If you are a small business owner, dealing with your business in your divorce could send you spinning into a scene from Little Shop of Horrors – except, instead of a carnivorous plant reeking havoc on your business, your attorney and your soon-to-be-ex do, crying “Feed Me!” Cash, that is, and lots of it.
The family business is often the largest marital asset. Worse, family business owners usually pour their savings into their businesses and secure business loans against their own property or guarantee. When divorce looms, one spouse develops SBLS (Sudden Business Losses Syndrome) and the other spouse develops SYTS (Sudden Yvonna Trump Syndrome). That is, one spouse thinks the business is worth nothing and the other a whole lot of something. They reach a stand-off and fight back-and-forth over whose value is “right” until one spouse caves in or their judge picks a value at, what seems to be, random. No one wins, except the attorneys and their pocketbooks.
How can you avoid this scene and deal with your business effectively? Here are some suggestions:
Decide What It Is
First, decide what it is.
The family business is often not only the largest asset in the marriage, it is the family’s main source of income. The family may have loaned the business certain assets (e.g., a vehicle) expecting to receive a return on the investment, just as one would expect with any property investment. But the business may also generate the family’s income stream, such as through a salary in addition to repayment for loans.
Your decision will drive the division method in your divorce. If you call the business “property,” as you might for a business that makes money with tangible assets, like an apartment complex, then it is subject to the “equitable” or “equal” division rules for property division. If you call it “income,” as you might for a business that makes money with intangible assets, like a lawyer’s practice, then it is subject to the alimony award rules.
Merely semantics this is not. Most states award each spouse one-half of the marital property. However, not all states award each spouse one-half of the other’s income as alimony. Therefore, when a business is both property and income, like a retro ice cream parlor with top-notch appliances and cash to pay salaries to boot, it is important to segregate the property from the income when dividing it to avoid a double dip. That is, without careful segregation, you could divide the entire business as property and then award the non-taking spouse alimony based on the taking spouse’s income from the already-divided business. See, e.g., McCallister v McCallister, 517 NW2d 268 (Mich Ct App 1994).
Choose Your Valuation Method
Next, choose your valuation method.
Choose wisely. Choose the wrong method, and you could over-value the business and shell out more cash to your ex than due, or under-value it and lose your credibility, or pay more to your expert business appraiser than the business is worth. At a minimum, the valuation should examine the business’s assets and liabilities (its book value), earnings history and potential, dividend and salary capacity, goodwill and other intangibles, industry, economic environment, stock sales, comparables and performance during the marriage. See Rev Rul 59-60. But, no surprise, divorcing spouses and their attorneys have a remarkable capacity to make the difficult even worse. For business valuations, this means choosing a method that focuses on certain factors at others’ expense to generate the value most favorable to their position.
For the SBLS-afflicted, a favorite method is the fair market value method or the going concern method. This method treats the business as an item of property sellable on the open market. The value is what a willing buyer and a willing seller, neither under a compulsion to act and both adequately apprised of the facts, would use. But where the demand for the unique business (e.g., a stamp shop) or dime-a-dozen one (e.g., a Detroit diner) is low, so is the value. This is true for most family businesses. SBLS-afflicted spouses make it even moreso by purchasing expensive equipment, taking out a hefty loan, making a risky investment, or otherwise incurring debts that put the business’s book value in the red. Therefore, the hypothetical sale might look more like a “going out of business” going concern sale. The hypothetical purchase price is low, and for the SBLS-afflicted that is ideal. After all, there is less value to divide if no one will buy the business – and no one wants to buy a business bad in debt, at least, not for much.
For the SYTS-afflicted, a favorite method is the capitalization of earnings method. This method treats the business as a stream of income valuable to its owners, if not to buyers in the open market. The value is what an investor would be willing to invest in a comparable risk to generate the same income. It is the product of the projected income steam and a capitalization rate (a risk multiplier). The capitalization rate is based on the rate of return for similar investments, the risk and the business’s historical earnings, among other things. SYTS-afflicted spouses make the cap rate as high as possible by comparing the business to lucrative ones (That hardware store is just like The Home Depot!), minimizing risk (Nothing’s as reliable as this business!) and glossing over low earnings years (Nevermind that low profit; look at the business trips, meals and clothes we got that year!) After all, the more the business generates for its owners, the more valuable it is – and the more to divide in divorce.
Get Creative
Finally, get creative.
For most, it is unwise and impractical to divide the business with each spouse retaining a share. If each spouse retains one-half, expect decision-making deadlock. If one spouse retains a minority interest, expect oppression. As the Michigan Supreme Court noted, “It would be a rare divorcing couple who would benefit from a judgment that requires them to maintain an ongoing business relationship.” McDougal v McDougal, 451 Mich 80; 545 NW2d 357 (1996). (This is true even for amicable divorces. Remember, you got divorced for a reason. Disagreements, particularly when business and money are involved, can and will happen.) Usually, one spouse buys the other’s interest.
That can be a sizable sum of cash. And daunting. And impossible to pay at once. (Enter those chants of Feed me! from Little Shop of Horrors again). Try these payment options instead:
Section 71 Payments: Pay the leaving-spouse’s share for the business as “Section 71” payments with IRC 71. IRC 71 treats payments as alimony for tax purposes, which means they are taxable as income to the recipient and deductible to the payor (which most find attractive). This is true even if the payments are not traditional alimony intended for support but actually a buy-out of one spouse’s property rights. The payments must terminate at death or the recipient’s remarriage. Therefore, be sure to tax-effect the payments (i.e., account for the tax treatment in the amount), factor the risk into the payment amount and/or require the payor to maintain life insurance or other security until paid in full.
Fiduciary Agreement: If you will retain a minority share in the business and your spouse the majority shares, before you sign the agreement be sure it contains fiduciary language. Fiduciaries owe duties of fairness, disclosure, and protection to the minority. They have responsibilities that other members do not. If they breach the responsibilities (e.g., by keeping a stock sale secret and reaping the profits), the harmed minority can file a lawsuit to disgorge the profits. In many states, majority business interest holders are fiduciaries by operation of law. If that is your state, be sure your agreement recites the law, at a minimum, and do not be afraid to contract for more responsibilities. If this is not your state, put the language in!
Base Payments, Plus Ceiling: Perhaps your spouse thinks the business is worth a whole lot more than you – that profits are “just around the corner.” If her suspicion stalls your settlement, consider a payment schedule that will reward her if she is right – with additional payments. For example, the payment schedule might require payments of $500 each month plus 10% of the net profits for the month, after payment for all reasonable business expenses. But protect yourself just in case she is right! Make sure the payment plan has a ceiling. For example, that 10% profits language might read “plus 10% of the net profits for the month, not to exceed an additional $2,000 each month, after payment for all reasonable business expenses.”
Most of all, accept that you will have to pay to keep the business (or step away from the business and accept your spouse’s cash) early in your divorce case and move on to planning the best way to do it. You must cut your emotional ties to that front desk or cash register and start anew, refreshed post-divorce.
Otherwise, you will fight and fight and fight and spend and spend and spend, and that business, neglected, really could do a Little Shop and crumble around you.