By: Leslie A. Satterlee and Ben Himmelstein
Going through a divorce is difficult in every way, but things can get especially difficult and complicated when you own a business with your spouse. There are three main avenues that people may take regarding the community business: buying out the other spouse, selling the business, and continuing to own the business together.
Before going into those three options, there are some other considerations to keep in mind. When dividing assets and a business in a divorce, it is important to identify whether it is community property or separate property. This classification depends primarily on whether the business was formed prior to the marriage, or whether the funds that were used for the business were acquired during the marriage. If a business is found to be separate property of one spouse, there may still be community interest to divide, but the Court is more limited as to disposition of the business. For purposes of this article, we assume the business is community and owned only by the spouses.
Buying out the other spouse
This first option is the most popular and as the name suggests, one spouse simply buys the other spouse’s interest in the business.
To do this generally, the parties need to obtain a business valuation. Although the spouses may agree on the value of the business, usually there is at least some debate. The valuation of the business’s value can be done in one of three ways: the income approach, the market value approach, and the asset approach. This valuation is typically done through a third party like an accredited senior appraiser, a certified business appraiser, or a certified public accountant accredited in business valuation.
Once a value is determined, then one spouse will buy the other out. An example of this would be: Scott and Karen jointly own an ice creamery and the fair market value is $500,000. Karen would like to continue the ice creamery whereas Scott would like to set up an e-commerce business after the divorce. Karen can buy Scott’s half of the business interest by paying him $250,000, typically drawn from her portion of other community assets (e.g. retirement accounts, savings accounts, or equity in real property). If the parties own a residence with $500,000 in equity, for example, it is simple enough for Karen to waive her interest in the home in exchange for Scott waiving his interest in the business. Karen would become the sole owner of the ice creamery.
Selling the business
The second option is to sell the business and divide the proceeds between the two spouses. This option may come into play when a buyout of the other spouse’s interest is not possible, e.g. because there are insufficient community assets to offset the or the spouse who wants to keep the business cannot qualify for a loan, or the parties cannot agree upon a value or who should continue to own the business post-dissolution.
This last option is normally the least preferred choice out of the three because the ex-spouses would continue to be involved in each other’s lives due to the business. The reasons why spouses may elect to stay co-owners include instances when there is too much debt attached to the business to sell, the parties both desire to get out of the business in a relatively short timeline (including retirement), or both spouses are gainfully employed in the business and, despite their divorce, have a good professional relationship.
For many, imagining continuing to own a business with your ex-spouse is preposterous; however, circumstances sometimes require this kind of creative solution. Particularly, during times of financial crisis or economic downturn (such as during a global pandemic) remaining co-owners – at least temporarily – may be the only feasible option.
How to maintain joint ownership of a community business after divorce
In the courtroom, judges can only award the business to a spouse with appropriate offsets or order the business to be sold and proceeds divided. The court cannot order that the parties maintain joint ownership of the business. In a recent case, Dole, the Court of Appeals of Arizona found that Title 25 (i.e. marital property) limits the court’s jurisdiction to just dividing community property and affirming separate property at the time of dissolution. Essentially, the court cannot order parties going through a dissolution to keep their business after the dissolution. If the court was to order the parties to continue to have joint ownership of the business, it is usually limited to extremely short periods (e.g. While a sale is pending).
Joint ownership can only be done through a settlement agreement which is usually achieved through private mediation. Furthermore, investing in the process of resolving your divorce through negotiation pays off in the long run in order to maintain a healthy business instead of having a judge ordering the business to be sold.
Practical considerations of joint ownership after divorce
What would co-ownership look like? The ex-spouses could either agree to completely own the business together or agree to jointly own the business together for a specified time until other options become viable. They may agree for one spouse to manage daily operations for the business while the other spouse becomes more of a “silent partner,” especially if these are like the roles they occupied during the marriage. The parties could also agree to hire a manager to operate the business and restructure their ownership so that they operate more as shareholders and directors to avoid conflict.
For this option to be effective for both parties, it is essential to restructure the way the community business was owned to take into account the fact that the business owners are not married anymore. Since understanding this is so imperative, we would recommend talking to a civil attorney to help the restructure through a partnership agreement or business operating document between the two co-owners.
Ben Himmelstein, a business attorney in Phoenix with Radix Law, has helped many businesspeople restructure their companies after a divorce, create new operating agreements, and otherwise navigate the challenges of significant life changes while owning a business. He provides some additional advice below:
What is a Limited Liability Company Operating Agreement?
Unlike corporations, limited liability companies (LLCs) are really creatures of agreement. Corporations, on the other hand, are much more strictly governed by each state’s particular statutory scheme. And, while there are fairly thorough statutes governing LLCs, most of the statutory provisions can be modified by way of an LLCs’ operating agreement. Of course, LLCs are the more preferred structure for most small to medium sized businesses for various reasons, including flexibility and taxation.
That is why it is extremely important for LLCs to have thorough and clear operating agreements. The agreement consists of the “rules of the road” between members, if member-managed and managers and members if manager-managed. It should attempt to define the contours of the business relationships and determine what will happen if disagreements arise before they do. So, while an operating agreement cannot possibly address every eventuality, it can certainly address common disputes and provide mechanisms for resolution.
Each operating agreement can be customized for the specific business and may be more complex where there are multiple members or unique circumstances (such as spouses continuing to own a business together after a divorce). No matter how much people love or trust the other members in the business when it was formed, the operating agreement is there for when relationships sour over time, and they often do.
Some key points an operating agreement should address: (i) who controls the day-to-day decision making; (ii) whether distributions of profit (including distributions for members to pay taxes) are required and when; (iii) what records members are entitled to see; (iv) how members can exit the business if necessary and for how much; (v) whether one party can force another out of the business; and (vi) how the members will handle conflicts between themselves. These types of provisions are critical, especially when the members are a married couple because the most predictable thing that can happen in that case is divorce.
Conflict of Interest
According to the Arizona Rules of Professional Conduct, one attorney can represent the “to-be-formed” LLC when creating the operating agreement so long as the members’ interests are generally aligned. But, the attorney must get a conflict waiver and cannot “prefer” one member’s interests over the other. So, the attorney merely writes the agreement up and brings up issues the parties need to resolve, as opposed to advising the members one way or the other.
If the members in an LLC are getting divorced, it is not advisable to use one attorney to draft an operating agreement. Each member should utilize separate counsel because their interests are completely divergent from each other. For example, one member-spouse may want to keep the business going and, the other may want to sell it. Or, one member-spouse may want to reinvest profit every year and the other may want to receive steady profit distributions.
Realistically, how successful is this?
Many divorcing couples continue to own businesses together. Obviously, the success depends on how acrimonious the couple is towards one another. Predictably, the more clearly defined the “rules of the road” are, the higher the likelihood of success of jointly owning a business post-divorce. But, often it is simply best for one member to buy the other out unless the divorcing couple can set aside their personal differences and unite towards a common goal.
Leslie A. Satterlee is a partner with Woodnick Law and has been practicing family law exclusively since graduating cum laude from ASU’s Sandra Day O’Connor College of Law.
Ben Himmelstein is a partner at Radix Law. He is a business lawyer whose practice focuses on business disputes and transactions. His practice includes business break-ups, misappropriation of trade secrets, business torts, sales contracts, buy and sell agreements, and non-compete and non-solicit agreements.