Strategic Planning Can Protect Your Business in a Divorce
A young entrepreneur looks to marriage after starting a new business; a sole proprietor looks to incorporate during marriage; a married couple decides to open a family business – there are a myriad of scenarios involving business owners that can result in financial disaster in the event of divorce. If you engage in the same level of strategic planning in preparing for the possibility of divorce as you do in operating your business, many problems that often times arise in the event of a divorce can be mitigated or even avoided altogether.
Understanding Community Property
Initially, it is important to understand the concept of community property. In Texas, community property is defined as “the property, other than separate property, acquired by either spouse during the marriage.” Separate property consists of (1) property owned or claimed by a spouse before marriage; (2) property acquired by a party during marriage by gift, devise, or descent; and (3) the recovery for personal injuries sustained by a spouse during marriage (except any recovery for loss of earning capacity during marriage). Therefore, the time, toil and effort of a spouse during marriage is an asset of the married couple and all income derived therefrom is community property.
At the time of divorce, all property is presumed to be community, but that presumption can be defeated by “clear and convincing” evidence (a higher evidentiary standard used to determine whether an asset is separate property). The manner in determining whether property is separate property involves determining when the property was acquired, either before or after marriage, and how the property was acquired. For example, a car owned before marriage can be clearly shown by the certificate of title to be a spouse’s separate property. A car purchased during the marriage is presumed to be community property but may be established as separate property if it can be shown that the car was a gift to one of the spouses, it was inherited by one of the spouses or, through a process known as “tracing”, the funds used to purchase the vehicle can be traced to a separate property source.
It is important to understand that the way a business is operated can affect its characterization. Strictly maintaining the formalities of the business by avoiding comingling business funds with personal funds is critical. Likewise, pay yourself a fair salary. The community estate can maintain a claim for your time, toil and effort used to build up the value of your separate property business if you fail to adequately compensate yourself.
How Agreements Can Alter Marital Property Law
Given the above listed scenarios, it is easy to see how a divorce can have a significant impact on a closely held business. For example, the entrepreneur who starts a new business should strongly consider entering into a prenuptial agreement to declare the startup business as separate property to avoid having to later attempt to defeat the community property presumption in the event of a divorce as well as avoid the risk of trying to meet the higher evidentiary standard. Also, agreeing that each spouse’s income during the marriage will be separate property may avoid a costly reimbursement claim.
Likewise, the sole proprietor seeking to incorporate a business during marriage should carefully consider the effect of doing so, as the stock will be created and acquired during the marriage and therefore is presumptively community property. The source of the funds used to capitalize the new corporation can certainly create a separate property claim, or the sole proprietor may want to consider entering a post-marital agreement that characterizes the new corporation as separate property.
The married couple may wish to own their family business as a community asset or, alternatively, enter a post-marital agreement characterizing their respective ownership interests as each’s separate property. The couple may further wish to create a “buy-sell” agreement to trigger on the parties’ potential divorce, thus preventing future problems regarding the operation of the business.
Divorce Without a Prior Plan
Each of the foregoing scenarios involves strategic planning prior to a separation or divorce. Understandably, this type of planning probably won’t be an option in the event of discord during the marriage. Even if a spouse has started a business during marriage and the business is inarguably community property, there are steps the operator can take to retain ownership of the business after the divorce.
Initially, your spouse may have no interest in owning any portion of the business, only being concerned with receiving fair value for the business in the ultimate property division. Getting a neutral business valuation early in the case can help frame the parties’ expectations and allow for meaningful negotiations regarding the disposition of the business on divorce. The valuation process is information intensive and cooperation with the valuation expert is critical in obtaining an accurate value as well as in saving a substantial amount of attorney’s fees.
Oftentimes, a party will not have sufficient assets to trade for the spouse’s portion of the business. In such instances, creativity in structuring a “buy out” is crucial. Ultimately, a party trying to maintain the economic engine that a closely held business represents should contact an experienced family law attorney in order to plan for the possibility or manage the risk associated with a divorce. After all, you’ve worked too hard building your business to leave its continued success to chance in a divorce.
This post was written by Tracey Gajak.
“If you only have a hammer, every problem you approach looks like a nail. With my years of experience in family law, combined with a strong background in civil litigation and appellate work, I have a wide range of solutions in my toolbox for my clients. ”
— Tracey E. Gajak