Many people own and operate small businesses, some as proprietorships and others as closely held corporations or limited liability corporations. It is important to understand how the operation of different types of business structures impact marital property and divorce.
Recall that all income earned during a marriage is presumed marital property and that all assets purchased during the marriage are presumed marital property. In the case of a sole proprietorship, all net income flows directly to the spouse and shows on the federal tax return jointly filed by the couple. It is very hard to argue, in the absence of a prenuptial agreement, that the proceeds of a sole proprietorship are not marital property. As a consequence, the assets of this business will be considered marital property subject to division, which means the ability of the business to continue could be in jeopardy if the spouse owning the business cannot pay out or offset the equity owed to the other spouse upon divorce.
In a limited liability corporation, the spouse has an equity share as a partner in the LLC, and each year that spouse’s share of the profits of the LLC gets reported as income on the spouses’ joint tax return. Law firms and medical practices are frequently organized as LLCs because it provides the ease of a partnership with the limited liability protection of a corporation. If the LLC began prior to the marriage, those interests owned by the spouse would be separate property. However, all income and increased equity that occurs during the marriage will be presumed marital property. In the absence of a prenuptial agreement, the spouse who has a share in the LLC will likely owe to the other spouse half the equity increase during the marriage. Also, if the partner tried to avoid taking shares in a given year and keeping them in the business, those funds could be subject to classification as marital property. A spouse could also argue that the increase in value over the course of the marriage warrants a share of the spouse in the LLC.
In a classic C corporation, the spouse has shares of stock in the business, potentially options on stock to exercise in the future, and may receive profits ask K-1 distributions every year that the company makes a profit. As with the LLC, if the original shares were created prior to the marriage, those shares will be marital property. Any profits and distributions received during the marriage are presumed marital property, as would any increase in stock values earned during the marriage and stock options awarded during the marriage.
Each business form creates potential problems for the business owner or shareholder. What can an owner or shareholder do to minimize exposure?
The best protection is a prenuptial agreement where the other spouse would agree that all ownership acquired during the marriage stays with the business owner spouse. However, that level of exclusion could be construed as too extreme or one-sided as to be unconscionable, particularly if the other spouse contributed in ways that helped the owner spouse accrue the equity. But an agreement that sets a percentage cap to the other spouse on increased equity value during the marriage would have a greater chance of withstanding a challenge.
The key concern of any business owner in this situation is to assure the ability of the business to continue smoothly. A prenuptial agreement can assure this happens by structuring payments of equity owed in a way that limits the “hit” to the shareholder. Another negotiating point might be for the business owner to trade some or all equity owed to the other spouse for some other marital asset.
When both spouses operate the business together, the spouses need to work out how the business would operate moving forward. If they cannot work together, one spouse will need to buy the interest of the other out, and that value can be a bargaining point in the divorce, knowing that destroying the business hurts both spouses.
Business owners or shareholders should give serious thought to these issues prior to entering marriage and certainly prior to divorce.
If you have questions about business ownership and divorce, contact us – we can help.