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Business Interests and Divorce

Posted Wednesday, March 24, 2010 by Michael A. Larson

alt textAn already painful divorce can be made even more painful and messy when the spouses and their attorneys consider the valuation and division of business interests and assets. This article touches on some of the issues surrounding valuation and division that family lawyers should consider when dealing with business assets.Community Property Agreements

Although Washington law distinguishes between separate property and community property, some couples getting married choose to go further by converting their separate property to community property through a community property agreement. While this is certainly a generous gesture, it can create problems in the characterization of business and other assets when dissolved.

One form of this type of agreement only converts separate property into community property upon the death of one spouse. Another form, generally called a “three-pronged” community property agreement: (1) converts all currently owned property to community property; (2) provides for all property acquired by the spouses in the future to be community property; and (3) provides for all property to be converted into community property at the time of the death of either spouse. This type of agreement will affect the division of property at dissolution by converting separate property to community property. It is important to be aware of any such agreement a spouse may have made before marriage.

In addition, courts will generally enforce community property agreements even if one party failed to read or understand it or if a party signed it without consulting with independent legal consultation. Thus a family law practitioner should ask her client about any potential community property agreements when valuating business assets.

Divorce and Wills

After divorce, people generally make new wills removing their former spouse as a beneficiary. To supplement this, Washington law provides for the automatic revocation at dissolution of any provision allowing for the transfer of non-probate assets to the individual’s spouse. Non-probate assets include benefits under a life insurance policy, employee benefits package, or IRA. However, dissolution proceedings can often stretch out, and if one spouse were to die before the divorce decree were finalized, it is possible that assets could still go to the surviving spouse. Thus, in order to protect his client’s business assets, a family lawyer should consider changing his client’s will at the beginning of the dissolution proceedings.

Buy-Sell Agreements

If one of the spouses has significant business assets, the valuation of these can cause difficulties during dissolution proceedings. One aspect of this is the valuation of businesses where the owners have completed buy-sell agreements. Buy-sell agreements essentially control the transfer of shares of the business, often allowing the corporation the right to buy shares of a departing shareholder at a reduced price. As a result, the market value of the shares and the valuation method set forth in the buy-sell agreement often result in different numbers. If a court is valuing shares, the existence of a buy-sell agreement is one factor to consider but is not the only factor. However, an accurate and persuasive estimate of the buy-sell value of the shares will be helpful to the stock-holding spouse, just as such an estimate of the market value will help the non-stockholding spouse.

Courts will generally uphold the terms of a buy-sell agreement or other partnership agreement in valuing a partnership interest of one spouse. If the partnership agreement made no provisions for discounting a partner’s interest upon sale, courts will bind themselves to that agreement and will not discount the value of the interest by sales costs, minority interest, and relevant taxes. Therefore, the terms of such an agreement should be considered when starting divorce proceedings. Business owners should consider buy-sell agreements so that in the event of a divorce, they can anticipate business planning and survival of the business.Valuation of Business Interests – Goodwill

Professional goodwill refers to the tendency of customers to return to the same business because of its reputation or other reasons, regardless of its location. A business with goodwill will have a value higher than just the sum of its assets. During divorce proceedings, the valuation of the goodwill of one or both of the spouse’s businesses may become an issue, and so it is important to become familiar with the different ways of valuing goodwill and other factors.

Washington courts have recognized five main methods of valuing professional goodwill. The first three are accounting formulas. The fourth is the market value approach, which considers how much the business would sell for. The fifth is the buy-sell agreement method, which values the goodwill based on the amount of a recent sale. Courts have stated that these methods should be used in conjunction such factors as ”the practitioner’s age, health, past demonstrated earning power, professional reputation in the community as to his judgments, skill, knowledge and his comparative professional success.” Courts must outline their reasoning for finding goodwill at a particular value, so it is important for an attorney to present credible evidence supporting valuation of her client’s or their spouse’s professional goodwill. Goodwill can potentially be a very large asset, so familiarity with its valuation is important for a family law practitioner.

Valuation of Business Interests – Stock Options

Stock options that are unvested during the marriage but vest after separation of the parties complicate the valuation of property. The Washington Supreme Court has adopted a complex rule for determining which of these options are separate property and which are community property. First, courts determine whether the options were given to the spouse in consideration of past, present, or future employment services. Then the court applies the “time- rule” formula, which is a fraction involving the time of the separation vis-à-vis when the options were given and when they are exercisable. This rule does not apply to socks purchased during the marriage, however, so it is important to have a good grasp of all of the dates involved. Like goodwill, stock options can be a potentially large asset, and a family lawyer should be familiar with how they are valued and how ownership is decided.

Tax Considerations

Taxes can be very important in determining property settlements and child support obligations after a divorce. For example, Washington courts have held that capital contributions a self-employed spouse makes to his firm that are not deductible for federal income tax purposes do qualify as “normal business expenses” for the purpose of determining child support obligations, and so are deductible.

The impact of capital-gains taxes can also be significant. Washington courts will only reduce the value of an asset for property settlement purposes by considering the effect of capital-gains tax if evidence is presented showing an imminent sale of the asset and sales costs. The issue of sale of an asset is essential, whether a spouse does or does not want capital-gains taxes considered. Thus, familiarity with tax implications of divorce is essential for a family law attorney.

“Meretricious Relationship” Dissolutions

Washington recognizes the meretricious relationship doctrine, which states that certain stable, cohabiting unmarried couples may take advantage of the community property scheme. This doctrine has been applied to characterize the increase in value of a cohabitant’s individual business during the relationship as community property, since it was achieved by community labor. An individual’s business interests will not necessarily be shielded from valuation and division simply because the parties were not actually married, so the nature of the relationship is important to consider in the division of business and other assets. Many business valuation issues are applicable in dissolving a meretricious relationship and important for a family lawyer to be aware of.

For more information, please contact Michael Larson at 206-340-2008.

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