Dividing The Family Business
Here’s a little story about Jack and Diane. Jack opened his own plumbing supply business a few years before he and Diane married and was able to ride the wave of Raleigh development. His business did so well that when the youngest child started kindergarten he agreed to send Diane to law school. Diane had an aptitude for law and now has a flourishing practice with 3 other partners in a cutting edge Research Triangle IP firm. With all the hours spent at work, and the different circles of friends they have, Jack and Diane have been forced to admit that unless they are talking about the kids or the house, they have nothing in common. Were it not for television, there would be silence, as they don’t talk much. They aren’t angry or upset, but neither of them wants to spend the rest of life this way. So, they mutually agree that a divorce would be best. They are agreeable on how to share custody of the kids, and neither wants nor expects to get alimony, but now they must divide the considerable property that was acquired during the marriage.
Both Jack and Diane feel their business isn’t worth much. Jack, because it’s the same business he had when they got married; he’s basically doing the same thing but just on a larger scale. He doesn’t keep much inventory in stock, but orders what his customers want when his customers are ready for it. He spends a lot of time on the phone and with clients and a lot of his business is based on his ongoing relationship he has built up with his clientele. In fact, with the use of the web and cell phones, Jack would not really need an office. Diane is making good money, but she works long hours and in effect she is the business. There are no tangible assets other than office equipment. She learned in school that Jack’s interest in her business stops at the date of separation, and any value it may have is solely based on her continued work there, which is an after separation act. So she figures that other than receivables, Jack’s interest in minimal. Both Jack and Diane are wrong.
In a divorce, only marital or divisible property can be divided. “Marital property means all real and personal property acquired by either spouse or both spouses during the course of the marriage and before the date of separation of the parties….” It includes debts, retirement benefits, stock options, and business interests as well as the more obvious assets and liabilities. “Separate Property means all real or personal property acquired by a spouse before marriage or acquired by a spouse by bequest, devise, descent or gift [from a non party] during the course of the marriage.” “Divisible property” is appreciation, diminution, or passive income from marital property after separation or property acquired as a result of pre-separation actions but not received until after separation and prior to the date of distribution. When dividing the marital property, “[t]here shall be an equal division by using net value of marital property and net value of divisible property unless the court determines that an equal division is not equitable.” In order for a court to divide the marital property it must go through a three step process to classify, value, and divide the property. With these definitions in mind, we return to the example of Jack and Diane.
Jack’s business was started prior to marriage. When we consider the definition of separate property it is clear that Jack’s company falls in this category. However, since Jack’s company increased in value due to his personal efforts, this increase is active appreciation which is marital property and subject to distribution. There are two ways in which Jack could keep his company separate property. One way is to remove himself from the operation of the business, having only passive gain. Where, as here, the business is a person’s daily work, such a solution is not possible. The second possibility is an agreement between Jack and Diane either before, during, or after marriage, that Jack’s business is his separate property. In our example, Jack’s business has a marital component and it will be classified as “mixed” marital and separate property.
Diane’s business is clearly marital. It was acquired during marriage and owned on the date of separation. However, Diane’s professional license itself is her separate property. While there is a school of thought urging the court to find value in the professional license itself, in North Carolina, as in the vast majority of states, neither an advanced degree nor a professional license has marital value. The majority reasons, “[a]n educational degree…is personal to the holder. It terminates upon death of the holder and is not inheritable. It cannot be assigned, sold, transferred, conveyed, or pledged….It may not be acquired by mere expenditure of money. It is simply an intellectual achievement that may potentially assist in future acquisition of property.”
Having established that each business is, in some amount, marital property, the next step is for the court to value the property. In valuing property, the court is vested with wide discretion. For the purposes of divorce, the value of the business is the net value. The two distinct types of value often used by the court in divorce situations are fair market value and investment value. Fair market value is “the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.” While courts in divorce cases often say they are applying the fair market value, often they are using the investment value. Investment value is “the value of a small business…or professional practice to a specific owner. Unlike the fair market value standard, this standard considers, (1) the specific owner’s expectation of risks, (2) the potential synergy associated with ownership of the subject business, and (3) the specific earnings expectations resulting from the subject ownership.”
