By Alexander Nirenstein, Nirenstein & Garnice PLLC
Featured Article in Scottsdale Airpark News
When a principal in a closely held business goes through a divorce, there are serious implications for the business as well as for the individual. Here are several questions to consider.
Separate Property or Community Property?
The first consideration is whether the business interest is community or separate property. A court cannot divest a party of his or her separate property interest. The income generated from the business will generally be community property, even if the underlying business is separate property. But if the compensation received by the community is inadequate, the spouse may be able to recover on a claim for reimbursement for the increased value of the separate business to the extent generated by the principal’s time, toil and talent.
Generally, capital contributions and retained earnings of a corporation or partnership are considered property of the business, and cannot be characterized as separate or community property, while a sole proprietorship does not have an existence separate from the principal.
Who Owns the Business’s Assets?
In a sole proprietorship, the business interest will consist of all the business property, minus any liabilities for the business. In a corporation, limited liability company or partnership, the “business interest” represents the right to receive a share of the profits and surpluses. Because the business property is not owned by its shareholders, members or partners, its assets are not characterized as community property or separate property. Business goodwill is an asset that belongs to the business as well.
However, if the principal has disregarded corporate formalities and used the business assets for personal purposes, the spouse may persuade the court to treat the business as the “alter ego” of the owner/spouse, like a sole proprietorship. This often results in more expensive and hostile divorces with resources being spent to track down witnesses, compel production of relevant records, and retain experts to prepare forensic accountings.
Principals who do not want to face such daunting consequences should take care to observe the formalities of the business entity, keeping business and individual property separated and ensuring that the business and its accounts are not used for personal purposes.
What Is the Value of the Business for Divorce Purposes?
Business value for divorce purposes will generally be the price at which the business would change hands between a willing buyer and a willing seller. Typically, both parties retain experts to value the business and present complex calculations to the court. The business owner must be prepared to make extensive business records available for expert inspection and know that these experts may testify in depth about the detailed bases for their opinions.
If there is a risk of proprietary or other sensitive information being disclosed, the business, as an entity, should give serious consideration to retaining its own counsel, separate from that of the owner, to minimize its exposure by insisting on written agreements to protect confidentiality and unnecessary dissemination of this information to third parties and the retention of this information by non-business personnel following the conclusion of the divorce litigation.
Are There Tax Implications?
Transfers incident to divorce may be nontaxable in most instances, but there could nonetheless be tax consequences. The principal should consult with a tax professional with questions about what may result.
Divorce litigation is open to the public. A business principal who desires to keep business operations out of the public eye is well served by ethical counsel, discreet transparency and good faith in the discovery and negotiation process. The business principal should keep in mind that there are many more options in negotiating a division of the marital estate than are available to a court in dividing the interests of the parties in trial.
When confronting divorce, it is imperative to secure legal counsel who understands the sensitive financial, emotional and business issues involved.