Use of Prenuptial (and other Marital) Agreements to Protect Closely Held Business Interests
The New Standard
Marriage/Divorce: Protecting Closely Held Businesses
By: Marguerite C. Smith
Maggie can be contacted at Maggie@flexxlaw.com
Disclaimer: Nothing in these materials is intended to be tax advice. References to tax are for issue spotting only. A CPA or other tax expert should always be consulted.
For the non-attorney: This is not something you should tackle without legal advice from an attorney who concentrates in the area of family law involving business assets. Many of the suggestions here are cutting-edge and have not been tested in a court. That does not mean that they will not work. We just do not know until the cases test them. My approach typically is that if you don’t try you will not get.
Note: One more word before we begin. We are using the terms “marriage and “divorce” for simplicity here. One should be mindful of other couple relationships which may give rise to rights under family law. A married couple may also choose legal separation over divorce. In addition, whereas the emphasis in this presentation will be on prenuptial agreements, other marital agreements will also be touched upon.
Full Disclosure and Procedural Fairness:
Marital and Premarital Agreements
In all marital and premarital dealings in Washington State there must be full disclosure and procedural fairness. Post marital, item specific agreements have their own lesser standard. See In re Marriage of Zier, 136 Wn. App. 40,147 P. 3d 624 (2006), review denied 162 Wn. 2d 1008, 175 P. 3d 1095 (2007). (Practice Pointer: I would tend to over protect rather than rely on a lesser standard; you never know when the court might say that in your particular case, the higher standard was required!)
Full Disclosure and Procedural Fairness:
Business Agreement: Is it the same when we are dealing with divorcing parties?
Although the courts pay special attention to procedural fairness and full disclosure in pre- marital and other marital contacts, they pay comparatively little attention to such matters in more arm’s length transactions. This makes sense, of course, because there is usually an element of special trust in a premarital and marital relationship.
Where enforcement is sought against a spouse of a shareholder or a shareholder spouse in a divorce proceeding, it may be advisable to ensure that procedural and disclosure safeguards are met.
When attorneys start to draft more protective language for their business client, this issue may be tested in reported cases.
When you (representing the shareholder spouse in a prenuptial agreement) work with the attorney who drafts the shareholder agreement /represents the corporation make sure that there is full disclosure of information and procedural fairness to the non- shareholder spouse associated with the business interest.
Making Prenuptial and Other Marital Agreements Work For Business Interests
Some of these suggestions are new and untested by the divorce courts. This does not mean they will not work. My philosophy is to try to agree to what you can but warn the client that the efforts may not work. However, typically there is no harm in trying. If they do work you will have a very happy client.
In addition, by way of disclaimer nothing in these materials is intended as tax advice for which one must consult a tax advisor. Tax is referenced for potential issue spotting purposes only.
Rarely do I see marital agreements which reference business agreements. Marital agreements should
reference and mirror business agreements wherever possible to increase the chances of legal enforcement of corporate business protections by divorce courts. Examples of typical business agreements are: shareholder agreements, partnership agreements, buy/sell agreements, confidentiality agreements, stock option plans, non-competition agreements, employment agreements, etc.
Business/Stock Valuation Date
Typically business valuations in divorce proceedings are conducted only once and are generally done to fit the schedule of the appraiser.
There is an art and science to fixing valuation dates.
An agreed valuation method can take much of the guesswork and contention out of the valuation issue and streamline and economize the process; it can cut down on litigation.
Whether or not the business is considered a community or separate asset, the business will be valued for divorce purposes, unless the parties can mutually agree on a value.
Valuation of business assets for divorce purposes does not always follow real world valuations: An example:
Washington State divorce cases have included professional (personal) goodwill, if any, of the working spouse as part of the value of the assets—not just the enterprise goodwill. Professional businesses are particularly at risk of this, e.g. doctors, lawyers, dentists, etc. Real buyers would not pay for the personal goodwill of the principal if the principal were to exit the business. This is in conflict with a real world business valuation.
Courts in Washington permit themselves discretion to consider all relevant facts and circumstances. This generally leaves the courts free to consider commonly accepted business valuation principles as well as their own opinions as to what is fair in a divorce setting. This may be something your client does not want to leave to the courts.
Don’t think when you get it to a court that is the end of it: Possible expense of not agreeing to a method and leaving it to the court:
In Washington the appeals court frequently states that a trial court must state what method and factors were used in the valuation. If the trial court does not state the method and factors, an appeal court can send the case back to the trial court to make these determinations.
