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Specialty tag(s): Divorce for Business Owners, Property Division

What Happens to an LLC in Divorce?

Rob Frazer, Thomas P. Goranson | December 9, 2021

Today, it is not unusual to see a spouse operating a business in the form of a limited liability company or owning an interest in an investment that is a limited liability company (hereafter sometimes referred to as an LLC). In 1991 Texas became the 7th state to authorize the creation of limited liability companies. Since then, all 50 states and the District of Columbia have authorized them. They are very popular because:

1. They offer protection for the owners from business liabilities (like a corporation or limited partnership),
2. Allow the members (what the owner of an LLC interest is called) to control the business (unlike the limited partner in a limited partnership), and
3. Allow for the “pass through” treatment for federal income tax purposes (like a Sub C corporation or a partnership).

As a recent Texas case dealing with LLC’s stated (SJ Medical Center, LLC v. Estahbanati, 418 S.W. 3d 867, 874 (Tex. App.—Houston [14th Dist.]2013, no pet.), “Limited liability companies have been said to offer ‘the best of both worlds—the limited liability of a corporation and the favorable tax treatment of a partnership.’”

In a divorce action that deals with an LLC, experienced divorce lawyers will tell you the five most important questions are:

• What is the value of the LLC interest?
• Has all of the original capital been contributed, or is there any chance additional funds will have to be paid to the LLC?
• What restrictions are placed on the transfer of the ownership interest by either state law or the Company Agreement?
• When was the interest in the LLC acquired – during marriage or before?
• If acquired during marriage, was it acquired with community or separate property?

Types of LLC’s

There are a number of very common uses for LLC’s.

An LLC can be the General Partner of a Limited Liability Partnership.

When a limited partnership is formed, there has to be a general partner. The general partner is the partner who manages the partnership but is also personally liable for the obligations of the limited partnership. The limited partners are just that – they have limited liability equal to their original contribution (and any subsequent required contributions) to the partnership when it begins its existence. Limited partners have no rights of day to day management of the partnership. It is quite normal for the general partner in a limited partnership to be an LLC. Thus while the LLC is responsible for the liabilities of the limited partnership, the LLC members individually have limited their personal liability to a specific sum. It is quite normal for this type of LLC to own a very small portion of the limited liability company but have all the liability – and also the right to manage the investment. To look at the formation scheme backwards, the member can manage the LLC which is the general partner and manager of the limited partnership.

Common investments that use this type of structure involve real estate or oil and gas development. Usually the general partner owns less than 1% of the investment. Thus if the LLC owned a 1% general partner interest in the limited partnership, and value of the whole limited partnership is $1,000,000, the LLC value would be no more than $10,000 assuming no additional discounts for lack of control or lack of marketability. If the member of the LLC owns only 1/3 of that LLC, then the value of that interest would be no more than $3,333.33 again subject to further reductions for lack of control and lack or marketability. The testimony necessary to value the interest could vary depending on the parameters the expert uses to make his or her determination, but for quick analysis purposes, simple math is enough to give a spouse – whether the owner spouse or the non-owner spouse – a general idea of what value this type of ownership has in the community estate (it is also common for one of the spouses to also be a limited partner so you would have two types of ownership interest to analyze and value).

The Investment Company

Because of all of the advantages described at the beginning of this paper, it is common to see many investments take the form of a limited liability company. In these investments, the owners make a commitment to contribute a certain sum of money into the business – either all at the beginning or over a period of years – for example, $100,000 original investment and a commitment to contribute $50,000 for the next three years for a total investment of $250,000. Normally, at least in this author’s experience, these investments are not too restrictive in the transfer of ownership for a number of reasons. If this investment exists, divorce attorneys recommend it is a good idea to finding out from the managers of the LLC what does it takes to transfer all or part of an interest. Also determine if any additional capital requirements are required. As stated below, get a copy of the company agreement as this will explain how membership interests can be transferred. These investments can be very difficult to value because it is not uncommon for them to own a number of investments, many of which are themselves LLC’s. For example, what if the LLC owned a minority interest in a portfolio of real estate mortgages? The effort it would take to value such an investment might exceed the value of the LLC interest owned. Joint ownership may be the only answer if that is possible based on the transfer rules of the company agreement.

