By William J. Donovan and Dorothy C. O’Neil
No one enters a marriage expecting it to end. Further, most people do not plan for their marriage to end, including what happens to their house, retirement or their business. As divorce attorneys, we often see a scenario such as this: During the marriage, one spouse expresses an interest in starting up a business. Both parties know there are risks and money involved, but they support one another to start the business. One spouse may focus his or her time principally on the business, while the other spouse maintains the household and primarily cares for the children. At some point, the parties find themselves in marital turmoil, and eventually one files for divorce. So what happens to the business?
Pennsylvania is clear that any marital property, which is property acquired during the marriage, is subject to equitable distribution through the divorce. The courts apply the factors set forth in 23 Pa. C.S.A. Section 3502(a) in making an equitable distribution division. Some business owners enter a marriage with a business already intact. This makes the business a premarital asset and therefore separate property not subject to division in the divorce. However, any increase in value of that business throughout the marriage is subject to equitable distribution.
Protecting Assets by Agreement
The most common avenue to protect a business (especially if the business is premarital) is to enter into a prenuptial agreement, which would outline how the business will be distributed if the parties divorce. While it may be difficult for a client to approach a potential spouse with this request, it will save both parties extensive litigation costs and attorney fees if a contract exists designating what shall occur in the event of a divorce.
Another avenue, particularly favorable if the parties elect to start a business during the marriage, is to enter into a postnuptial agreement. It would similarly outline how the business would be valued or distributed upon death or divorce.
In either case, prenuptial and postnuptial agreements require a written contract, voluntarily entered into by the parties with full and fair disclosure of the parties’ financial positions in order to be deemed valid and enforceable. So long as these requirements are met, even if the agreement appears to be one-sided, courts will enforce such agreements.
Additionally, the business itself may take steps to mitigate the impact of a divorce of one of its business owners. Partnership or shareholder agreements can specifically address the methodology for a buyout or valuation if a divorce is filed against an owner. While such an agreement may not be binding on a trial judge for divorce purposes, it may minimize the impact on the other business owners by ensuring they maintain control. Further, business owners may mandate that all owners enter into a prenuptial or postnuptial agreement with their respective spouses to protect the business in the event of death or divorce.
Protecting Assets During the Marriage
Because distributing a business in a divorce can severely impact the business, business owners should consider not only “divorce-proofing” their businesses prior to marriage, but also protecting these assets during the marriage itself. Specifically, a business owner should never commingle the business with personal assets and liabilities. Doing so complicates the distribution of these assets in a divorce, even if the types of agreements discussed above are already in place.
Further, a business owner should pay himself or herself a consistent, competitive salary to avoid suspicion as to his or her income stream. This will aid a forensic accountant in determining whether the business’s cash flow is income to the business owner, or part of the underlying asset to be divided through divorce. This is essential to avoid a double-dip situation. A double-dip may occur where the business owner’s income is also considered when assessing the overall value of the business. The Superior Court in Rohrer v. Rohrer, 715 A.2d 463 (Pa. Super. 1998), found that “money included in an individual’s income for the purpose of calculating support payments may not also be labeled as a marital asset subject to equitable distribution.” As such, it is critical to identify the double-dip issue early in the case.
Protecting Assets Once A Divorce Action Is Filed
When a business is subject to distribution, there must first be a determination as to whether or not a business is marital or separate property, and if it is separate property, whether or not it increased in value during the marriage. The business will eventually be valued in order to determine how much it is worth, and how it can be distributed through the divorce.
The process of valuing a business can involve several players, such as each party’s respective attorney, certified public accountants, financial advisers, bankers, or forensic accountants and business valuators. As noted above, it is often essential to obtain an expert to calculate the business owner’s disposable income available for support from that business early in the divorce litigation, as the lower wage earner will usually file for support, and the business owner’s income stream will come into question. While parties to a divorce action often want to avoid retaining an expert early in the proceedings because they are concerned about the cost, Heather Baranowski, director in BDO Consulting’s Pittsburgh office, suggests it can be more cost-effective to hire an expert early on. Beyond the support issue, a forensic accountant can assist with the drafting of discovery, cross-examination questions, and the organization of business records.
In Pennsylvania, most businesses are valued in accordance with the fair market value standard. This means that an expert determines the amount at which property would change hands between a willing buyer and a willing seller, when neither party is under compulsion to buy or sell and both have reasonable knowledge of relevant facts.
Whether or not the parties use one expert to value the business, or each obtains their own respective expert, there are also several common issues that parties often quarrel over when it comes to the business. The first issue is often the valuation date. One party may argue that the valuation date is the date of separation, and the other may argue that it is the date closest to the divorce trial date, or the date of distribution. This issue often arises when the business has increased in value since the date of separation. The Pennsylvania Supreme Court has stated a preference for the valuation to occur at or near the time of distribution, in Sutliff v. Sutliff, 543 A.2d 534, 535 (Pa. 1988). However, the trial court is free to select the date that best serves to provide for economic justice between the parties, per Sergi v. Sergi, 506 A.2d 928, 931-933 (Pa. Super. 1986).
Additionally, small business owners often argue that the business owner himself or herself makes up the business, and without that person, there would be no business. In other words, the business owner argues that his or her own personal goodwill is what drives the business. In determining the true value of a business, a trial court must assess the goodwill of a business. Personal goodwill is not divisible through equitable distribution. However, if the reputation is attributable to the business itself, which is called professional goodwill, then it is divisible. A forensic accountant can help prepare your argument for personal versus professional goodwill assessed to a business.
Distribution of the Business
Ultimately, the business valuation will lead to a number, which will be used in the divorce proceeding. The focus will then shift to how the business asset will be distributed. Generally, this is done via one of the following ways:
- The business owner and ex-spouse become partners in the business. This usually only occurs if the ex-spouse was extremely involved with the business. With this approach, each party’s decision-making capabilities must be clearly defined, as well as a resolution for instances when the parties disagree on a business decision. Mediation is often required in such instances.
- The business owner retains the business but buys out the ex-spouse by giving the ex-spouse a higher percentage of the other assets, which may include the house, retirement accounts and more. This approach involves risk for the business owner if the business fails in the future. Without other assets, he or she will have no other financial safety net.
- The business owner pays a monthly amount to the ex-spouse, which serves as an equitable distribution payment. This may be accomplished based upon the cash flow of the business or by the business obtaining a loan. The risks involved with this resolution are that if the business fails, the business owner may still owe the ex-spouse monthly payments. As such, a forensic accountant should prepare a cash-flow analysis prior to proposing this approach.
- The business owner may sell a stake in the business, such as an employee stock ownership purchase plan, to raise additional capital to buy out the ex-spouse.
All of the above options involve assessing the business, forecasting the effect of a potential buyout on the business, and determining which is the best resolution for the business to continue operating. No matter the avenue used, it is essential that business owners begin divorce-proofing their businesses as part of a long-term business plan. Doing so may save them extensive litigation costs, as well as protect their futures and the future of their businesses.
Dorothy C. O’Neil is co-chair of the family law practice at Burns White, with experience representing clients in all types of family law matters, including those involving complex divorce, custody and support. Contact her at email@example.com.
William J. Donovan is a member and co-chair of the family law group at the firm, where he draws from his diverse civil litigation practice and background in accounting to assist individuals and business owners in protecting and maximizing their assets. Contact him at firstname.lastname@example.org.
Reprinted with permission from the July 14, 2015 issue of The Legal Intelligencer. ©2015 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.