If the appeals court determines that it does not have sufficient evidence, it may direct the trial court to obtain additional business value evidence.
Costs of Sale:
In Washington, the rule for divorce actions is that costs of sale are typically only considered for valuation purposes if a sale imminent. Otherwise, so the reasoning goes, the issue may be too speculative to be considered. Generally, divorce valuators should not include costs of sale in valuations absent a contemplated sale. There are exceptions/refinements.
Taxation on Sale
Disclaimer: The following is not to be considered tax advice; only issue spotting
Generally, taxation, like costs of sale tends not to be considered by the court as it is often, in the courts’
opinion, too speculative to be considered, unless a sale is imminent. The Washington State courts have made some exceptions to this. Beware of the fact that our cases are arguably not all consistent in this area. Tax consequences on a sale can have a material financial impact. Taxes can also differ substantially depending on the form of sale.
Including Taxes on a Sale Transaction in the Divorce Valuation:
Can the form of a transaction be predicted in a valuation exercise performed for divorce purposes? Because buyers favor asset purchases, valuations should arguably consider the tax effect of a hypothetical asset purchase. However, arguing tax on sale expense in Washington divorce courts may be difficult unless a sale is considered imminent.
Taxes on a sale transaction can be significant and extreme. The following example of a real world corporate sale transaction (non-divorce related) illustrates this point.
Trapped in Depreciation Recapture Taxes:
Y Company received a $35MM valuation based on an agreed six times multiple of EBITDA. Most of its equipment assets were fully depreciated for tax purposes. Most buyers would insist on an asset purchase to revalue the assets for future re-depreciation. Conversely a stock purchaser would have to assume the fully depreciated value of the equipment and lose the future tax shelter potential. The stock buyer would be paying higher income taxes on future unsheltered earnings and logically would be willing to pay a lower price for the company. These two scenarios (stock sale vs. asset purchase) basically shift the current and future tax liability from buyer to seller.
The scenario above is an extreme but real life example demonstrating how the form of sale can materially alter the after tax proceeds to the seller. A divorcing active spouse could argue a lower valuation due to anticipating the form of an eventual sale.
Discount for Lack of Marketability:
This discount generally applies to the inability to freely sell stock on the open market. The case law in Washington at this time is arguably unclear and/or inconsistent as to when this is to be applied. Does your client want to provide for it in the prenuptial?
- Discount for lack of control:
The divorce courts may discount for a minority interest.
Identification of Interests of Spouses at Divorce:
Identification of the separate interests of each spouse/the community in the business and how that interest is to be determined/valued upon divorce should be clearly set out in the marital agreement.
Personal Goodwill of the Active Spouse
Washington State is among a minority of states in the U.S which include personal good will, not just enterprise goodwill, in valuing a business for divorce purposes. This can make a significant difference to a valuation in our courts. This concept is frequently seen in cases involving professional service businesses, for example, a dentist’s practice. The dentist may argue that the value of her business should be at liquidation value of net assets, because she cannot transfer her own goodwill (future earning value) to a buyer. In Washington, this argument would not succeed. The courts here look to what the practice is worth to her, not to a market buyer, at the time of divorce.
Many states have found this analysis to be unfair and have argued that it “double dips,” if spousal maintenance is awarded to the other spouse and the dentist pays for her own personal future earning power embedded in the valuation. They have also argued that it is unfair, because if one spouse works in the community owned business and the other works outside of the business, the owner of the business has to share the personal goodwill while the other spouse has no asset value attributable to his/her salaried job. Whether we like it or not, this is our law in Washington at this time. Not every state thinks this way. In fact, Washington is in the minority.
The spouse that takes the business in a divorce will be attributed a higher valuation in this state than in many others, if the spouse is important to the business. This is good for the non- business spouse and terrible for the business spouse.
- Goodwill Brought Into the Marriage
In Washington you can deduct the goodwill in existence at the start of the marriage as separate property.
However, one should be ready for issues such as:
- Does any of the pre marriage goodwill still exist?
- How do you establish the value of the business at the time of marriage?
What you can do for the business owner: Establishing a provision for business valuation bookends may help eg. value at date of marriage and value at date of divorce—a valuation of the business should be conducted prior to marriage. If this valuation is accepted by agreement, it sets the beginning value of the business as the parties enter into the active phase of possible post marriage community goodwill.
