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Divorce settlement is seriously complicated by the existence of a closely held business. The business can be a professional practice (medical, dental, accounting, attorney, real estate brokerage) or a retail outlet (restaurant or shop). To further complicate matters, the business is usually a source of income for the family as well as an asset subject to division. Each type of business has it’s own set of problems and complications, but there are basically three methods to handle the business during divorce:
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Both parties continue to own the business. If both work in the business prior to divorce, it may be possible to continue a working relationship even though divorcing. They may have a better business relationship than personal. However, if there is a great deal of rancor between the individuals, continued joint ownership is a recipe for future strife. This is not normally an acceptable solution.
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Sell the business and divide the profits. This method allows both individuals to invest in their own business venture with the proceeds of the sale without ties to the ex-spouse. However, most businesses cannot be easily sold and take a long period of time to find a buyer. This still requires one spouse to run the business until sold, thereby controlling to a certain extent the property of the other.
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One spouse keeps the business and offsets a portion of its value with other assets. This is usually the best option, assuming that there are other assets to complete the transaction.
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The equity in the homestead is often used as an offset for the buyout, although the ongoing cash flow needs of the spouse must be considered, as well. A home does not provide income and actually requires cash outlay to maintain.
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IRAs or 401k plan assets are often used to offset the business, however, these should be calculated at their estimated after-tax value in order to compensate for the eventual taxation of withdrawals.
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Securities and cash equivalents outside of qualified plans are often the most desirable in offsetting the value of the business. Little or no tax liability is associated with these accounts and they can provide needed liquidity to the spouse.
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If the business comprises most of the couple’s net worth, it may be necessary to utilize a “property settlement note” or “structured settlement” to equalize the outcome. A property settlement note is similar to a note at a bank, having a reasonable rate of interest, a definite term and a principal amount.
Example: Susan and Steve have two significant assets, the $100,000 equity in their home and the value of Steve’s business, $350,000. In order to keep the business, Steve can provide a property settlement note to Susan in the amount of $125,000 ($350,000 - $100,000 = $250,000 / 2 = $125,000). Assuming a 5% rate of interest, Steve could pay Susan $1,350 per month for ten years, thereby keeping the business undivided and assisting Susan with cash flow for ten years.
Separate versus Community Property
A business started during marriage with joint funds is community property in Texas. A business that was already in operation or was begun with separate funds is more complex, since the community interest may involve joint funds used to expand the business and any appreciation attributed to that contribution. If both spouses played a role in the operation, the contribution of each spouse must be considered. Even if no joint funds are contributed, a marital interest may exist and should be reviewed by a qualified family law attorney. The key elements to determine community property vs. separate are:
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The source of funds for the startup of the business
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The date of the marriage
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The date of valuation due to divorce
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The contribution of each spouse to the business
The date of the valuation can be either the date of separation, the date of filing, the date of the hearing or some other agreed upon date.
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