Business owners face unique issues when divorce proceedings begin
by Tate K. Sterrett and Gena G. Morris
Tate K. Sterrett and Gena G. Morris are shareholders with Horack, Talley, Pharr & Lowndes PA in Charlotte. Both attorneys have been certified as specialists in family law by the N.C. State Bar Board of Legal Specialization and are fellows in the American Academy of Matrimonial Lawyers. They represent business owners, professionals, key employees and others involved in marital disputes and in need of advice and services to equitably distribute assets and debts, determine alimony and child support and resolve issues concerning custody and parenting of children.
Certain divorce issues are unique to business owners. This article highlights a few of the most common property and support issues so divorcing business owners will be aware of what is at stake and can plan accordingly.
Any interest in a business can be valued by a valuation professional for equitable distribution (property settlement) purposes. Methods for valuing closely held businesses include: the cost approach (book value), the income approach (capitalization of the income stream), and the market approach (using comparable sales). Retaining a good valuation professional can be as important as retaining a good divorce lawyer, but you want the lawyer to hire the valuator so, at least initially, the report will be a protected attorney-work product.
Most business owners with partners have operating agreements or shareholders’ agreements that contain buy-sell provisions with formulas or guidelines for determining the value of the ownership interests. While the buy-sell provisions are instructive, they are not conclusive in determining value for divorce purposes.
While book value might be the most objective and easiest way to value a business, it generally produces the lowest valuation number and is usually disregarded or weighted less than the values produced by the other approaches.
Separate property that increases in value
If a business is started before the marriage or is acquired by inheritance or gift during the marriage, it is separate property. But what happens if the value of the company increases during the marriage and before the separation? Will the increase in value be classified as marital property and be subject to distribution by the court? Yes, if the increase in value is due to active forces such as the investment of marital funds or management efforts by the owner spouse. No, if the increase in value is passive and results from sources outside the marriage — for example, the management skills and labor of a third party (such as a plant manager or the chief operating officer), market forces or government action. The presumption is that the increase is active and therefore marital, but it is a rebuttable presumption.
Assume that the business is marital property and the cost basis, for tax purposes, is $50,000. Also assume that the value of the business interest has increased to $300,000 on the date of separation. If the owner were to sell his or her ownership interest for $300,000, he would have a taxable gain of $250,000 and would pay income taxes on that gain. We refer to this potential income-tax liability as imbedded taxes. Will the court consider these imbedded taxes in valuing the business interest for divorce purposes? No. The value of the business interest is determined without regard to unrealized taxes imbedded in the ultimate value. The court can consider imbedded taxes in deciding what is a fair division of property but often divides property in shares of equal value and does not give the business owner extra assets to offset the future tax liability.
Company financial statements
In determining the value of the ownership interest, neither the business valuator nor the court will accept the company’s financial statements at face value, even if prepared by a certified public accountant. Business valuators frequently make adjustments to the balance sheet and the income statement. The amount of depreciation may be added back to the income statement, thereby increasing the company’s net profit for purposes of the valuation. Company expenses might be reduced to the extent they consist of the payment of the owner’s personal expenses (vehicles, cellphones, club dues and the like). This will increase the net profit for purposes of the valuation.
Alimony and child-support obligations are determined, in part, by the amount of the payor’s income. For support purposes, the payor’s gross income is likely to be an amount different from the gross income reported to the Internal Revenue Service on an income-tax return.
- W-2 statements. If the business is a C-corporation and the owner’s compensation is reflected on a W-2, his gross income will normally be the amount shown in line five for Medicare wages, not the amount shown in line one.
- Income versus cash distributions. If the owner receives a Schedule K-1, line one will reflect “ordinary income,” this is the amount reported on the income-tax return. The cash distributions you receive from your business in any given year are likely to be different from the amount on line one of the Schedule K-1. In early years of a business, the owners often do not distribute all of the net profits but instead retain some amount for future expansion or for cash-flow purposes. In later years, cash distributions may exceed income, as the owners release some of the previously retained earnings. So, which number is used to determine income for alimony and child support? The judge has the discretion to use either number. An analysis of the company’s financial circumstances will be important as is the explanation from your CPA and the advocacy of your attorney.
- Partnerships, S-corporations and proprietorships. A business owner’s income, for support purposes, is not necessarily the same as his or her share of the net profit of the business. Gross income from these business ventures is defined as gross receipts minus ordinary and necessary expenses required for business operations. Such expenses do not include amounts allowed by the IRS for accelerated depreciation, investment tax credits or other expenses deemed inappropriate by the court. Inappropriate expenses typically consist of personal expenses of the owner paid by the company. These adjustments might result in a company profit that differs from the amount on the company’s financial statements and tax returns, thereby increasing the owner’s income for support purposes.
- Net income. Net income is a consideration in all alimony cases and in those child support cases where a family’s combined gross income is greater than $300,000 per year. Net income consists of gross income reduced by income, Federal Insurance Contributions Act and Medicare taxes. In determining that income, the court does not consider contributions to retirement plans, payments for health-insurance premiums, deferrals of income in connection with a deferred compensation plan or any other voluntary reduction in gross income.
The alimony double dip The net income or cash flow of a business is often used to value the owner’s interest in the company to equitably distribute property. The owner’s alimony obligation will be based, in part, on his or her income. If the business profit is considered as part of the owner’s income for support purposes, then the same income stream that was used to value the business is being used a second time — giving the spouse two bites at the same apple. The judge is supposed to consider this in deciding the amount and duration of alimony, but nothing requires the judge to ignore the business income in deciding support issues.