As part of the marital dissolution process, spouses generally need to identify, value, and divide assets. For certain types of property, such as bank accounts, the process is fairly simple. But what do you do if the spouses have an ownership interest in a private business?
The first determination that must be made with respect to a private business in a divorce is whether the business interest is considered a marital asset or separate property. That determination depends upon whether the interest was owned prior to the date of marriage, the source of funds used to acquire the business, and the extent of financial contributions and personal efforts contributed to the business by either spouse during the marriage. Moreover, the analysis of marital versus separate property differs from state to state.
Next, the business interest needs to be valued. Although it is theoretically possible that both spouses may agree on value, the valuation of a business interest often is a major source of disagreement in a divorce. Because private businesses are not publicly traded on a public stock exchange such as NASDAQ or the New York Stock Exchange, ascertaining the value of a business can be a complex process. There generally are three approaches to determining the fair market value of a business interest, including an asset approach, a market approach, and an income approach. These approaches may exclude some discounts that are not appropriate in a divorce context. In most cases where a business interest has significant value, it will be necessary for one or more independent qualified valuation professionals—such as an Accredited Senior Appraiser (ASA), Certified Business Appraiser (CBA), or Certified Public Accountant (CPA) with an Accredited in Business Valuation (ABV) designation—to be engaged as part of the marital dissolution process to help determine the appropriate fair market value of the business interest. Often, each spouse will hire his or her own expert. If the spouses end up in litigation, then a judge will be required to determine which expert has a more credible valuation, which could be substantially more time-consuming and expensive than compromising with a settlement.
After the business interest has been valued, the spouses then need to determine what should happen to the business interests after the marriage has been dissolved. In general, the three options for addressing private business interests in divorce include: (1) one spouse buying out the other spouse; (2) selling the business; or (3) remaining co-owners.
Buying Out the Other Spouse
The most popular method for dealing with private business interests in a divorce is for one spouse to purchase the other spouse’s interest in the business. For certain professional services businesses, such as a law practice, only the licensed spouse may own the business.
Example 1. Anna and Bob jointly own and manage a restaurant. Based on an independent third-party valuation, they agree that the fair market value of the restaurant is $1 million. Anna intends to continue to own and run the restaurant, and Bob plans to move across the country and open a new restaurant after the divorce is finalized. For Bob to get half of the value of the business as part of the divorce or settlement agreement, Anna could purchase Bob’s interest for an amount up to $500,000, depending on the potential tax impact (discussed below).
A spouse’s purchase of a business interest from the other spouse as part of a buyout typically is not treated as a sale for tax purposes. Transfers of property between spouses that are incident to divorce generally are not subject to income tax under IRC § 1041—that is, the transfers are a tax-free non-recognition event. A transfer is considered incident to divorce if (1) the transfer occurs within one year after the marriage ceases, or (2) it is related to the cessation of marriage, which generally means that (1) the divorce or separation instrument requires the transfer and (2) the transfer happens within six years after the marriage ceases. If the transfer occurs more than six years after the marriage ceases, then there is a rebuttable presumption that the transfer is unrelated to the marriage ceasing. Ultimately, if the purchase of a spouse’s interest is not treated as a sale for tax purposes, it means that the purchasing spouse would receive the same basis in the property as the selling spouse—known as a carryover or transferred basis—and the selling spouse would not be required to pay any taxes on the sale of the business interest. It is important to consider the tax consequences of a buyout during the marriage dissolution process because the purchasing spouse could owe more in taxes if he or she eventually sells the business interest to a third party down the road.
Example 2. Assume that Anna and Bob in Example 1 each have a $100,000 basis in their respective 50 percent ownership of the restaurant. If Anna purchases Bob’s interest in the business for $500,000 as part of the divorce process, it would be treated as a tax-free transfer for tax purposes, as opposed to a true sale—which means that Bob would not owe any taxes on the transfer. Anna’s basis in the business would be $200,000 after the transfer—that is, she would carry over Bob’s $100,000 basis and keep her $100,000 basis. If Anna later sells the property for $1 million, she would have a gain of $800,000. Anna ultimately may end up with only $220,000, which is equal to $1 million in sales proceeds minus $280,000 in taxes (assuming a 35 percent effective federal and state income tax rate) and minus the $500,000 she paid to Bob, whereas Bob would have received $500,000 from Anna free of taxes. Given that result, a more equitable plan would be for Anna to purchase Bob’s interest for less than half of the value of the business, taking future taxes into account—such as an amount closer to $360,000—especially if there is a possibility of a future sale transaction.