The Operating Business

The next type of LLC is one that is actually set up and run for one or two special reasons – a shoe store or a computer software developer would be typical examples. It is possible for this type of LLC to have only one member. If there is only one member, then it is easy to manipulate the ownership rules. This can be done in a destructive fashion if that is the desire of the member. But a spouse owes a fiduciary duty to the community estate, and with such a duty, it is not recommended that a member (owner) conduct his or her business that way. Since it is the duty of the trial court to divide the community estate in a manner that is just and right, the flexibility in modifying the terms of the company agreement can be very useful in resolving a marital property dispute. The value of this type of LLC is similar to valuing any other small business in Dallas, Plano, or Austin, Texas. If there is only one owner, it is not particularly difficult to divide the ownership interest between the two spouses. The real question is whether it is a good idea to divide the interest versus having one spouse awarded the LLC, and the other spouse awarded either assets of equal value or making a payout over a period of time.

It is also possible for the LLC to have two, three or four members. As the number of members increases, the form of the company agreement may go through a number of changes. It is not unreasonable that the complexity of the ownership rules will change during this process. If the entity has a number of members who have joined then left the LLC, that can create a pattern of how membership interests are bought, transferred, and even sold. This history is important in looking at one’s options in resolving the divorce case.

The Family Business

If a family has created a large business or a number of businesses, it is common for them to use a combination of business entities including LLC’s. They can be for investment purposes, to control how the family businesses are run, to limit liability, or for many other legitimate business or estate planning reasons. It is quite common for there to be many restrictions on who can become a member of these entities. It is common for the entities to be stacked on top of one another. The reason for such complex dealings is to make sure that that the family business stays that way – and that the ownership interests cannot be diluted by divorce. For example, if Grandma was instrumental in creating a successful business – for an example, an oil and gas pipeline or a computer business – she might clearly want to make sure that only her descendants own the business in the future. As the generations pass, this becomes more and more difficult, but the use of LLC’s can make it easier to accomplish no matter how small the investments become from the dilution of passing generations.

The Professional Business

It is common for many professional businesses – for example a medical practice or a law firm, to be set up as an LLC. These entities even have their own special name – Professional Limited Liability Companies or PLLC. If this is true, there are special rules that apply to who can own them – for example, if a law firm, only a licensed attorney could be a member of the LLC. These entities have their own set of interesting problems that are outside the scope of this paper.

The Company Agreement

The most important document in the creation of an LLC is the company agreement (sometimes called the operating agreement).  This document states how an LLC is operated, what payments are permitted to members or obligations to be paid by the members, and who can be a member.  Except for a very few statutory requirements, the operating agreement is binding on the members and any restrictions on transfer are strictly enforced.   Most company agreements regulate how the ownership can be transferred.  It is not uncommon that the operating agreement states that the ownership interest can only be transferred in very limited circumstances – for example, to a trust created by a member without the approval of all other members or only with the approval of the other members of the LLC.

What Happens to an LLC When Spouses Divorce?

There is very little case law that deals with divorce and limited liability company interests.  Based on current Texas statutory law the only interest that can be owned by “the member’s spouse, to the extent of the spouse’s membership interest, if any, is an assignee of the membership interest.”  (Texas Business Organization Code, §101.1115.  “Effect of Death or Divorce on Membership Interest” (hereafter TBOC)).

An assignee does not have the right to participate in the management or affairs of the LLC.  An assignee does not have the right to become a member of the LLC.  An assignee does not have the right to exercise any rights of a member.  All that an assignee has is the right to be allocated income, gain, loss, deduction, credit or similar items, and to receive distributions to which its assignor (the owner spouse) was entitled, to the extent those items are assigned.  In addition, the assignee acquires the right for any proper purpose to require reasonable information or account of transactions of the LLC and to make reasonable inspection of the LLC’s books and records.

As case law regarding Limited Liability Company in a divorce continues to develop through the Courts of Appeals, a good place to find analogous situations is in closely held corporations and in partnership law.  The statutory scheme for partnership interests is very similar to that of limited liability interest.  Texas case law regarding partnerships is quite clear – a divorce court can only award the non-partner spouse the rights of an assignee.  If the analysis was that of a closely held corporation, perhaps the situation would be different – in Earthman’s Inc. v. Earthman, 526 S.W.2d 192 (Tex. Civ. App.—Houston [1st Dist.] 1975, no writ) the non-shareholder wife was awarded shareholder husband’s stock in a family corporation.  

