Characterization: Separate vs. Marital Property
The threshold issue is whether the business interest is separate property belonging solely to one spouse or marital property subject to valuation and distribution. Generally, an interest acquired during the parties’ marriage using marital funds or labor will be classified as marital property. Conversely, an interest owned prior to marriage or received via gift or inheritance, such as an interest in a family business, is typically classified as separate property. However, if marital funds or efforts substantially increased the value of a separate business interest during the parties’ marriage, the asset may be characterized as mixed, with the pre-marital component of its value classified as separate and the increase in value classified as marital. A spouse may also convert separate property to marital by express or implied agreement.
Tracing the source of funds used to acquire a business interest and the timing of acquisition and growth in value is critical when such an interest may have both a marital and separate component. Obtaining and analyzing business and personal financial records, tax returns, and formation documents is essential to accurately determine whether the interest should be characterized as separate, marital, or mixed.
Post-Separation Changes in Value
In most jurisdictions, the marital estate is valued as of the date of separation of the spouses. Fluctuations in value after separation may be characterized differently, depending on their cause:
- Passive Changes: Increases or decreases in value due solely to market forces, economic conditions, or the efforts of third parties are generally deemed passive. Absent agreement to the contrary, the passive post-separation increase or decrease in the value of a marital asset usually remains marital or divisible property subject to distribution.
- Active Changes: Changes in value attributable to the individual efforts, financial contributions, or business management decisions of a spouse after separation will likely be considered active. The active post-separation increase in a marital asset’s value is often considered non-marital and solely the property of the spouse whose efforts generated it. The active diminution in value of a marital asset attributable to the post-separation conduct of a spouse may be remedied by an offset in asset division, effectively distributing the amount of the decrease to the spouse who caused it.
The burden is typically on the spouse opposing distribution of the post-separation change in value to prove that it was active in nature. Detailed financial records and expert testimony are often required. Agreements between the spouses or court orders distributing property on an interim basis may address the treatment of post-separation changes in value.
Valuation Methods and AICPA Principles
If an interest is classified as wholly or partially marital, it must be valued for the court to distribute it. Valuation of a closely held entity involves application of generally accepted valuation principles, is highly fact-intensive, and almost always requires the use of an expert appraiser.
The American Institute of Certified Public Accountants (AICPA) has promulgated standards and best practices for business valuation. Under the AICPA’s Statement on Standards for Valuation Services (SSVS), a valuation expert uses his or her professional judgment to apply the appropriate valuation approaches and methods. AICPA, Statement on Standards for Valuation Services No. 1, section .04 (June 2007).
Business valuation experts must decide the appropriate standard of value, typically fair market value (the price at which property would change hands between a hypothetical willing buyer and seller with knowledge of relevant facts) (Id. at appendix B, section .81, definition of “fair market value.”) or fair value (generally, the value that would be received to sell an asset or paid to transfer a liability, but this term may be more specifically defined by state law). Financial Accounting Standards Board, Accounting Standards Codification (ASC) 820-10-20.
Experts commonly employ one or some combination of three core valuation approaches to determine the value of a subject interest:
Income Approach: This approach values a business interest as a going concern based on the expected economic benefit stream (e.g., earnings or cash flow) to be derived from the business, discounted to present value at an appropriate risk-adjusted rate of return. AICPA, supra note 1, at section .33 and appendix B, section .81, definition of “going concern value.” Within this approach, the following methods may be used:
- Capitalization of Benefits/Cash Flows Method: Value is determined by dividing a single benefit stream by a capitalization rate that reflects the risk and growth prospects of the business. AICPA, supra note 1, at section .33.a and appendix B, section .81, definition of “capitalization of benefits method.”
- Discounted Future Benefits Method: This method involves projecting earnings or cash flows over a discrete forecast period, typically 5-10 years, and discounting them to present value using a discount rate. A terminal value represents the business’s value at the end of the forecast period. AICPA, supra note 1, at section .33.b and appendix B, section .81, definitions of “discounted cash flow method” and “discounted future earnings method”; John A. Bogdanski, Federal Tax Valuation § 3.05 (Thomson Reuters 2024).
Market Approach: Value is based on pricing multiples derived from sales of comparable public companies or private businesses. AICPA, supra note 1, at sections .36, .61.c. Pricing may be based on one of the following:
- Guideline Public Company Method: Pricing multiples are derived from actively traded public companies in the same industry, adjusted for differences in size, growth, profitability, and risk.
- Guideline Transaction Method: Pricing multiples are based on actual sales of comparable private companies, with consideration given to material terms of the sale and market conditions.
Asset Approach: Value is based on the business’s assets net of its liabilities. This approach is most appropriate when the business to be valued is a holding company or other capital-intensive entity. Id. at sections .34, .81 definitions of “excess earnings” and “excess earnings method.” Methods include:
- Adjusted Net Asset Method: Fair market values of tangible and identifiable intangible assets and liabilities are used to determine the overall value of the business interest.
- Excess Earnings Method: Sum of the value of net tangible assets and intangible assets, such as goodwill, and capitalized excess earnings beyond a specified rate of return on the base assets.