The Thorny Problem of Active Versus Passive Appreciation of the Business
In order to determine the character of appreciation, we need to examine active versus passive appreciation. If the business appreciated in value due to market forces, for example, a favorable economy, a competitor going out of business, or regulatory changes, the appreciated value of the company occurring during marriage arguably continues to be the separate property of the active business owner. However, the facts can become much more complicated. The general rule is that “quantifiable” success due to the insufficiently compensated efforts of the business owner during the term of the marriage and before separation is community property.
What you can do: Advise your client to compensate himself /herself sufficiently so to avoid this problem.
Handcuffs and the Active Shareholder
The General Rule regarding Non-Compete : See case handout under Non-competition Agreement.
Marriage After Sale of a Business:
For those who enter into a marriage with future proceeds from a covenant not-to-compete, those proceeds would arguably be separate property. It is not uncommon for covenants not-to-compete to extend for five years or even longer.
There is some suggestion in Washington, that the community may have rights to non-competition proceeds in the event that it substitutes community income which otherwise could be earned during the marriage.
What you can do: It would be advisable to clearly address the character of the non-competition proceeds in a prenuptial agreement.
Workshop discussion: Practice discussing the above valuation factors with your ‘client’: Consider how you will approach the subjects; how much detail will you include? What prenuptial provisions do you recommend? What experts would you advise be involved?
Impact of Exit Strategies:
Closely held business owners generally have an exit strategy in mind, especially if they are considering retirement. The following are amongst the typical ways to exit the business:
- Selling to employees using an Employee Stock Ownership Plan (ESOP)
- Selling to co-owners
- Selling to outsider third party (individual investor or strategic acquirer)
- Selling to key employees as part of an incentive plan
- Transferring to key employees as part of an incentive plan
- Retain only passive ownership
- Transfer to a family member
- Initial public Offering
The exit strategy chosen can have a significant impact on valuation. What the drafter of the prenuptial agreement should consider is how that valuation might affect the valuation on divorce.
Take each of the above exit strategies and discuss how they might affect valuation on divorce.
How might you draft the prenuptial agreement to reflect a divorce value which your client wants?
Terms for Buying Out the Spouse’s Interest
Issues: The business is often the largest marital asset. Buy out can be crippling to the shareholder spouse and or/the company. Sometimes the shareholder is assisted by the company in the buy-out. This rate can be far in excess of what it would buy the shareholder’s stock!!! Sometimes the credit of the divorcing spouse has been relied on for credit.
So how can you help? Define buy out terms in the prenuptial:
Issues to keep in mind when drafting provisions:
Phantom shares (defined here as stock ‘owned’ by a non- listed shareholder spouse) can be purchased by the former spouse or redeemed by the corporation on an agreed schedule.
A corporate redemption may have unfavorable tax consequences. Closely held business owners need to seriously consider ahead of a divorce, to what extent they wish to allow or preclude phantom stock.
The most traditional form of buyout is payment of cash. Often however, other marital assets, such as home equity, are sufficient in value to trade for the value of the business interest. Trading outside (non-business) assets is a very practical way to deal with a buyout without restricting or financially compromising the company.
The holder of the note, the departing spouse, will want security or collateral. Pledging the stock may be an option if the shareholder is not in violation of a shareholder agreement prohibiting using the stock as collateral (pledging) for any purpose.
A stock pledge is generally strategically favorable to the stockholder spouse and not the note holding spouse. Here’s why: Should the company perform badly and there is a future default, the non-active spouse can foreclose on the collateralized stock, converting back into an ownership position. If the company does well, the active former spouse has every incentive to pay the note according to its terms.
What can you do: Discuss with the business attorney the fact that pledging the stock may not be a bad option and coordinate in the shareholder agreement a provision for the other shareholders to buy the stock or the corporation to buy back the stock if the divorcing shareholder spouse does not do so.
Leveraging the Business to Buy-out the Spouse
Financing the Buyout With A Bank
Funding the Buyout Through a Corporate Redemption
The other form of buyout is for the company to redeem the stock and hold the associated debt. This transaction leverages the company’s balance sheet and may cause interference with bank and other creditor relations
Note: If a corporation has negative net worth under the definition of Washington Business Corporation Act
(RCW 23B.06.400) the board of directors is precluded by law from redeeming any shares.
Consider also potential capital gains treatment when involving stock purchases by a non-divorcing spouse, i.e. the corporation. A CPA or tax attorney must be consulted when considering any form of buyout to structure it so that it does qualify as pursuant to divorce and therefore a nontaxable event. This is complex: It is not always obvious (without an expert to assist) to decipher who is the transferor or transferee.
What can you do to help?
