The Family Business: Options to the Buy-Out in a Divorce When Other Assets are Not Sufficient to Create an Equal Division

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In my work as a family lawyer, I often have the opportunity to work on divorces that involve a family business.  The business must be valued and then the disposition of the business must be determined.  When there are plenty of assets in the marriage to offset the value of the business, the disposition issues are significantly lessened.  When there are not enough assets in the marriage to make the offset and create an equal division of assets, how to handle the disposition of the business becomes a problem.

The financial issues involved in disposing of the business are many and require other professionals to participate in the valuation analysis.    The BNY Mellon Wealth Management (www.bnymellonwealthmanagement.com) team of professionals has taken the time to collaborate with me on this post to help demonstrate a specific business scenario in a divorce.  It is critical to have a team who will work with you as well as with your other trusted advisors in analyzing, creating and assisting you with implementing a strategy that will help meet the goals and objectives you’ve established.

Outlined below is a scenario that addresses some of the key considerations when divorce involves a family business.

The Scenario

Most owners of small businesses have the majority or even all of their wealth tied up in their business.  When the owners are divorcing, dividing the business becomes a critical element to the settlement process, irrespective of whether one spouse does not wish to use his/her assets to buy out the other spouse or simply does not have such additional assets.

Some assumptions for this overview:

  • Spouse A and B reside in a community property state.
  • Their business is held as community property.
  • Spouse A is responsible for the day-to-day operations of the business.
  • Sale of the business is not possible in today’s economic environment.
  • Spouse A wants to own the entire business rather than being in partnership with Spouse B for
    the foreseeable future.
  • Spouse A does not have sufficient non-business assets to buy out Spouse B’s share.

Some Alternatives

Given these circumstances, Spouse A still has several different options for completing disposition of the business successfully.

Promissory Note

Spouse A issues a promissory note to Spouse B for his/her half of the business.  This option can be a good idea, but there are several issues that both Spouse A (day-to-day owner) as well as Spouse B (recipient owner) need to consider:

Spouse A

  • The business must be able to afford monthly cash outflows to Spouse B for interest payments on the note and/or balloon payment of principal and any accumulated but unpaid interest.
  • Whether interest rates rise or fall will have an impact on the affordability of note payment.
  • The terms of any prepayment penalty on the note can affect the transaction’s affordability.

Spouse B

  • The promissory note should be secured, preferably with collateral outside of the business
    (e.g., other assets).  There are various sources for such security – including Spouse A’s interest in a qualified pension via a qualified domestic restraining order (QDRO) on his/her half of such a pension plan.
  • If payments are tied to the profitability of the business, or unsecured beyond the business,
    Spouse B must  guard against Spouse A’s letting the business fail while he/she establishes sole ownership in a new company and focuses on making it profitable at the expense of the original business.
  • There should be an independent recent appraisal if the original valuation was done so far ahead of the division of the business that a significant change in value may have occurred.

Refinancing Business

In today’s economic environment the credit landscape has changed dramatically, making this option available only to businesses with proven strong cash flows and revenues.  In addition, the business needs sufficient equity to support any further leverage.

The following would be some considerations when evaluating this strategy:

  • Service businesses with minimal assets are not good candidates for refinancing.
  • Businesses with accounts receivable are good refinancing candidates, because banks may lend up to 70% of the value of the receivables plus an additional
    percentage based on the value of the company’s inventory.
  • Companies based on seasonal business might have inconsistent cash flow that could be a deterrent to extending credit.
  • Recapitalizing the business with cash from venture capital or individuals  is an alternative to bank refinancing.  With such a cash infusion Spouse B might surrender his/her minority stake thus bringing new/additional partners and/or creditors into the business.  This may impact Spouse A’s ability to control the business.

Other Alternative Strategies

There are other potential solutions to avoid pulling money/equity out of the business in order to make a division of assets:

  • Life Insurance.  Borrow against existing whole life or other cash value insurance policies on
    Spouse A
  • Stock Transfer to Trust.  Transfer the stock that is allocable to Spouse B into an irrevocable
    trust for his/her benefit and appoint an independent trustee.  This option is particularly
    helpful if the business cannot be sold now, but will be sold in the foreseeable future when the trust can get the proceeds and diversify.
  • Investment Credit Line.  If there are eligible investible assets, put an investment credit line in place and use a portion of the investible assets while keeping the remainder in cash.  This reduces the impact to the investment account by maintaining assets to generate income and fund regular business functions.  This is particularly important if the investment account is used as the day-to-day operations account for the business.

Create your Team

Prior to making any decisions on a specific strategy for division of family business assets, it is critical that you understand the many options available and the potential benefits and challenges of each.  In addition to your family law attorney, a financial advisor, a CPA, a trust and estate attorney and a wealth manager can help to round out a comprehensive and effective team that can take a holistic look at the situation and uncover opportunities.  Together, these professionals can put in place the planning and supporting legal and fiduciary structures to help you best meet your future objectives.

To learn more about how BNY Mellon Wealth Management may be able to deploy its considerable expertise and resources to assist in your particular situation, please contact Kim Archer at 310-551-7670 or kim.archer@bnymellon.com.