TWO SIDES OF THE COIN
Two Sides of the Coin is a series of articles written by Ian Steinberg, a matrimonial and family law attorney, in conjunction with an array of other professionals from different industries. The series provides insights into issues from the perspective of each party to a divorce. Each article provides readers with practice tips that are helpful when navigating through the divorce process.
What Happens to a Business in Divorce?
By Ian Steinberg, Esq. and Jason Soman, CPA/ABV, ASA, CFE, CDFA®
Divorce is a difficult process. There are financial and emotional aspects to a divorce, not to mention the additional challenges that exist when children are involved. If one or both spouses own a business, there can be an extra layer of complication.
A business owned by either or both spouses will likely be the epicenter of the financial issues of the case. There may be questions about whether or not a business, or part of it, is marital property, and how much the business is worth. The amount of income earned from a business will have implications on the amount of spousal support and/or child support paid by each party. Determining the valuation and income will require a significant amount of documentation, most of which is typically held by the spouse who owns the business (the “Titled Spouse”).
Whether you are the Titled Spouse or the Non-Titled Spouse, there are murky waters that must be navigated when a business is involved. Here are some important considerations to keep in mind if you are divorcing with a business.
Marital and Separate Property
While the income earned from a business is important for determining spousal support and child support (which is discussed in greater detail below), the business is also considered an asset for purposes of equitable distribution. As such, the way a business is divided during a divorce will largely depend on whether the business is marital or separate property. The “division” typically does not mean that the Non-Titled spouse will own a portion of the business, but instead, the business needs to be valued and a buy-out will be paid.
In New York, if a business is formed by the Titled Spouse during the marriage will generally be considered marital property. While other marital property, such as bank/investment accounts are typically divided equally, businesses are divided “equitably.” This means that the Non-Titled Spouse most likely will not necessarily be entitled to 50% of the value of the asset, and instead, he or she will be entitled to a percentage that is typically between 10% and 40%. Therefore, the percentage that the Non-Titled Spouse will be entitled to is discretionary and is dependent on both the direct and indirect contributions made by the Non-Titled spouse. For instance, direct contributions can include being the bookkeeper when the business was started or working as an employee of the business. Indirect contributions include taking care of children and/or the home, which allowed the Titled Spouse to have the time to work at the business.
On the other hand, if the Titled Spouse owned the business prior to the marriage, the business is generally considered separate property. However, there can still be a marital competent of the business that is subject to equitable distribution. The question then becomes what, if any, increase in the value of the business occurred during the marriage? And then what portion of that increase was related to active marital efforts and/or financial investment and what portion is due solely to passive market forces? In New York, this is important as the active appreciation of separate property may be considered marital property, while passive appreciation of separate property will remain separate property. This concept can be understood by way of example:
Active Appreciation – Medical Practice – John and Jane Doe got married in 2012. At the time of marriage, Jane owned her own medical practice. In 2012 the practice was worth $100,000. At the date of commencement in 2022, the practice was worth $1.1 Million. Since Jane’s sole source of employment during the marriage was her work at the medical practice, the $1 Million in appreciation is considered active and therefore subject to division upon divorce. John would therefore be entitled to a percentage of the $1 Million, which percentage depends upon his direct and indirect contributions to the medical practice.
Passive Appreciation – Partnership Interest – In addition to Jane’s medical practice, John was the owner of a 1% limited partnership interest in a private equity fund (the “LP Interest”) that was inherited from his grandfather in 2015. John is employed as a teacher and has no active involvement in the management of the LP Interest whatsoever. At the time of inheritance in 2015, the LP Interest was worth $50,000, but at the time of divorce, it was worth $500,000. The entirety of the LP Interest, including the appreciation, will be considered John’s separate property because the appreciation was passive.
Business Income for Maintenance and Support
Determining one spouse’s obligation to the other for child support and spousal support are often the primary financial issues in divorce actions. Both child support and spousal support obligations are determined by statutory formulas. The statutory formulas are based on both parties’ incomes and calculate the appropriate support obligation. For a typical W-2 employee, determining income available for support should be straightforward. However, when there is a business involved, determining available income becomes more complicated.
