Use of Prenuptial (and other Marital) Agreements to Protect Closely Held Business Interests
Based on: The New Standard Marriage/Divorce: Protecting Closely Held Businesses
By: Marguerite (Maggie) 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.
My book the New Standard focuses on protecting the interests of the business owner or active business spouse. However my divorce clients include spouses who are active in the business and those who are not. This article should interest both categories. True, this article is based on my book and my book advises trusted advisors (eg CPAs, business, and estate planning attorneys) as well as their business owner clients. Nonetheless, the non-active business spouse should inform himself/herself of the issues involved when considering any pre marital or marital agreement.
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 and in my book 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.
Before drafting any pre or marital agreement that can impact the business, the layperson should involve her/his business attorney, estate planning attorney, CPA, and family law attorney who focuses on closely held businesses .
Note: This article discusses pre and post nuptial agreements. The term prenuptial applies to those before marriage and postnuptial to after the wedding day but during the marriage. Throughout the article I sometimes use the words “marital agreements” to cover both of these.
Full Disclosure and Procedural Fairness:
In all pre and post nuptial/ marital dealings in Washington State there must be full disclosure and procedural fairness. There is case law to help us know what the courts may find to be an acceptable process for the agreement. The WA courts generally look to procedural fairness rather than the content of the agreement as they typically like to uphold contracts. However beware of terms that are unconscionable. It is advisable not to test their limits if you hope to feel reasonably secure about enforceability. Note also that courts do not uphold terms that are contrary to public policy.
Making Prenuptial and Other Marital Agreements Work For Business Interests:
Some of these suggestions I make here and in my book 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, all the better!
Rarely do I see marital agreements which reference business agreements. Marital agreements should reference and mirror business agreements wherever possible to increase the chances, in a divorce setting, that provisions might be enforced 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.
Note that I say “increase the chances”. One thing that one must keep in mind as you read this article is that family law and business law are two different animals. Marital agreements are not arm's length business agreements.
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.This could be addressed in the marital agreement.
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 should 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: 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.
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.
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 as a trusted advisor: Advise your client to compensate himself /herself sufficiently so to avoid this problem.
Handcuffs and the Active Shareholder:
- 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.
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.
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 as the trusted advisor help? Define buy out terms in the prenuptial:
Issues to keep in mind when drafting provisions:
- Phantom Stock:
Phantom shares (defined here as stock ‘owned’ by a non- listed shareholder spouse) may or may not be permitted by the shareholder agreement. They could be purchased by the former spouse or redeemed by the corporation on an agreed schedule.
Transfer of assets raises tax issues, for example, a corporate redemption may have unfavorable tax consequences. There are special rules that apply to spouses and divorcing spouses that may avoid individual taxes depending upon timing and other factors. This is a very complicated area and needs the expertise of a closely held business family law attorney and a CPA.Closely held business owners need to seriously consider ahead of a divorce, to what extent they wish to allow or preclude phantom stock.
- Cash Payout
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.
- Structured Payout
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
Consider: Risk/Benefit Analysis
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 as the trusted advisor do to help?
State in the marital agreement the desired result (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 state terms which 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.
- Subordinated Debt
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.
- Seller Financing
1. Promissory Note:
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.
2. 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. 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. A marital agreement could potentially help if the matter is addressed in the document.
Provisions to Keep a Lid on Litigation:
Minimizing litigation most often serves the interests of both parties. Good examples of litigation avoidance provisions are:
- 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, or a seasoned professional business arbitrator, or the method or appointment can be pre-agreed. In the case of mediation or arbitration of a divorce case it is advisable to appoint a family law mediator who is well versed in closely held business interests.
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 commingling 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.