Originally published by J.R. Smith.
“You can’t always get what you want
But if you try sometimes, well, you might find
You get what you need”
You Can’t Always Get What You Want, The Rolling Stones
In addition to Mick Jagger’s legendary performances on stage and vinyl, the song lyrics of The Rolling Stones reflect wisdom that often goes unappreciated. This post focuses on issues that arise when spouses divide their private company ownership interests in the context of family divorce proceedings. When the private company ownership stakes held by the couple are highly valued, there is a potential for a win-win property division and settlement in the best interests of both spouses. You Can’t Always Get What You Want therefore aptly describes the prospects of negotiating a successful Business Divorce in a marital divorce action.
Important Legal Disclaimer
This discussion will consider different scenarios that regularly arise in marital cases that involve private company ownership interests. Please note, however, this post does not provide legal advice or guidance for any specific situation. The thorny issues that are involved in these matters require a case-by-case analysis, and in a blog post, we cannot address all legal issues that should be carefully reviewed in each case with legal counsel and tax advisors.
Ownership Transfer Concerns – Fair and Full Transfer of Interest
The most common Business Divorce scenario that arises in divorce proceedings is the transfer of one spouse’s ownership interest in a private company to the other spouse as part of the divorce settlement. It is rare for divorcing spouses to be able to continue working together in a business after a divorce. Even if they are not active in the business, the co-ownership of business interests by divorced spouses can often lead to conflict, which is why dividing the couple’s ownership interest in businesses is a typical part of the divorce settlement.
When one spouse transfers an ownership interest in a private company in the divorce, it is vital to remember that the transfer of this ownership stake gives the company a seat at the table in the divorce. Therefore, when the transfer takes place of an interest in a private company, the spouses need to address the following points:
- The transferee spouse (who receives the interest being transferred) needs to provide the transferor (who is transferring the interest) with a release of claims from the business, and not just from the spouse. The transferor spouse may have been quite active in the business before the transfer took place, and does not want to be subject to any future claims that are asserted by the business (at the direction of the transferee) after the divorce is final.
- The transferor should also seek an indemnity from the business for any future claims that are made against the transferor by third party creditors or others after the divorce. If the transferor is dragged into a lawsuit by a third party after the divorce, the business should indemnify the transferor against the claims, which covers both the transferor’s legal expense and any resulting liability. The transferee may insist on including a carve-out that eliminates the indemnity if the transferor is found to have acted in bad faith or was grossly negligent, which caused the lawsuit to be filed by the third parties.
- In the year after the divorce becomes final, the company may issue a K-1 tax document to the transferor, which is based on his/her ownership in company during the prior year. The transferor needs to secure a representation from the business that this K-1 will not include any “phantom income” that would require the transferor to pay taxes based on income that was not distributed to the transferor in the preceding year.
- Finally, the transferee needs to make sure that all rights, title and interests of every kind and character are transferred by the transferor in the transaction, and that there are no hold backs of any retained interest by the transferor in the company or any of its assets.
The Liquidity Problem – High Value But No Cash Available
Another common scenario is the liquidity conundrum. This situation arises when the company in the marital estate is highly valued, but the couple does not have enough other value in assets outside the business to allow either spouse to pay the other spouse one-half of the value of the business. One spouse generally wants to buy the other spouse’s ownership interest in the business, but this spouse (the proposed buyer) lacks the funds necessary to purchase the interest and cash out the other spouse (the proposed seller).
In this situation where sufficient funds are not available at the time of the divorce to permit one spouse to buy the other spouse’s interest in the business, there is a creative solution we have presented that does work for some couples. We refer to it as the “kick the can down the road” strategy in response to this problem created by the liquidity crunch, and the elements of this approach are summarized below.
- The spouses will continue jointly owning the company after their divorce, but one spouse will operate the business, and they will also receive an option they can exercise at a set point years down the road (usually 3, 4 or 5 years). This is known as a put/call option, with the operator spouse having the right to purchase the non-operator spouse’s interest in the business at the agreed point. The non-operator spouse will have a put right that, when exercised, requires the operator spouse to purchase the non-operator’s interest in the business at the agreed point.
- Importantly, the spouses’ ownership interest in the business is not valued at the time of their divorce. Instead, the couple will adopt a specific, detailed valuation formula, which will be applied to determine the value of the ownership interest at the point at which they exercise the put/call option years down the road.
- During the holding period before the put/call is exercised, the operator spouse will be required to provide full transparency regarding the operation of the business. This will require the operator spouse to issue regular financial reports and also require the operator to obtain/provide audits of the business at least on a yearly basis by independent auditors.
- Also during the holding period, the non-operating spouse will have a set of veto rights regarding the operation of the company to protect him/her during this multi-year period. These veto rights do not permit the non-operator to micro-manage the business, but they protect the non-operator and ensure that the fundamentals of the business will remain the same. Some examples are that, without the consent of the non-operator, the operator spouse cannot declare bonuses for management, add new partners to the business, require the non-operator to contribute capital or dilute the ownership interest of the non-operator.
This kick-the-can approach has three attractive features. First, it avoids a fight about the value of the business during the divorce, which can be both time-consuming and very expensive. Second, it gives the operator spouse several years after the divorce concludes to determine how to secure the funds necessary to purchase the interest of the non-operator spouse. This can be accomplished by finding another investor to take the place of the non-operator, by securing a loan or by selling the business, in whole or in part. Third, the delayed division of the business does not have any tax impact – a division of the business within 3, 4 or 5 years is still regarded by the IRS as incident to the marriage and it is therefore is not deemed to be a taxable event.
The delayed division of ownership interests until a set period of years after the divorce only works, however, when there is some liquidity in the marital estate at the time of the divorce. The non-operator spouse can afford to wait for a buyout of his/her interest only when the couple does have some liquid assets to divide at the time that the divorce becomes final.
Continued Ownership Challenges – A Buy-Sell Provision Is Essential
In some cases, both spouses want to continue to maintain an ownership in the business. This is not due to liquidity problems, but it may be because: (i) they both enjoy working at the company and it is providing them with high compensation, (ii) while they are not active in the business, they are receiving sizable annual profits distributions from the business or (iii) they believe that the business has the potential for very significant appreciation, and they want to realize the benefit of its increased future value.
When couples continue to own a shared interest in a business, however, they will want to ensure they have the right to obtain a buyout of the interest they continue to hold in the business after the divorce. This will require that the spouses themselves, or other partners in the business agree to provide them with a buy-sell agreement that applies to their interest. Stated simply, a spouse who becomes a minority interest owner in the business will not want to be left holding an illiquid and unmarketable ownership stake in the company. The value of the ownership interest is not really relevant if the spouse has no way to ever monetize that value.
The subject of a buy-sell agreement goes beyond the scope of this post, but we have written about these agreements in other posts. Issues that will need to be addressed in the buy-sell agreement include all of the following; (i) when can the buy-sell be triggered, (ii) how will the interest be valued when the buy-sell agreement is triggered and (iii) how will the purchase price be structured once the value of the interest has been determined.
Divorcing couples have many areas of disagreement in the dissolution of their marriage and their ownership interests in private companies is no exception. But when these private company ownership interests are highly valued, there are paths to the division of the interests that can be negotiated to provide them with an outcome that is mutually beneficial. The couple and their business and legal advisors therefore need to focus on how to optimize that high value in the divorce settlement so that they can both get as much of what they want as possible.