An article by Jeffrey K. Epstein, Esq., Partner
For some, divorce signifies a painful failure of a once promising relationship. Others perceive divorce as an opportunity for a new beginning and an end to a strained marriage filled with discord. For small business owners, divorce can have unforeseen consequences and significant ramifications for the divorcing parties as well as fellow partners or shareholders. The following is a representative sampling of how a divorce can affect small businesses and an outline for dealing with those challenges.
Few business owners relish the thought of outside scrutiny of their books, records and financial statements by either the IRS or for litigation purposes. Yet, because our divorce courts have very liberal rules of discovery, virtually anyone connected to a business either as an employee or a principal, is subject to being subpoenaed to a deposition and producing documents. The reason discovery is so liberal is that a Court must ultimately decide the actual income of an employee or a business owner. This means that whatever appears on a W-2 is just the start. The courts in our state adopt a philosophy that virtually no document is unattainable. For that reason, it is crucial for business owners to enter into a Protective Order or Confidentiality Agreement with all the parties as well as any professionals which may be reviewing corporate documents. Divorce files are not typically sealed; they are public records. Many corporate documents, financial statements, books and records should not get into the wrong hands.
Another important action to take is to put the divorce participants on notice that the corporation is an entity unto itself that needs to be protected. There are legitimate objections that can be raised to excessive requests for discovery. Moreover, a participant in a divorce action can ask for the appointment of a Receiver or a Fiscal Agent of a business to make sure that it is either being run properly or that the profits are being distributed fairly without any siphoning off of revenues. While this may be a drastic remedy, it is something that a business owner must keep in mind and be concerned about depending on the nature of the business.
The next step cannot be over-emphasized. Many business owners delay the creation of Buy/Sell Agreements for partners and principals. This is a mistake. A predetermined methodology for the buyout of a shareholder or partner is essential in order to avoid costly valuation issues when a shareholder or partner leaves as a consequence of a divorce. However, it must be noted that such shareholder or Buy/Sell Agreements are not binding on a spouse who is asserting an equitable interest in a business if he or she is not a shareholder. There is a case in New Jersey entitled, Bowen v. Bowen, 96 N.J. 36 (1984), which provides for these Buy/Sell Agreements to be relevant, but in no way determinative of a shareholder’s interest in a small closely held business. It must be noted that it is not uncommon for a shareholder who is going through marital difficulties to also be having difficulties at his place of employment, which might trigger the Buy/Sell Agreement. A difficult issue, thereafter, arises as to whether that shareholder should be bought out of his interest in the business before the divorce ensues, so as to avoid the different methods of valuations.
In a divorce litigation, our courts often ignore the typical valuation methods relative to fair market value of an interest in a closely held business. The valuation standard for divorce purposes is called “fair value,” as opposed to “fair market value.” This is particularly appropriate in the selling of a closely held corporation where there is no ready market for the shares and consequently, no fair market value.
Many divorce attorneys and accountants disagree with the methodology of our Courts in disallowing discounts for marketability and minority interests. The logic of the Courts is that since the interest of the shareholder is not actually being sold, those discounts are premature or unrealistic. Another consideration and what many shareholders in small businesses do not realize is that there are no tax consequences to a non-titled spouse who is being compensated for his or her equitable interest in a business. The IRS Code specifically permits the transfer of assets or liquid funds to a non-titled spouse to be tax free. Thus, compensation to a non-titled spouse by a shareholder is a non-taxable event, although when a shareholder sells an interest in a business or is bought out, it is a taxable event.
The valuation methodology in divorce places a very high premium on cash flow. Accountants typically add back income to a titled spouse for all of the benefits of being a shareholder in a particular corporation. These add backs include payments to pension plans, medical insurance paid by the corporation, travel and entertainment expenses, automobile expenses, and basically any other payments that ensure to the personal benefit of the shareholder. This calculation is done for two purposes. First, it ascertains the actual income of the titled spouse for the purpose of spousal support. Next, it determines the proper income so that a valuation methodology can be employed to determine the actual value of the shareholder’s interest in the company.
Many attorneys have argued that this approach is a “double-dip” in the sense that if a supported spouse is receiving spousal support or alimony based upon reconstructed income, they should not also receive an equitable interest in a business based upon the same reconstructed income. In the case of Steneken v. Steneken, 183 N.J. 290 (2005), our courts recently decided that such an approach is not a “double-dip.” This is yet another example of differences in valuation methodology for divorce purposes versus any other purposes. It should be noted, however, that the non-titled spouse’s equitable interest for divorce purposes is not typically an equal interest. That interest is typically somewhere between 25% and 40%, although there are examples of cases when it can be less or more. Small business owners should be aware that even if the business was owned prior to the marriage by the titled shareholder, the appreciation in value of that business can be subject to equitable distribution in the divorce case. This would also be the case with respect to inheriting an interest in a business.
Most attorneys who are involved in divorce today consider divorce to be the dissolution of an economic partnership. The reasons for divorce are relatively irrelevant from a practical point of view. When there is a small business at stake, it is incumbent upon both parties and their attorneys to be rational and reasonable in fairly compensating the spouse who will no longer be involved with the business, yet who has an equitable share in the business. At the same time, they must preserve and protect the ability of the business to continue to function and generate a cash flow which is necessary to support the family and the titled owner. Unfortunately, it often takes some time for both parties to realize that it is in everyone’s best interest to be straightforward and honest, yet preserve the confidentiality of the books, records and nature of the business. Once that is achieved, however, a divorce involving an interest in a small business will proceed more easily and expeditiously for the spouses, the shareholders and everyone involved in the process.
Areas of Focus:
- Child Custody
- Child Support
- Domestic Violence
- Family Law Appeals
- Parenting Time
- Prenuptial Agreements
- Separation Agreements