State in the prenuptial what your client wants (typically to have no tax on transfer pursuant to divorce). As you go through your agreed scenarios for the benefit of liquidity state the tax objective and put the issue in the hands of an arbitrator or upon recommendation of a stated CPA if there are disputes as to how to accomplish this.
Structuring any new seller debt should be done in concert with the company’s major lender.
What you can do? Be mindful of current (and possible future creditors of the business) and provide for agreement as to subordination of any new debt to the spouse.
The inactive spouse takes a promissory note in exchange for the value of the shares purchased. The maker of the promissory note can be either the spouse or the business.
Personally Funding the Buyout Through a Salary Increase
If the company is wholly owned by the divorcing couple, the active owner will typically increase his/her share holding to 100 percent at divorce. This affords the shareholder the flexibility to increase his/her salary to fund a personal buyout of the former spouse’s shares. Repayment with after tax salary is generally not a cost efficient strategy and should be contrasted with the tax liability of a corporate redemption. Remember, a qualified transition of stock between the parties incident to divorce is tax free. An important dynamic to take away from this is that changing the maker of the note can make significant differences in tax consequences. A tax advisor should be consulted.
What you can do? Again make provision in the prenuptial for the buy- out which is most beneficial to the business/the shareholder spouse. When you cannot see into the future specify the objective and appoint a CPA /arbitrator after input of CPA to find a way to the agreed end.
Agreed Statement of Cooperation of Both Spouses in Signing Business Documents Governing Marital Interests and Liabilities During Divorce
An obstinate spouse during divorce can hold up the normal progression of your business. Cooperation can
be used as a bargaining chip and become monetized, thereby holding the business as ransom.
Provisions to Keep a Lid on Litigation
Minimizing litigation most often serves the interests of both parties. Good examples of litigation avoidance
- Appointment of a discovery master (someone who oversees and manages the exchange of information concerning the business) to avoid business intrusion and disruption.
- Identification of a contact person at the firm.
- Appointing an arbitrator or business monitor
Note that: Employment of a third party defuses conflict and speculation of skullduggery. However, be careful whom you appoint; that person may turn out to be a problem for you depending upon his/her personal agenda/skill.
Non-Interference of the Non-Active Spouse in Business Decision Making During Divorce
A non-interference clause can be very useful when the marital community owns a majority interest and a disruptive non-active spouse attempts to block major events such as mergers and acquisitions, expansion, refinance or any other significant business changing decision.
As an alternative to this provision, a third party arbitrator or monitor can be nominated, by name or concept, in an agreement.
Provision for the Appointment of an Arbitrator
As a way to avoid court interference, a third party arbitrator can be identified in a marital agreement as someone who will arbitrate marital business related disputes when the couple is no longer a cooperative unit. This nominee could be a named person, trusted by both parties, who has knowledge of the business, a seasoned professional business arbitrator, or the method or appointment can be pre-agreed.
Business owners should be very wary of the courts. Many divorce attorneys, family law commissioners and judges can also fail to appreciate business needs and processes. After all, it is often not their area of expertise.
Provision for the Appointment of a Business Monitor
Monitors may be appointed to oversee business activities. The designated monitor’s supervision may be specifically defined, e.g. the monitor must approve all expenses over $5,000 or approve any action not in the “ordinary course of business,” such as business expansion or research and development initiatives. The monitor may just report on activities. The scope of appointment should be defined.
Keeping the Business as Separate Property
In the event that the business owner spouse wants to keep her business as separate property, care must be taken to keep it separate. The trusted advisor must discuss the fact that comingling of separate and community assets must be avoided. A common trap is when the community or non-shareholder spouse’s separate property guarantees a business debt.
This can, depending on the facts of the case, lead to allegations of a change in the separate character. Acknowledgement of the separate character of the business should be captured in a prenuptial agreement or other marital agreement.
- Other Business/Divorce Planning Strategies
The following are some excellent planning strategies to limit business disruption during a divorce:
- Include divorce planning provisions in premarital, marital and business documents, e.g. shareholder agreements.
- Obtain the signature of every non-active spouse in business agreements which might have an impact on divorce.
- Keep good records.
- Provide complete information when requested.
- Demonstrate a willingness to provide information.
- Be realistic in valuing personal property on any written document.
- Appoint, by the court or by agreement, an independent discovery master to keep discovery reasonable and contained.
- Address discovery proceedings in marital agreements, i.e. pre or postnuptial and separation agreements.
- Appoint a single representative in the company as a go-to person, not the divorcing party, for the business.