Divorce and the Family Business

In any divorce case, property needs to be: 1. identified, 2. classified 3. valued, and 4. divided. Identification of property is the act of discovering what’s there. Classification involves determining whether the identified property is marital property to be divided or non-marital property of one of the spouses. The valuation phase puts a number on the property based on its fair market value. Finally, division involves allocating the property equitably. Sometimes the property itself is divided, and other times there are offsets and buyouts arranged.

This formula is fairly straightforward with most assets such as real estate, retirement benefits, or investment accounts. However, when dealing with the family business, the process becomes complicated due to the nature of the asset. Other issues also ensue. For example, there may be questions about ongoing management when the parties both work at the business. Placing a number on the value of the business can be knotty. And finally, determining the income of the self-employed spouse poses challenges as well.

Classification of a Business

The “classification” of a business as either marital or nonmarital property depends on when the business was started, the source of the funds to start the business, the existence of any prenuptial or postnuptial agreements, and various other factors. With a few exceptions, if the business is considered the nonmarital property of one of the spouses, that spouse would keep the business interest as his or her separate property without needing to “buy out” the other spouse’s interest. If it is marital property, it will need to be valued and divided as part of the divorce. Regardless of its classification as marital or nonmarital, any income earned by the owner is subject to consideration for maintenance or child support.

Who’s the Boss?

In many closely held family businesses, both spouses work in the business. It’s rare that a divorcing couple––who can’t get along as life partners––can continue as business partners. Marital conflict during the case may make ongoing business collaboration unworkable. In those instances, arrangements need to be made, either by agreement or involuntarily through a court order, to remove one of the spouses from the business.

Also, decisions need to be made regarding ongoing control of the business pending the conclusion of the case. Controls may need to be put into place to ensure no improprieties occur. If a spouse is removed from the business, arrangements will need to be made for maintenance or support. Sometimes parties may agree that the departing spouse continues to receive his or her salary in lieu of maintenance for a period. Other times, because of the need to replace the departing spouse with a new employee, there may be cash flow issues prohibiting the payment of both the departing spouse and the new employee. These are the types of issues that need to be worked through on a temporary basis when both spouses work at the business.

What’s it Worth?

Regardless of which spouse works at the business, if the business is considered a marital asset, it needs to be valued for the purposes of the divorce case. Valuation of the business is done by a business valuation appraiser, who has expertise assessing the value of the business at issue. The valuation expert will assess the value of the business based upon its balance sheet and profitability. The expert reviews historical financial records considering the state of the economy and industry and ultimately renders an opinion on the business’s fair market value.

Generally, a more profitable business will render a higher value than one bleeding money. This is common sense. But the act of valuation is much more subtle and scientific. The expert will undertake a full 360° view of the business to determine the value. Factors considered:

•history of earnings;

• control (majority versus minority interests);

• risk;

• macro-economic circumstances;

• sales of comparable companies;

• debt.

While it’s not always the case, both parties often retain their own experts to value the business. As a result, there may be disagreements as to the fair market value of the business interest. Disagreements between experts often result in trials with the experts rendering their opinions and the basis, therefore. Lawyers handling divorce cases for business owners need sufficient experience to cross-examine a business valuation expert on his or her methods and procedures. There are a number of subjective assumptions that a business valuation expert must make, and it requires a high level of skill for a lawyer to be able to attack those assumptions.

Dividing the Pie

If, for example, the business is valued at $2 million, the spouse keeping the business needs to pay the other spouse their share, which ordinarily is 50% of the value. Terms need to be negotiated (or determined by the judge if there is no agreement) as to how that sum is paid. If there are sufficient assets to offset the business interest, the non-owning spouse will take more of the marital estate to compensate for his or her share of the business. If there aren’t sufficient assets to do this, a payment plan or terms will need to be worked out to give the spouse his or her share. Other considerations would include interest and security for the outstanding obligation.

Assessing Income

Assessing the income of the business owner can be challenging. Business owners derive income in a number of different ways. Some pay themselves salaries, and others take periodic distributions based upon the cash flow of the business. Others supplement their “income” by paying personal expenses as business expenses. Experts are sometimes used to assess income when tax returns don’t tell the whole story. For example, when the business owners write off personal expenses from the business. They minimize their income for the purposes of taxes. Under Illinois law, however, payment of personal expenses from the business would qualify as income when the court is setting maintenance for child support. The true indicator of income for the purposes of support and maintenance is the owner’s benefits, not necessarily just what he or she decides to pay themself.

Do your Homework

Use care and caution when dealing with businesses in divorce. While some businesses have a high value, others are worthless. You don’t want to spend thousands of dollars in legal and expert costs only to find out the business has no value. An experienced lawyer can generally assess early on, based upon review of tax returns and other financial documents, if the investment of time and money to value the business makes sense. Sometimes spouses are kept in the dark regarding the full financial picture, which is critical to assess business issues in divorce. But the law provides many avenues to gather the necessary information to assess the scope of the marital estate. Don’t enter into agreements blindly. Make sure your attorney has the requisite knowledge and experience to ensure your interests are protected.