A married couple may enter into a new business venture as optimistically as they began their marriage. Just as they walked to the altar without a marital prenup, however, they often fail to enter into agreements to provide for what happens to the company if they later divorce. The lack of any agreement will create confusion and lead to disputes over who owns and controls the business once a divorce is filed. These disputes can destroy the operations of the business and greatly diminish its value.
The Right to Control the Family Business
The issue of who controls the family business depends on the type of business entity at issue. In this Blog Post, we focus on issues regarding the right to control and own a limited liability company (LLC). LLCs are a popular type of business entity because (i) as the name suggests, they provide limited liability protection to their owners (known as members), (ii) they allow the members to enjoy the benefits of partnership taxation, i.e., pass-through taxation, and (iii) they allow the members great flexibility for operations and management.
The issue of who controls the LLC depends on whether one or both spouses are members of the LLC. If either the husband or the wife is the sole member of the LLC, then this spouse controls the LLC. Under Texas law, while the other (non-owner) spouse may have a community property ownership interest in the LLC, he or she does not have any say in the management of the company.[1]
Questions about who has an ownership interest in the LLC can be answered by reviewing its certificate of formation. In order to form an LLC in Texas, a certificate of formation must be filed with the Texas Secretary.[2] The certificate of formation states whether the LLC is managed by its members or by its managers.[3] If the LLC is managed by its members, the names and addresses of each initial member of the LLC is listed on the certificate of formation. If the LLC is managed by its members, then the certificate of formation must include the name and address of each initial member of the LLC.
Potential Deadlock Scenario In the Family Business
If both the husband and wife are members of the LLC, how the company is managed depends on the terms of the LLC company agreement,[4] which is the principal governing document for the LLC. It is substantively equivalent to the by-laws for a corporation or a partnership agreement for a partnership. A company agreement can provide for the rules regarding the management of the LLC and the members’ rights and responsibilities between each other and the LLC.[5] Except for few provisions of the Texas Business Organizations Code (BOC), the members can waive or modify the default rules governing Texas LLCs in the BOC.[6]
One common provision in a company agreement is the establishment and appointment of managers or officers, which authorizes the managers or officers to take actions on behalf of the LLC. The terms of the company agreement may specify the scope and limit the authority of the managers and officers for certain major decisions that require approval by the members.
When it comes to married couples who form an LLC during their marriage, it is often the case that the couple never entered into a company agreement. In the absence of a company agreement, the BOC provides the rules for management of the LLC.
In this scenario, each member or manager, depending on whether the LLC is member managed or manager managed, can bind the LLC in any action for carrying out the “ordinary course of business” of the company.”[7] While certain actions, like defending a lawsuit and hiring counsel to pursue or defend litigation, have been recognized by courts as falling outside the ordinary course of business, the BOC does not define what constitutes ordinary course of business.[8] This lack of guidance can result in confusion and disputes between the spouses and ultimately impact the operations and value of the company.
For an action that is “not apparently for carrying out the ordinary course of business of the company,” the majority vote of the members or managers, as the case may be, is needed to bind the company.[9] When there are just two members or two managers, a majority requires the affirmative vote of both parties, which could results in a deadlock scenario between the parties and prevent major decisions from being made. Again, a deadlock situation will certainly impact the operations of the business and likely harm the value of the company.
Uncertainty in Divorce: How Will the Divorce Court Divide the Family Business?
A divorce court has great flexibility in dividing up community property. Under Texas law, the divorce court is charged with ordering “a division of the estate of the parties in a manner that the court deems just and right, having due regard for the rights of each party . . .”[10] When the community property includes the interests of the married couple in an LLC, the divorce court has discretion to award the entire LLC to one party or divide the interests between the parties.[11]
In light of the uncertainty as to how a divorce court will divide an LLC between the spouses, the parties are likely to be better off if they are able to reach an agreement regarding the terms for dividing up the ownership and setting the rules for the operations of LLC. Taking control of this process allows the couple to negotiate and structure more sophisticated approaches to the division, and the management, of the LLC than the relatively simple division that would be ordered by the divorce court after an expensive pre-trial and trial of the couple’s competing claims.
Examples of Structured Business Divorces by the Divorcing Couple
For example, the couple who owns an LLC together may decide during their divorce that it would be most profitable to allow one of the spouses to manage the LLC for a set period of time after the divorce is final. This management period would then be followed by the right of the non-managing spouse to exercise a buy-sell agreement (also known as a buy-out agreement). The parties would need to agree on the details including the triggering events, the methodology for determining the purchase price, and the procedure for closing the transaction. In addition, this type of agreement would also impose some limits on the “operating spouse” such as: (1) preventing him or her from receiving excessive (or any) compensation or bonuses, (2) precluding additional debt being taken on by the business without agreement of both spouses and (3) requiring the distributions be made to both spouses to cover their tax liability.
In another example, the couple may decide to sell their business to a third party with the sale taking place after the divorce becomes final. Under this scenario, the parties would agree in their settlement and divorce decree as to how to allocate the sales proceeds.
There are numerous ways to structure a business divorce involving a family-owned LLC all of which are likely to be significantly better than what a court can or would order. This type of solution is so much better for both parties because the couple would be taking control to customize a business outcome that is specifically tailored to their needs and objectives