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 has its own set of problems and complications, but there are basically three methods to handle the business during divorce:
- Both parties continue to own the business. If both have worked 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.
- 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.
- One spouse keeps the business and offsets one half of its value with other assets. This is usually the best option, assuming that there are other assets to complete the transaction.
- 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.
- IRAs or 401k plan assets are often used to offset the business, however, these should be calculated at their after-tax value in order to compensate for the eventual taxation of withdrawals.
- 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.
- 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 that was 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 in value 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:
- The source of funds for the startup of the business
- The date of the marriage
- The date of valuation due to divorce
- 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.
Valuation of the Closely held business
Valuing (“appraising”) a business is a very complex task, requiring the assistance of a professional business appraiser. The appraiser must be skilled in identifying the relevant information and applying the appropriate valuation methods. The relevant information will include both quantitative (such as from financial statements and tax returns) and qualitative information. The appraiser must have a thorough understanding of the business.
The appraiser selects appropriate valuation methods based upon such factors as the characteristics of the subject business and the availability of relevant information. All valuation methods fall within three categories (“valuation approaches”). These are the Market Approach, the Income Approach, and the Asset Approach.
The Market Approach estimates the business value by using one or more methods that compare the subject business to similar one that have been sold. The Income Approach estimates the value by one or more methods that convert expected economic benefits (such as profits or cash flows) into value. The Asset Approach estimates the value by one or more methods based on the values of the assets and liabilities of the business. These assets include both tangible and intangible assets.
To value most private businesses, the skilled appraiser will use one or more methods from the Income Approach and the Market Approach. At least two methods are preferable, since business valuation is not an exact science and does require professional judgment. While the appraiser selects from numerous methods, please note that book value (the assets minus the liabilities on the balance sheet) is not a valuation method.
Most skilled business appraisers offer more than one level of appraisal service. The price of these typically ranges from roughly $3,000 to $12,000 or more. The price largely depends on the business itself and the level of appraisal services (amount of detail in the analysis and the report) that the client selects. Talking to a professional business appraiser early on in the divorce process about the different options can save money and increase peace of mind.
If there is a contested divorce, spouses often obtain separate appraisals. A significant problem is that many appraisers who value businesses for divorce slant the results to favor their clients. While this behavior is absolutely wrong (the courts require expert opinions to be “independent”) many appraisers violate this requirement. Fighting this out in court can increase the cost of divorce tremendously. If the divorce is “collaborative“, the couple uses only one appraiser. That appraiser works for the couple and is far more likely to produce a fair, independent valuation. This can save a lot of money and help yield a result that both parties feel comfortable with.
The treatment of the businesses’ “goodwill” value presents appraisal complexities and can have huge effects on the outcome for each party. Goodwill value is essentially the total value of the business minus the total value of the company’s tangible assets. Goodwill is sometimes called “blue sky.” Texas courts often require that the value of business goodwill be split into two types for divorce purposes: “personal goodwill” (sometimes called “professional goodwill”) and “enterprise.”
Personal/professional goodwill is the portion of goodwill that is directly associated with the person running or otherwise working in the business. Texas courts hold that this part of the business’ goodwill is not marital property subject to division between the parties. It is viewed as going with the individual person. The enterprise goodwill is attached to the business itself, even if the individual were to leave the company. Texas courts typically treat enterprise goodwill as marital property that is subject to division between the parties.
In order to save money when employing an appraiser, organize your documents and provide a full set to your own lawyer and business appraiser, as well as to the spouse’s.
In cases where both spouses are shareholders or partners and one buys out the other through the divorce settlement, usually there are no income tax ramifications. Your attorneys needs to make sure that no language in the agreement results in a tax liability to the spouse who is selling his or her interest in the business to the other spouse. Ideally, an accountant representing each spouse should meet with an accountant for the business to structure the transition of business ownership, in order to assure no disruption to day-to-day operations and yet protect the interest of both spouses.
Choosing an Appraiser
Choose an expert business appraiser. Finding a true expert is more difficult than you might think. Business valuation is a relatively new profession. Many top business appraisers estimate that a very high percentage of business appraisers produce incompetent work — even many who have a certification in business valuation.
Choosing a true expert is far more important that selecting someone with experience in the company’s particular industry. You’ll be much safer if you start the search by looking for appraisers who hold either the Certified Business Appraiser (CBA) or Accredited Senior Appraiser (ASA) in business valuation credentials. Earning either of these credentials requires the applicant to (i) pass a highly technical exam and (ii) submit appraisal reports proving that they can perform appraisals competently. The process is rigorous and the pass rate is low. Other appraisal certifications exist. They may look good on paper, but they lack the rigorous requirements that a CBA or ASA appraiser must meet. Look for a CBA or ASA appraiser at these organizations:
- Institute of Business Appraisers (IBA), http://go-iba.org
- American Society of Appraisers (ASA), http://www.appraisers.org/
While the interests of the family and the business must be considered, the goal is to keep the business in operation with as little divorce-inflicted damage as possible. Competent appraisal is an absolute must, since the value provided by the business’s CPA or by an incompetent or dishonest appraiser could be extremely misleading. Your attorney plays a key role in coordinating the appraisal and business settlement with other issues in the divorce. Additionally, a financial planner (CFP) trained in divorce financial issues can illustrate the outcome of the proposed settlement with tables and graphs, assisting both spouses to see the long-range implications.
Click to hear more guidance from Patricia about closely held businesses.