There are many reasons why determining the income of a business owner is complicated. At the outset, business owners are in charge of deciding how much they pay themselves. Further, a business owner can determine how much money to keep in the business (which accounts would not be subject to an equal distribution upon divorce) and how much to distribute to themselves (which accounts typically are divided equally upon divorce). For instance, a doctor can purchase a Picasso painting for the waiting room of his/her office (a business asset) instead of paying himself/herself as income (a marital asset). This is not to mention the fact that business owners can run personal expenses through their business, including vacations, cars, etc. Suffice it to say, determining a business owner’s income is challenging, making calculating child support and spousal support an even more difficult task than with typical W-2 employees.
This is even more complicated when a divorcing party owns a passthrough entity, such as an S-corporation, LLC, or partnership. This is because the income from the business will not necessarily be equal to the distributions they receive. Oftentimes, additional documentation will be needed to understand the true cash flow available. There is often an overlap between determining income and cash flow available for support and the valuation process. It is common that the same valuation and forensic CPA will also analyze income.
Valuation and Equitable Distribution of a Business Interest
Unlike other assets with a readily ascertainable value such as a bank account or investment account, the fair market value of a privately held business will need to be valued by a qualified business valuation professional. The parties can each hire their own competing business valuators or agree to hire a neutral that works for both sides of the coin.
When a couple owns a business, it is common for a significant portion of their marital wealth is tied to their illiquid privately held business or businesses. This presents a challenge for the Titled Spouse when he or she is buying out the other’s interest in the business. For example, if the business is valued at $10 million and the Non-Titled Spouse is entitled to 25%, the Titled Spouse will need to pay $2.5 million to buy out his/her spouse. Depending on the rest of the “marital pot,” this may be a challenge. The Titled Spouse may have to borrow, sell investments, or severely constrain his/her liquid resources to payout the value of the marital interest in the business.
The starting point of any valuation is the financial statements of the business. Oftentimes, the Non-Titled Spouse will dispute the true earnings and value of the business. This is prevalent in a situation where the business owner controls the business and receives perks such as travel, car, gas, excess compensation, and entertainment. Therefore, business valuations in divorce are frequently performed by those with a background in forensic accounting.
To that end, the business valuation process for purposes of a divorce is typically a very document-intensive process, The Non-Titled Spouse often wants the person valuing the business to “look under the hood,” especially if there are concerns of “divorce planning” or financial impropriety. Therefore, valuation professionals in divorce cases typically request detailed books and records, site visits, interviews with management and attend depositions to get all the necessary facts.
On the other side of the coin, the Titled Spouse will frequently perceive detailed document requests as onerous, a waste of time, or not relevant. When the Titled Spouse does not cooperate and disputes the need to produce evidence the other is requesting, the information-gathering process can take several months or sometimes years to complete. The Titled Spouse can often perceive this behavior as suspicious or evasive, thus making the divorce process more complicated.
Cases involving a business valuation that doesn’t settle ultimately go to trial. At trial, each valuation professional will submit their opinion to the court, and the judge will weigh the relevant opinions and testimony and issue a decision. When a judge decides a case, it presents risks to both sides as the judge’s ruling can go either way. The risk, plus the time and expense required to argue a case involving a valuation is what motivates most cases to settle. This is also a reason why a prenuptial agreement may be a beneficial tool for those who own a business that was started prior to his/her marriage.
Whether you are the spouse who started a business or the spouse who may have made both direct and indirect contributions to the business, it is important to keep the above in mind if you find yourself going through a divorce. The more aware you are of the challenges presented when a business is involved in a divorce, the more likely you are to walk away with a beneficial outcome.
Ian Steinberg is a matrimonial and family law attorney with Berkman Bottger Newman & Schein. He can be reached by email at firstname.lastname@example.org or by phone at (212) 867-9123.
Jason Soman is a divorce forensic accountant and business valuation professional with Accounting & Valuation LLC, headquartered in Boca Raton, FL. He can be reached at email@example.com or by phone at (561) 419 6111.