Selecting the appropriate approach and underlying methods requires careful analysis of the business’s industry, operations, financial trends, competition, growth potential, and risk factors. Discounts for lack of control or lack of marketability are often applied when the interest at stake is a non-controlling, minority interest in the business. Id. at sections .41, .81 definitions of “discount for lack of control” and “discount for lack of marketability.”
Impact of Governing Documents
The company’s governing documents, such as bylaws, shareholder agreements, and/or operating agreements, must be carefully reviewed. These documents may contain provisions restricting or triggering the transfer of ownership upon certain events, including divorce. For example:
- A buy-sell agreement may require a divorcing owner to sell his or her interest to the company or other owners at a specified price or at a price determined by using a specified formula.
- A shareholder agreement may prohibit the transfer of shares without approval of all, or at least a majority, of other shareholders.
- An operating agreement may provide a mechanism for valuing and buying out a member’s interest.
These agreements are not always dispositive and may not be binding on the court for purposes of equitable distribution. In fact, a majority of jurisdictions have held that the value specified by a buy-sell agreement is not automatically binding on the court, because the non-owner spouse is usually not a party to the agreement and the value established by the agreement is often inconsistent with fair market value.
Options for Distribution
Once the value of a business interest is determined, the marital portion must be equitably distributed between the spouses. The most appropriate distribution method depends on factors such as each spouse’s role and experience in the business, the potential for ongoing cooperation, liquidity of the spouses, value of other property in the marital estate, and marketability of the business interest. Options for distribution include:
- In-Kind Distribution: Each spouse receives a percentage ownership in the entity. This is more likely to be feasible when both spouses are already actively involved in operation of the business and have demonstrated the ability to continue working together without negatively impacting the company’s value.
- Buy-Out: The owner-spouse essentially purchases the value of the non-owner spouse’s marital interest, often through an equalization that involves distributing other assets to the non-owner spouse or by a distributive award payable over time. This requires sufficient liquidity of the owner-spouse or a marital estate that includes other assets of sufficient value to balance out the value of the business interest and achieve an equitable distribution.
- Sale: The business interest is sold to a third party, and the proceeds are divided between the spouses. This may be necessary if an in-kind distribution is not possible and the owner-spouse cannot afford to buy out the marital interest of the non-owner-spouse. However, it requires the interest to be marketable and not subject to restrictions that would prohibit the transfer of ownership.
Ancillary Litigation Risks
Business divorce cases can result in additional litigation beyond a domestic action between spouses for division of the marital estate. For example:
- A spouse may bring a shareholder derivative or oppression action against the company or other owners, including the other spouse.
- An owner-spouse dissatisfied with the valuation or distribution of a business interest may seek judicial dissolution of the company.
- Business partners may intervene in the domestic case to challenge the division of ownership or control.
Whether the court presiding over the domestic action or another court has jurisdiction to resolve a dispute affecting the business depends on the facts, procedural posture, and parties involved in each case. If a domestic case is initiated prior to an action in a different judicial division and ownership of the business interest is at issue in the subsequent action, the court presiding over the subsequent action may defer to the domestic court and stay proceedings until the domestic case is resolved. But if the relief sought does not involve ownership of the business interest, such as in a shareholder derivative action, even if the shareholder action is filed after the domestic action seeking distribution of the marital estate, the shareholder action may proceed independent of the domestic case. It is crucial to anticipate the ways in which a divorce can affect the operation of the business and the interests of non-spouse shareholders to avoid or mitigate the risk of concurrent proceedings that could delay resolution of the domestic case.
Settlement Agreements and Voluntary Buyouts
Like most issues that must be resolved in connection with divorce, a thoughtful, well-crafted agreement between the spouses is often preferable to the uncertainty of an outcome that may be imposed by the court. A voluntary buy-out of the non-owner spouse’s equitable interest by the business or owner-spouse may be a way to ensure that the business is able to continue operating, allow the owner-spouse to retain his or her interest and role in the company, and avoid a forced sale. Key considerations in crafting a buy-out:
- Financing: Are there sufficient assets in the marital estate to balance out the value of the business interest distributed to the owner-spouse? If not, will it be funded by a lump sum cash payment, installments payable over time, or a combination? Is third-party financing needed?
- Security: Should the non-owner spouse receive a security interest to secure payment? If so, what property will be the collateral? What steps need to be taken to perfect the security interest?
- Indemnification: Did the spouses personally guarantee any obligations of the business? Can the obligations be satisfied prior to or contemporaneously with the buy-out? The owner-spouse should indemnify the non-owner spouse against existing and future liabilities.
- Tax Allocation: Tax treatment should be addressed, along with responsibility for any tax liabilities.
- Releases: The spouses should release all claims relating to the business, including any claims against the business itself. Obtaining releases from the business or business partners should also be considered.
- Protection of Business Information: If the spouse whose interest is bought out worked for the company or had access to proprietary information, are confidentiality or non-compete agreements needed?
Divorces involving closely held business interests are complex, high-stakes matters that require creativity and skillful advocacy. By understanding the goals and interests of the spouses, the company, and other stakeholders, family law attorneys can effectively navigate these challenging cases.