Often the parties to a divorce action will hire an expert to evaluate the business. Business valuations in the divorce context differ from valuations for sale or for bank purposes as the business in the equitable distribution situation is not expected to be sold. Most business evaluators will require certain documents be provided to aid in the evaluation. In some cases the parties can agree to share the expense of an expert in business valuation. In other cases, the court will appoint an expert. However, in many cases each party will hire and pay for his or her own expert. This service depends on the complexity of the task involved, and the experience of the expert, but the cost is significant.
Jack needs to show the value of the business on the date of marriage, including any capital or retained earnings. He needs to show whether there has been any passive growth in the business since that date. Passive appreciation is growth which is not due to the efforts and or labor of either party. Jack is entitled to a percentage of this appreciation as his separate property. Valuing a business is always difficult. Small businesses have many pitfalls that are not readily apparent. Many people run their corporations as if they were just an extension of their personal income. Hence many small businesses pay personal expenses from corporate accounts, “lend” money to the owners which is never paid back, or place a spouse on the payroll “for tax purposes.” All these extras which have been taken for granted for years need to be removed from the calculation and placed in the proper place. In addition, paid in capital, retained earnings, and shareholder loans will be significant factors in the valuation.
Jack and Diane both need to understand that their businesses have an intangible value known as “good will.” “Goodwill is commonly defined as the expectation of continued public patronage. It is an intangible asset which defies precise definition and valuation. It is clear, however, that goodwill exists, that it has value, and that it has limited marketability. The execution of a covenant not to compete, in connection with the sale of a business, is essentially a sale of the goodwill of the business.”
Diane’s business is a professional corporation. She has three partners who share the profit and risk. If there is a buy-sell agreement or similar document which is actually an arms length agreement between the partners, it can be an important tool in determining value “In valuing a professional practice, a court should consider the following components of the practice: (a) its fixed assets including cash, furniture, equipment, and other supplies; (b) its other assets including accounts receivable and the value of work in progress; (c) its goodwill, if any; and (d) its liabilities.” In a professional corporation, goodwill can often be the largest asset of the business.“ Courts are cautioned to value goodwill with great care, for the individual practitioner will be forced to pay the ex-spouse ‘tangible’ dollars for an intangible asset at a value conceitedly arrived at on the basis of some uncertain elements. Among the factors which may affect the value of goodwill and which therefore are relevant in valuing it are the age, health, and professional reputation of the practitioner, the nature of the practice, the length of time the practice has been in existence, its past profits, its comparative professional success, and the value of its other assets.” There is no set method to determine good will for a business and any widely accepted methodology which can be supported by sound factual basis will be accepted by the court. In determining Diane’s interest, it is also important to note that she has a minority interest in the business and that an interest in a professional corporation is not easily sold.
Once Jack and Diane have classified and valued the businesses, the court must divide them. In most cases the party working in the business will receive the business as part of the equitable distribution. However, it is often difficult to find a substantial amount of other assets to offset the value of the business in dividing the assets. Therefore the owner of the business will often have to “buy out” the other party’s interest by payments over time. The internal revenue code requires that payments as part of a divorce settlement must be completed within six years of the date of divorce unless there is a sound business reason why such a time period was not possible.
Jack’s business will be first valued but then the value will be reduced by the percentage of his business that is separate. Diane’s business will be valued and then adjustments for Diane’s 25% interest will be made. Thereafter the court will entertain the possibility of entering an unequal distribution of property based on the statutory factors. Of particular significance in our example is the fact that the marriage paid for Diane to attend professional school, helping to develop her career potential.
If you believe that you may be faced with the possibility of separation or divorce, see an attorney and a CPA for some pre-separation planning. If you have been retaining some of the earnings of the business in contemplation of a future purchase, it may be time to use those funds. Loans to shareholders should either begin to be repaid or be taken as salary and taxes paid thereon. If you and your partner have been thinking about a buy-sell agreement, this may be the time to enter into it. The value placed on a business often surprises the owners. Good will is an intangible asset, personal and hard to value.