward. For instance, Wife has a Mary Kay business generating $30,000 per year. This business is probably worth nothing. If Wife stopped working the business wouldn’t generate revenue. She has essentially created a job for herself.
However, sometimes it is obvious that a business interest is a significant asset, and will be the cause of a major dispute amongst the spouses. The following example shows how important it is to be deliberate in considering the value of a business interest when dividing assets.
A young couple of seemingly modest means decided to divorce. Holly was a stay-at-home mom and George drew a salary of $50,000 annually at a software company that he was part owner of. When they decided to go their separate ways, things were fairly amicable. George claimed on his interrogatories that his ownership interest in the software company equated to $40,000. The couple, as a show of good faith agreed that George would pay Holly $100,000 in order to equally divide the community property (including his interest in the software company).
Mere months after the settlement, the software company that George had ownership stake in was sold for millions of dollars; his payout was handsome. The truth was that George knew his interest in the company was worth a lot – there were other comparable offers that came in before the divorce had been finalized. Despite this knowledge he casually reflected on his interrogatories that his ownership interest was only valued at $40,000. Holly (and her attorney) had no reason to believe that this figure was only 3% of what his actual ownership interest was worth.
When the truth came out, Holly sued George claiming fraud. She engaged in a ten-year legal battle before the parties were able to reach a settlement. After paying her extraordinary legal fees as well as fees for expert witnesses, Holly only realized $200,000.
This story clearly exemplifies what can happen if a spouse undervalues a business asset. If there is an ownership interest in a business, be sure to take the valuation process seriously, or you could end up dealing with a situation similar to Holly in our example.
How to Value a Business Interest
There are three approaches to how you can go about determining a value of a business interest: the asset approach, the market approach, and the income approach.
The asset approach calculates a value using a fairly simple formula: assets minus liabilities = value. Assets include both tangible and intangible assets. Tangible assets include the infrastructure, inventory, and anything else related to the business that you can actually touch. Intangible assets are patents, accounts receivables, and other assets that are not actually physical objects. While this approach seems straightforward, it can actually be rather difficult. For instance, how do you place a value on the business assets? Some items, like company vehicles, may be easy to value by using a value book. Other items, such as the computers in the office, or the tables in a restaurant would be harder to place a value on. Additionally, an issue arises when it comes to valuing inventory as well. Typically inventory is valued at cost, but this can vary based on the age and type of inventory. Further, there may not be a value book that covers the type of inventory at issue. This approach also doesn’t take into consideration any unrecorded assets and liabilities which could create further issues; consider a significant unrecorded loan being given to a family member around the same time the business was being valued. Because of the complications mentioned, this approach tends to work best for small businesses.
The market approach calculates the value of a business by comparing it to similar businesses that have been sold. This approach is similar to how appraisers will look at “comps” in a neighborhood when determining the value of the house being appraised. This approach can prove difficult, however, if there are no similar businesses that have recently been sold that can provide an accurate comp.
The income approach uses historical information and particular formulas to predict expected cash flow and profits in calculating the value of the business. The formulas used consider future benefits as well as the rate of risk or return. This is the most common approached used to determine a value of a business.
Determining the Value of a Business for Divorce
Who actually values the business? The answer to this question can be as simple or as complex as you want it to be. If the business interest is small, and there is no dispute as to its worth ($30,000 Mary Kay Consultant), then the parties can easily stipulate to its worth and use that value when dividing the marital property.
Sometimes, if the interest is small and not overly complex, attorneys may place a value on the business. The may be appropriate is a start up that is pre-revenue, or a business that was recently purchased, giving us a good idea as to it’s value. Typically, however, the attorney advocating for the person who owns the interest in the business will argue that the business is worth less than the attorney for the person who does not have the ownership interest.
Most often, an expert “Business Valuator” is needed to dig into the finances, assets, liabilities, history of the business and it’s industry and competitors, and other aspects of the business to determine a value. These experts will use one of the approaches listed above in arriving at a number they feel is a fair estimate of a person’s interest in a particular business. Usually, the expert will be a Certified Business Appraiser (CBA) or an Accredited Senior Appraiser (ASA). Sometimes a Certified Public Accountant (CPA) will be called on to help value a business interest. If your case calls for such an expert, your attorney will certainly have a referral for an expert of this caliber to help in your case.
In cases where the business interest could have a high monetary value, typically both spouses will hire independent experts or choose to use an agreed upon valuator. When both spouses hired experts, a “battle of the experts” will ensue and both experts will do research and value the business. If the parties end up in litigation, then both experts will testify in court as to the value they concluded the business is worth. Ultimately it will be up to the judge to decide which expert she finds more credible.
It is worth noting that spouses who engage in a “battle of the experts” can expect their legal fees to increase dramatically. Hiring an expert may increase your legal fees, as the attorney will have to spend time learning and understanding the expert’s analysis. Also, your expert will need to be compensated, and the more complex the valuation is, the higher you can expect the fees to be. On the other hand, where the ownership interest is worth a significant amount of money, it may be worth it to retain an expert. That being said, a thorough cost benefit analysis should be undertaken when making the decision of whether or who to hire for the valuation.
Sometimes, we find evidence of fraud or hidden assets or income within a business. Here are just some of the ways that money can be disguised within a business:
Prepayment of taxes
Business owners need to pay estimated taxes. There is no penalty for overpayment of taxes and a tax payment is a perfectly legitimate business expense. However, if a business owner makes a hefty payment to the IRS knowing that they will receive the vast majority of those funds back, they could be hiding money.
Lawyer fees are similar to the prepayment of taxes. Paying an attorney or lawyer is a perfectly legitimate business expense but not if the owner is using a lawyers trust account to hide money! Most of the time, attorneys are paid through a trust deposit or retainer. The business owner could pay attorneys thousands of dollars for services that they don’t need and never intend to use. Just like the IRS the lawyer will need to refund the money that isn’t used.
What if a business owner does work and simply doesn’t bill his or her clients or customers? Income could appear low or lower than it really is if your clients or customers owe you money. Make sure you look at the accounts receivable as an asset of the company that needs to be divided. At the same time, realize that you cannot be sure that invoices were created for all customers. You may want to double or triple check against calendars and emails to make sure that all of the work that has been done is reflected in the bills that are created.
Business owners could theoretically go out and buy inventory or assets that they do not need or intend to take back. An experienced accountant will need to review the receipts and transactions to make sure that a business owner didn’t spend $50,000 in computers to artificially decrease the income or assets of the company.
Safe Deposit Boxes, Cash, or Undisclosed Accounts
Business owners have more control over their income, expenses and cash flow than almost anyone else. Cash may not be deposited anywhere but may instead be stashed in a safe deposit account. Alternatively, money may be deposited into undisclosed accounts. Looking at the merchant services account can help us find accounts that may not have been disclosed.
The income of a business owner can also be very difficult to determine. We need to determine income in order to calculate child support and in order to evaluate whether spousal maintenance is appropriate and in what amount. In a non business case, we would simply look to pay stubs and W-2s or tax returns. Simply looking at these statements for business owners will not tell us an actual income. Taxable income for IRS purposes is not the same as income for the purposes of spousal maintenance or child support. With business owners, compensation can come in terms of salary, distributions, or the payment of expenses. Sometimes there are perfectly legitimate expenses like phones, cars, maybe even rent to a portion of your home or property that you can deduct for the purposes of taxes. However, when determining income, we look at all of the financial benefits of the business to determine child support and spousal maintenance.