Getting divorced when you own and run a business together with your soon-to-be-ex presents unique challenges. If you don’t want to continue running the business with your spouse after divorce, you have a case of business divorce colliding with marital divorce.
Business divorce is the separation of two or more business partners formerly bound together as shareholders in a corporation or members of a limited liability company. I’m assuming everyone knows what a marital divorce is. Each situation follows its own rules and when they happen together it is important that you have counsel who understands both.
The number one question in the divorce of a couple that owns and runs a business together is……is the business marital or separate property?
Is the Business Marital or Separate Property?
The question is important because, in a marital divorce, the divorce judge ultimately has to separate the couple’s property and divvy it up between the spouses. This is called “equitable distribution.” Equitable distribution only applies to marital property. Separate property remains for each spouse to keep and do what they want with it.
In simple terms (leaving out some exceptions, more on that below) marital property is all property acquired by either or both spouses during the marriage. Separate property is all property acquired before marriage. Everything you acquired while you were married is owned together as marital property.
When the Business is Marital Property…
Let’s say A and B were married in 2015 and in 2018 formed a business. Each of them owns 50% of the membership interests of the business that was formed as a limited liability company. The LLC is marital property. Now, in divorce proceedings, the court pretty much has the power to distribute the business as it sees fit (in the context of the law of equitable distribution). What is yours in the business is also your spouse’s property and the other way around. The business will be valued and the value needs to be distributed one way or the other.
What many people don’t realize, the divorce court really has incredible power to interfere with whatever business structure you had set up. Let’s say you formed an LLC and have an elaborate operating agreement, which deals with each spouse’s rights and obligations in managing the LLC, their rights to distributions and profits, and their rights to sell to third parties, or force a buyout. These agreements and the New York Limited Liability Company law all pretty much become meaningless once the court gets a hold of this business in a divorce. The court will apply the principles of equitable distribution, i.e. what is fair, what should be given to Spouse A and what to Spouse B. For example, they could order one spouse to keep the business and the other to keep the house.
The court can do what it thinks is fair according to certain factors listed in the law, Section 236 B Domestic Relations Law. It depends on what each spouse contributed to the marriage and the needs of each spouse after divorce. Distribution may be equal, but not always, if the court thinks one person really should have or needs more of that asset, it will give more to that person. If you really want to continue being active in the business, there is no guaranty that you will be granted that wish.
Preventing Divorce Desaster to the Business by Prenuptial or Postnuptial Agreements
Could this have been prevented? Yes, absolutely. You could have entered into an agreement with your spouse anticipating divorce and specifically excluding the business asset from the court’s power. In other words, you could have entered into a prenuptial agreement (before marriage) or even a post-nuptial agreement (after marriage).
“We entered into an operating agreement for our LLC, does that not suffice”, you ask? No, operating agreements usually do not follow the formalities required for pre and post-nuptial agreements. A proper and enforceable pre and postnuptial agreement require a special form of notarization and acknowledgment by the spouses. Operating agreements do not usually follow these formalities.
Negotiating the outcome of Divorce when Owning a Business with a Spouse
Now, not all is lost if you find yourself in this situation. The answer is, to negotiate. Come to a reasonable solution before you have to face the judge in divorce court. Agree on a separation agreement which will then be part of the judgment of divorce. The sequence is as follows: Negotiate and execute a separation agreement. Submit it to the court with some other documents. Never see a judge. The court will review the agreement and other papers and sign a judgment of divorce. Finished. The end. Getting this done properly when a business is involved, requires the expertise of business lawyers and divorce lawyers.
Possible outcomes of negotiation:
- One spouse buys out the other one.
This requires that you agree on the value of the business. If the business is complex, you may have to engage the services of a professional business valuation firm. Which, by the way, would be the first thing the court would order in a divorce. The court cannot decide on equitable distribution if it doesn’t know the value of the asset. Especially if there are other assets. Of course, a buyout requires that there is enough cash to buy out the other spouse. If there isn’t, maybe some sort of financing can be arranged. If that falls through, maybe one spouse gets the house and the other spouse gets the business.
- You sell the business and share the proceeds.
Selling a business requires time and organization. It may possibly go on longer than the divorce, so it could be part of your separation agreement that the business will be sold according to a certain procedure.
- You keep owning the business together.
Given that your marriage failed, one wonders if you can keep the business relationship healthy and functional. But each situation is unique and it could possibly work. One could also consider having only one spouse being active in the business whereas the other spouse is entitled to ongoing profits from the business without any management responsibilities, so as to avoid any friction between the couple. At the end of the day, after the divorce, you would then be “regular” unmarried co-owners of a business. But be aware that a “divorce” of co-owners of a business is not as easy as getting a marital divorce. It is by no means guaranteed. So, it is highly recommended to have agreements in place that expressly deal with all eventualities of the now non-married business owners and the business.
When the Business is Separate Property…
A and B formed a business in 2015 and got married in 2018. Each of them owns 50% of the membership interests of the business that was formed as a limited liability company. The LLC is separate property. Your 50% of that business remains your 50%. The divorce court has no power over separate property, it remains the property of each spouse. Whatever operating agreement you have in place and the law governing the rights of business owners stays in effect.
But wait, there is a possible wrinkle. Part of the business could still be marital property. Enter the concept of “appreciation of separate property”. What is it? The increase in the value of the business after the marriage could still be considered marital property if such appreciation is due in part to the contributions or efforts of the other spouse. So let’s say the business was valued at 100 when A and B got married. When they decided to get divorced it was valued at 200, each spouse having contributed equally to this increase with sweat, tears, and blood. That 100 is marital property. Since both parties contributed equally, it may be a wash. It could get more complicated, if one spouse sort of withdrew from active participation in the business after marriage and thus contributed less to the increase in value.
Another wrinkle. Appreciation attributable to market forces remains separate property. So if the increase in the business is due solely to outside market forces, for example, the value of a business increased because some world event or change in the law gave it a huge competitive advantage, this increase will remain separate property.
Getting divorced when you own a business together, requires a business lawyer and a divorce lawyer, ideally one who knows about both, such as myself. If the business is marital property, your best bet is to negotiate a reasonable business separation with your spouse rather than have the divorce court interfere in your business. If you are thinking of starting a business with your spouse or are already running one, think about a postnuptial agreement. It could save you a lot of headaches later.