Deferred Gratification and Other Key Business Considerations
People marry out of love, and notions of romance are inconsistent with a view of the marital unit as a business entity. Yet, if the marriage falters and the couple seeks a divorce after they have accumulated significant assets, business concepts may play a large role in their divorce proceeding. This Post focuses on some significant business issues that frequently arise when couples divide business assets in a divorce proceeding.
Investments in Private Companies
Most divorces end with the couple separating their ownership of all assets they owned during the marriage, because that is typically the most simple, straightforward result. When the assets that make up a sizable portion of the marital estate include minority ownership interests in private companies, however, dividing the ownership of all assets at the time of divorce may be a bad business decision for one or both spouses. Similarly, when one member of the couple continues to own the asset after the divorce, that frequently will require a valuation to be obtained, which may result in an expensive legal fight between the parties regarding value of their ownership interest.
1. Deferred Gratification – A Gem of an Idea
What business solution will help spouses avoid serious conflict and achieve a win-win solution? The answer is continued co-ownership of assets after the divorce. The couple continues to co-own these investments in private companies after their divorce is completed.
While structuring the continued co-ownership of assets after the divorce is not the norm, it may be an excellent business decision. This is the deferred gratification approach. Continuing to own assets jointly after divorce for some period of time makes sense for the couple in the following situations: (i) when the asset/investment is expected to appreciate significantly in value over time, (ii) when the value of the asset at the time of the divorce would be discounted substantially because it is a minority ownership position in the business, or (iii) when both spouses would prefer to continue to own the asset after the divorce.
2. Continued Co-Ownership Requires Protective Provisions
In the continued co-ownership scenario, one spouse usually controls the investment after the divorce is completed, but important protective terms should be negotiated and included to protect the interests of the non-controlling spouse. These protections include, but are not limited to, the following: (i) an anti-dilution term preventing any reduction in the percentage interest held by the non-controlling spouse, (ii) limiting increases in compensation or salary of the controlling spouse, and (iii) requiring the controlling spouse to make distributions from the business that are sufficient to cover the tax liability of the non-controlling spouse. Finally, the couple must also include the right for either one of them to be able to trigger a buyout at some point in the future pursuant to a specific valuation formula.
All of these measures are geared to provide the parties with a divorce that provides them with the highest economic benefit both at the time of the divorce and in the future. In addition, by agreeing to continue their co-ownership of the investment after the divorce for some period of time, the parties avoid the need to engage in an expensive battle of the experts over valuation.
This Blog Post is not the proper forum for an extensive discussion of tax issues that arise in a family divorce. Certain key tax issues, however, should be considered.
First, for marital estates that have substantial assets, including investments in private companies or investments held in trust, it is essential for the parties to consult with a tax advisor. This is critical so that the division of assets taking place in the divorce can be structured in a manner that provides the most favorable tax-advantaged treatment for both parties.
Second, it is important to always keep in mind whether the revenue at issue will be subject to ordinary income tax rates (typically the highest tax rate) or whether the distributions, dividends, or sales proceeds will be subject to different (lower) tax rates. As just one example, a distribution or dividend by a limited partnership is typically taxed as ordinary income when it is received by the limited partner, but when the limited partner receives a buyout of his or her limited partnership interest in the business, this is generally subject to (lower) capital gains rates.
Finally, the Internal Revenue Code allows for assets to be reallocated between spouses in a way that is not subject to tax. In this situation, the reallocation of assets between spouses is a non-taxable event. Whether the couple’s assets can be divided in a way that avoids or reduces the payment of taxes should be a key point of focus by the family law counsel for each spouse, along with assistance, as needed, from an outside tax advisor.
The Jointly Owned Business
The joint ownership of a business by a married couple presents the polar opposite of the private company investment situation in which the couple owns a minority stake in the business. As noted earlier, it may well be the case that holding onto a minority stake in a private company is the best course of action for a married couple going through a divorce. By contrast, when the couple are owners of a private business, in most cases, the couple is better off to decide how to divide the business themselves and not let the divorce court make this decision for them.
In marriages in which the couple jointly owns a successful, operating business, it may be the most valuable asset in the marital estate and dividing their ownership interest in the business may be the most contentious issue in the divorce. Notwithstanding the difficulty involved in negotiating this business divorce in the context of a family divorce action, the couple would be well advised to make this decision themselves.
Taking any case to trial involves some uncertainty, but the trial judge in a divorce action has such broad discretion in deciding how to divide assets that the court’s “solution” may make both parties unhappy. For example, the judge can: (i) require the business to be sold, (ii) order that one spouse receives full ownership of the business, or (iii) decide that the couple will remain co-owners of the business in either the same or different percentages. The court will make its decision in efforts to deliver a fair result, but the court’s order may create significant practical problems in operating the business and may also result in one or both parties feeling like they were hurt economically by the court’s ruling. Only by taking matters into their own hands can the couple avoid an uncertain, and potentially, unfavorable judicial ruling regarding division of their ownership interest in their business.
The family divorce often involves numerous conflicts and disagreements. Bringing a business approach to the process can help matters by presenting the parties with solutions that will lessen conflict and, at least potentially, allow them to achieve a win-win resolution.