Protect Your Business from the Financial Fallout of a Divorce

Oct 5, 2012

Many positive things have been written about the benefits of starting a family business. Not only does it provide job security for the current generation; it adds stability for the family’s future. A successful business gives a family more flexibility and a clearer path to the American dream. But what happens when a couple gets divorced?

If your business is a success but your marriage isn’t, it adds another layer of difficulty the division of marital assets. With 52 percent of all first marriages ending in divorce, it is never unwise to have a back-up plan in place. Depending on the “amicability” of the divorce, options range from buying a partner out entirely, to trading day-to-day management for a share of the profits. However, there are some practical ways to guard your most valuable financial asset.

In order to protect your business assets in a divorce, it’s important to understand the difference between separate and marital property. It also helps if you have some basic protective measures in place, such as a prenuptial agreement. Otherwise, depending on your financial circumstances, it is possible that your spouse will be entitled to 50 percent of your business.

Separate vs. Marital Property

While each state has its own laws pertaining to divorce and marital property, here are some general rules about what is considered “separate property” in a divorce:

  • A gift received by one spouse solely from a third party, but not from the other spouse
  • Property that was owned prior to the marriage
  • The pain and suffering portion of a personal injury judgment
  • An inheritance received by one spouse solely

Important: Separate property often loses its “separate” status if it is comingled with marital property. This means if you deposit your share of an inheritance into a joint bank account, that property will most likely be considered marital property.

In general, all property that is acquired during the marriage is “marital property” regardless of which spouse owns it or how it is titled. Marital property consists of all income and assets acquired by either spouse during the marriage, such as pension plans, IRAs, 401(k)s, stock options; bonuses; commissions; life insurance, brokerage accounts, closely-held businesses, real estate, boats, art, antiques and tax refunds. In many jurisdictions, if your separately owned property increases in value during the marriage, that increase is also considered marital property.

If you live in one of the Community Property States, such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin, spouses are considered equal owners of all marital property using a 50-50 split. The remaining 41 states are Equitable-Distribution States, which means other factors are considered such as the spouse’s earning power, the length of the marriage and each spouse’s level of involvement in building a business. In Equitable Distribution States, settlements don’t need to be 50-50; they just need to be fair.

Knowing the distinction between separate and marital property can help business owners structure their assets in a way that keeps them separate. This will prevent you from inadvertently doing something that might cause your separate property to be construed as marital property.

Partnership and Shareholder Agreements Can ‘Lock-out’ Your Spouse

When a business is formed, there are often certain partnership and/or shareholder agreements that go into effect. Many of these are designed to protect the interests of the other owners if one of the owners gets divorced. For example, it may be required that all unmarried shareholders provide a prenuptial agreement prior to marriage which includes a waiver from his spouse-to-be of his or her future interest in the business. An agreement might also include a prohibition against the transfer of shares without the other partners’ approval.

Pay Yourself a Competitive Salary

While it is often overlooked by business owners, it is important to pay oneself a competitive salary instead of reinvesting everything back into the business. A soon-to-be ex-spouse might claim a larger share of the business if he or she is not benefitting from a decent share of your income. In other words, if the perception is that all the earnings from the business went back into the business, that spouse may feel entitled to a larger percentage of the business.

How to ‘Pay-off’ Your Spouse

If for some reason you were not able to protect your business from becoming marital property and your spouse is entitled to ownership interest, here are some ways to pay him or her off:

  • Property Settlement Note – this is a long-term payout (with interest) of the amount you owe your ex-spouse for the value of her share of the business.
  • Use your share of other marital assets including cash, stocks, real estate, retirement funds, etc.

While this is obviously the least-preferred method, you could sell the business and divide the sales price, but this is only recommended when the business represents the vast majority of all assets and there is no other way to pay off the other spouse.

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