The corporation, pursuant to their shareholders agreement, redeemed the stock awarded to the wife and offered to pay, pursuant to the shareholder’s agreement actually signed previous to the divorce by the now ex-wife, the book value of the stock (book value of an asset is seldom any indication of actual value and is most likely greatly less than actual market value).  The appellate court decided that since the corporation was formed in a community property state and the stock was community property, that the wife could own the stock subject to the provisions of the shareholder’s agreement – basically meaning that she could own the stock but if she wanted to sell it, she had to comply with the shareholder’s agreement.

Dangers of ownership of an assignee’s interest – since the limited liability is a “pass through entity”, what happens if the entity has taxable income but does not make a distribution?  What happens is that the assignee gets to report taxable income without receiving any funds to pay the income taxes?  Typically partnerships and limited liability companies make distributions to cover income taxes, but there is no guaranty that this will happen.  And if one is in a family business situation, or an entity where the other owners would rather reinvest the income of the entity rather than distribute it out, the assignee has little or no recourse (unless the refusal to make a distribution was not for legitimate business purposes).  As far as the IRS is concerned, the taxes attributable to the undistributed income will be due in the next year.

The fight to determine the legitimacy of a failure to make a distribution could take years to resolve.  In a somewhat different situation, but one that has implications of the danger of suing the business entity during divorce, the case of Lifshutz v. Lifshutz, 199 S.W.3d 9 (Tex. App.—San Antonio 2006, pets. denied) is informative.  In that case, in the middle of a divorce action, the wife sued the husband’s family businesses claiming that she had been defrauded by her husband and his family.  During the discovery in the case, the other family members learned that the husband and wife had taken monies out of the partnerships and corporations without authority.  The case was tried three times and appealed twice over a 9 year period.  The final results were that the husband and wife each owed the partnership considerable money and the wife did not appear to gain any appreciable amount of assets.

Another strategy depends on how the LLC is managed.  In extreme situations one can attempt to collapse the LLC in a process called reverse piercing the veil.  There is a line of cases that permit a creditor to collapse the corporate veil so that the creditor can collect against the shareholders of a corporation.  These cases have been used by courts to also collapse the LLC.  The reverse piercing allows the spouse to claim that the assets of the LLC are not shielded by the LLC and belong to the member spouse.  The normal reason for this type of result is where an LLC is claimed by the owner spouse as his or her separate property.  As of the writing of this paper, no reported case has been successful in Texas (that does not mean that they have not been tried without appeal or settled and subject to confidentiality agreements).  These cases are very complex, time consuming and expensive to litigate.

A different strategy would be to simply value the limited liability interest even with discounts for lack of marketability and lack of control, and suggest to the court either (1) the whole interest be awarded to the owner spouse with the non-owner spouse receiving other assets or (2) order the owner spouse to modify the company agreement to allow for two or more owners or simply be an assignee for half or some other percentage of the LLC.  

The suggestion to the court should also make clear that any income tax obligation resulting from the ownership of the asset also be allocated to the owner spouse irrespective of whose income tax return the taxable income is reported.  For icing on the cake, if any tax losses have accumulated, determine the amount and how the IRS Code allocates them – many times they have to be allocated equally to each party depending on the type of loss.  Sometimes the loss follows the asset, so it is another valuable asset being “divided”.

Most property cases are settled in high net worth divorces. The most obvious reason for settlement is that in settlement one can carefully construct a division of property (including LLC’s) that is creative and doable.  In settlement everyone is purportedly in agreement so obtaining concessions from other owners of the business entity or using devices such as a liquidating partnership or trust can make the division of property a more positive experience.

Documents to Request

At the beginning of any divorce proceeding in which a spouse owns an interest in a limited liability company, our Texas divorce attorneys recommend that you get copies of the LLC’s:

• Tax returns
• K-1’s
• The company agreement 

If necessary, agree to a confidentiality order to protect the privacy rights of other members (and subsequently your privacy rights if the asset is allocated to you).  Also determine how and when the interest was acquired. Then determine if the interest can be transferred so that the non-owner spouse can be accepted as a member into the LLC. 

The final step is to determine if one should attempt to value the LLC with the assistance of a qualified business appraiser.  With this information, one can then determine what strategy works best within the framework of a division of property that is “just and right”. As you can see, the process can be quite complex. At Goranson Bain Ausley, our divorce lawyers have the knowledge and experience necessary to assist you throughout this process.

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