We’ve all heard the family business statistics before, but they’re worth repeating. Approximately 80% to 90% of US businesses are family firms. They range in size from small “mom-n-pop” businesses to the likes of Walmart, Ford, Mars, and Marriott. Family businesses in the United States represent 57% of gross domestic product and employ 63% of the US workforce.
Nearly 33% of the businesses that make up the S&P 500 are family controlled. Family businesses are also more successful than non-family businesses, with an annual return on assets that’s 6.65% higher than the annual return on assets of non-family firms. Unfortunately, only a little more than 30% of family businesses survive into the second generation. By the third generation, only 12% of family businesses will be family-controlled, shrinking to 3% at the fourth generation and beyond. When love turns to hate there can be a lot of collateral damage, including damage to the family business. Approximately, 50% of all marriages end in divorce. That number rises to nearly 70% for second marriages. Divorce can be devastating, with long-lasting negative effects on the individuals involved as well as their children.
By its very nature, the act of splitting up is destructive and as such divorce can many times bring out the worst in people. If up to 90% of businesses in the United States are family
businesses and divorce rates are so high, it should be no surprise that if protective steps are
not taken in advance, divorce can result in not just the breakup of the family but also of the
family business.
A family business tends to be the most valuable asset of a marriage. Typically, it is also
inherently illiquid. That means that it is difficult to divide in a divorce without either having a
divorced spouse as a partner or having a forced sale at potentially fire sale prices. Neither of
these results is ideal, but if planning is not done in advance of a divorce (and ideally before the marriage), they could become reality under the equitable distribution rules applicable to divorce in most states.
Fortunately, a variety of advance planning techniques are available, including premarital agreements, trusts, and buy-sell agreements. While none of these techniques are necessarily foolproof, they can be highly effective (particularly if used in combination) in protecting the family business in a divorce. Better to plan for the worst (in consultation with your legal counsel) and hope for the best.
How property passes in divorce:
Although some divorcing couples decide how to divide property between themselves (perhaps with the help of a mediator), many do so under the supervision of a court, which applies the laws of the specific state when dividing the property. There are two types of state distribution laws - community property and equitable distribution.
There are nine community property states (Arizona, California, Idaho, Louisiana, Nevada,
New Mexico, Texas, Washington, and Wisconsin).
The other 41 states apply equitable distribution.
Two states, Alaska and Tennessee allow couples to create community property by
agreement by creating a community property trust. Whatever regime a state chooses, state laws can vary in how they apply community property or equitable distribution in divorce.
Under equitable distribution there are two basic types of property–separate property and
marital property. Separate property is property owned by each spouse prior to the marriage,
along with any appreciation on such property as long as it is not connected to the efforts of
either spouse.
Separate property also includes inheritances, even, in most states, if such inheritance was received during the marriage.
Marital property typically includes property acquired or accumulated during the marriage.
Separate property can be transformed into marital property either (i) because of the active
management of one of the spouses during the marriage (in which case appreciation on
separate property becomes marital property) or (ii) because separate property was commingled with marital property. Separate property is typically not up for grabs in a divorce, but it can be taken into consideration when determining the equitable distribution of the marital property.
Although the status of property as separate property won’t protect it from equitable distribution in every state, an individual bringing an interest in a family business into a marriage may nonetheless want to make sure that such property is treated as separate property (note that it is likely that appreciation on the family business during the marriage because of the efforts of one of the spouses will be considered marital property).
So how does one preserve separate property treatments?
Generally, the key is not to commingle the separate property with marital property. Clear
identification and documentation of ownership may help keep interests in a family business
separate property, as may keeping liquid assets in a separate account. Utilizing a revocable living trust to own the separate property can also be helpful. A good rule of thumb is that the other spouse should not be a trustee of the revocable living trust or have any powers over the trust under a power of attorney. Consulting legal counsel regarding the specifics of your situation is essential.
In a community property state, all of the assets of a married person are classified as community property or separate property. In a divorce, community property is typically divided equally between the two spouses, while each spouse is allowed to keep their separate property.
Premarital agreements:
Properly structured, premarital agreements are among the most effective mechanisms for
protecting family business interests in a divorce. They are, however, potentially problematic from an emotional point of view, particularly in the context of a first marriage. Asking your spouse to execute a premarital agreement is not necessarily the best way to start a marriage.
But what if the family business required all owners to enter into premarital agreements? That would seem far more palatable.
Premarital agreements deal with what happens to property in the case of divorce or the
death of a spouse and are typically entered into before second marriages, among other
situations such as where a family business is involved.
Postnuptial agreements:
Postnuptial agreements are marital agreements entered into after the marriage. But it should
be noted that postnuptial agreements are still in their legal infancy and are less reliable regarding enforceability than premarital agreements.
Trusts:
Trusts can be highly effective in protecting family business interests in the context of
divorce. Such trusts fall into two broad categories - third party spendthrift trusts and
self-settled trusts (either domestic or offshore).
Buy-sell agreements
Many times there are several owners of a family business and neither they nor the divorced
owner want to go into business with the other spouse upon divorce. Without a premarital
agreement or trust in place, this could clearly be the case. Fortunately, there is another kind of
agreement known as a buy-sell agreement that can prevent this from happening.
A buy-sell agreement is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder’s interest, either by other shareholders (in a cross-purchase agreement); the business itself (in a redemption agreement); or some combination of the other shareholders and the business (in the case of a hybrid agreement) upon the occurrence of certain events described in the agreement (the
so-called “triggering events”).
The most important of the triggering events is the death of a shareholder, but others include the divorce, disability, retirement, withdrawal or termination of employment or bankruptcy of a shareholder.
A buy-sell agreement’s primary objective is to provide for the stability and continuity of the
family business in a time of transition (like divorce) through the use of ownership transfer
Restrictions.
Typically, such agreements prohibit the transfer to unwanted third parties (like divorcing
spouses) by setting forth how, and to whom, shares of a family business may be transferred.
The agreement also usually provides a mechanism for determining the sale price for the
shares and how the purchase will be funded.
Although the non-owner spouse is typically not a party to the buy-sell agreement, if they review the document and signs an acknowledgement that they are aware of the agreement and has reviewed it, this could prevent a claim in divorce that the non-owner spouse was not aware of the buy-sell agreement.
Combination of methods:
While keeping property separate during a marriage, premarital (and even postnuptial)
agreements, spendthrift trusts and certain self-settled trusts, as well as buy-sell agreements,
can each be effective in protecting family business interests in a divorce, they are more
effective when used in combination.
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Sources:
Disclaimer:
Information provided is for informational purposes only, and does not constitute an offer or solicitation to sell, a solicitation of an offer to buy, any security or any other product or service. Accordingly, this document does not constitute investment advice or counsel or solicitation for investment in any security. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.