With our wedding day 1 month from today, November 21, marriage is on my mind. For those of you that are not familiar with my decision to leave corporate law to start my own law firm, it was not a solo decision.
Of course despite our almost wedded bliss, as a business owner, it is your responsibility to consider how getting married may impact your business. This especially means contemplating what would happen in the unfortunate event you end up going through the divorce.
Let’s start really with the two theories of property division in the US. There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Alaska is an opt-in community property state that gives both parties the option to make their property community property. This means the rest of the country is a non-community property state.
In a community property state, spouses equally own all money earned by either one of them from the beginning of the marriage until the date of separation. This is referred to as either “community property’ or “marital property.” In addition, all property acquired during the marriage with “community” money is owned equally by both of the spouses, regardless of who purchased it. The property that is not included, is any property obtained during the marriage by gift (not a gift from your spouse but a third party), bequest, devise or descent, or property otherwise provided for in a written agreement. Like community assets, all debts contracted from the beginning of the marriage until the date of separation is community debts. Essentially, after a couple gets married, all their income, assets, and debts become merged into one marital pot.
All non-community property states divide assets ‘fairly’, where divorce law requires a judge to divide property accumulated during a marriage according to each party’s involvement in obtaining the property and the use of marital funds.
Before and After Marriage
The percentage of the business that you owned before your marriage will typically remain yours after you are divorced. If that percentage of the business has appreciated (which we all work so hard for, growing our impact and scaling our income), however, the court will consider the growth to be marital property and will divide it according to state law.
In community property states, your spouse will receive one-half of the value.
In all other states, your spouse will receive the portion of the value that the judge allocates to them based on their involvement in the business’s growth.
Notice that in both instances I said “value” not “ownership”. This means your spouse’s interest in your business interest does not translate into ownership percentages (aka: equity) that would impact the company’s management or inner workings, however, this valuation can have a dramatic impact on your future not only personally but the future of your business.
I am going to use Arizona as an example because while Arizona is classified as a community property state, in Arizona, the law requires an “equitable” division (which looks more like the fairness principle of non-community property states). An equitable division does not always mean an equal division, though I think that can often be a subconscious measuring stick. Unlike many other states, Arizona does not have a statute that sets out a list of factors that a judge must consider when the judge distributes community property. While some general rules apply, the judge has broad discretion, which can be scary to hand over decision making for your life and business to another though unbiased party. For instance, a judge can order the business to be sold or its assets to be liquidated. There is also what is called an “in-kind” distribution which means each spouse walks away with comparable assets. Unless the divorce decree indicates otherwise, any value your business earns after your divorce belongs to you.
What this means for the two businesses I built. I am the sole owner of my businesses and I built them while we were dating and engaged. However, I like most of you plan to have my business continue to grow and appreciate for years to come. So while before November 21st the income and value of my business is separate property, after November 21st my income and the value of my business will be community property.
For those of you who started a business during the marriage or started a business with your spouse, 100% of the income and the value of your business is community property.
How to Protect your Business
So now I am sure you are asking, well how do I protect my business? Fair question. There are commonly three ways:
- Get a prenuptial agreement: If you and your spouse signed a valid prenuptial agreement that details the way your business should be divided during a divorce, the judge will most likely adhere to the terms of the agreement.
- Get a postnuptial agreement. Much like a prenuptial agreement, a postnuptial agreement details the way your business should be divided during a divorce, it just happened during your marriage.
- Get a buy-sell agreement, which can be part of a well-drafted Operating Agreement. This will determine exactly how, and under what terms and conditions, the transfer of an ownership interest in the business will take place, if and when, certain “triggering events” occur, such as the death, disability, departure (quits, gets fired, retires) or, for our purposes, the divorce of one of the owners.
Since the ownership interests in a closely held business are fairly illiquid (meaning not easily turned into cash), a well-drafted buy-sell agreement should provide for:
- a market for the sale and/or purchase of those ownership interests
- a mechanism to determine the price, terms and conditions for the sale and/or purchase of those ownership interests
- the source of funds for the purchase of any ownership interests (life or disability insurance, cash on hand, or loan).
In addition, a buy-sell agreement can (and often should) do the following:
- prohibit an owner (or their estate) from transferring and/or selling any ownership interests without the prior written consent of the other owners
- automatically convert the ownership interest into a non-voting interest upon a triggering event
- require all owners to have an acceptable prenuptial agreement in place before marriage or remarriage that would require that owner’s soon-to-be-spouse to waive any and all rights to any ownership interest in the business in the event of a future divorce.
That last bullet might have sparked a thought for all my business owners who started a business with a friend. Yes, the marriage of your business partner is a liability to your business and needs to be considered.
Fully transparency Will and I are not getting a prenuptial agreement, but rather signing an Operating Agreements to formalize our team approach to our finances but protect my ability to control the businesses I have built (with his full and unwavering support) in the terrible event of divorce. I am sure it goes without saying, but I will say it anyway, what Will and I have decided is a personal preference and there is not a wrong answer as you are making a plan for your future.
For those of you who have a business partner or are married, if an Operating Agreement seems like the right fit for you, Legally Aligned just launch our Operating Agreement in the shop!
I know today’s conversation has been a ray of sunshine, but planning for life’s misfortunes is a necessary evil of being an entrepreneur. Besides, I am doing you the favor of leaving the conversation of death of a spouse or business partner for another day.
Before you head out for the rest of your day, I want to share one more pivotal resource if you and your spouse have decided to start a business together. The question we often hear, is do I need an Operating Agreement? The answer is always yes! The benefits of an LLC owned by spouses are that you can file as a disregarded entity. There is no need to file a separate partnership return. To make things even more straightforward, we just recently added an Operating Agreement to our contract shop, which makes it easy to finally check this off your list.