A common issue with the buyout option is that it only works if there is sufficient cash or other liquid assets (such as stocks or bonds) for one spouse to buy out the other spouse. Often, it may be possible for the purchasing spouse to obtain financing from a commercial bank or third-party lender—such as mezzanine financing—in order to generate sufficient liquidity to acquire the other spouse’s interest. Borrowing can be a tax-efficient strategy, especially in a low interest rate environment, compared to selling stock for a capital gain or withdrawing funds from a retirement account (e.g., a 401k or IRA), which could result in ordinary income taxes and potentially a 10 percent penalty. Alternatively, the purchasing spouse may want to offer a non-pro-rata division of other marital assets in lieu of cash, such as allowing the selling spouse to keep full ownership of the principal marital residence or other assets of equivalent value. Also, the spouses could agree to a structured settlement, which means that the purchasing spouse could use a property settlement note to make a series of payments over time, as opposed to one lump-sum payment. A structured settlement is considered a non-taxable division of property in divorce, so the selling spouse would not owe taxes on the receipt of principal payments, but would owe taxes on the interest.
Example 3. After agreeing to a $1 million fair market value of the business and discussing the potential tax consequences of a future sale of the business, Anna and Bob agree that Anna will purchase Bob’s interest in the business for $360,000, which would be approximately the same after-tax amount that Bob would have received upon sale of the business to a third party. Anna does not have sufficient liquidity to pay Bob $360,000 in cash. Accordingly, a bank may be willing to lend Anna the funds at a reasonably low interest rate for Anna to purchase Bob’s interest.
Selling the Business
If a buy-out of a private business is not a viable solution for both spouses, then the next most likely strategy for each spouse may be to sell the business and divide the proceeds. This often is a common solution to divide other types of property, such as the marital residence. But a sale of the business may not be possible without a court order if one spouse insists on continuing the business.
Example 4. After months of negotiating, Anna and Bob determine that it would be best to simply sell the business to a third party and split the proceeds equally. Fortunately, the restaurant has been highly profitable, it is in a desirable location, and the economic cycle is good for business sales. With the help of a middle market business broker, a third-party purchaser agrees to buy the business for $1 million, which is equal to the independent valuation that was prepared for the spouses as part of their divorce proceedings. Accordingly, Anna and Bob will each receive 50 percent of the proceeds from the sale of the business, less any applicable fees and expenses.
Even if both parties initially agree, selling a private business may have its own challenges, depending on marketability, profitability, and economic conditions. It may be difficult to find an independent third party interested in buying the business for strategic or tactical purposes, and it could take many years to actually sell the business. The spouses also need to consider how the business will be managed until it is ultimately sold. Moreover, the spouses may disagree about the price offered by a third-party purchaser, especially if it is lower than the independent valuation that was prepared as part of the divorce proceedings.
A third potential, but rare, option for a private business is for the spouses to continue to jointly own the business even after the divorce. Although this obviously could involve emotional and psychological challenges from a relationship and dynamics perspective, amicable spouses could continue to co-own and manage the business even after a divorce or marital separation. Alternatively, the spouses could agree that only one spouse will have primary management responsibilities for running the business, while the other spouse will receive a percentage of future payments from the business’s profits to satisfy his or her share of the marital assets. Depending on the future success of the business, each spouse would be taking a risk of receiving more or less assets by maintaining co-ownership of the business.
Example 5. Instead of Anna purchasing Bob’s interest in the business, Anna and Bob agree that Anna will continue to have primary responsibility for running the business and that Bob will be entitled to 50 percent of the business’s profits until the business is ultimately sold. Even though the business earned $100,000 in profits last year, if the business only earns $50,000 in profits this year, Bob only will be entitled to receive $25,000. On the other hand, if the business earns $200,000 in profits this year, Bob would be entitled to receive $100,000.
Co-ownership typically is not a very popular way to deal with a private business in divorce, because many spouses are not able to maintain a cordial working relationship after going through the divorce process. In limited circumstances, maintaining co-ownership could work if both spouses remain amicable, trusting, and respectful. To the extent the spouses will remain co-owners after a divorce, it is important that they have a formal written agreement—such as an operating agreement or shareholders’ agreement—to address their future business relationship as if they were unrelated independent investors in the business.
Ultimately, the three methods discussed above are the most common ways for spouses to deal with a private business in a divorce. The process can be even more complicated when debt, third party agreements and other owners must be considered. Therefore, it is important for each spouse to address the pros and cons of all the options for dividing private businesses with his or her attorney, tax advisor, wealth manager, and other advisors before agreeing to and implementing any specific strategy.