Beware Stock Redemption for Small Business in Divorce

Many of my clients own small businesses which bring a mountain of complications to the financial negotiations of divorce. From cash flow analysis to business valuation to perquisite incomes to ownership interests, the existence of a small business in a family net worth statement brings challenges and opportunities. One of the challenges becomes apparent when a couple wants to negotiate for one party to be awarded a business as part of the divorce settlement.

Here’s an example

Steve and Martha co-own a business we will call Divorce, Inc.. During the marriage Steve ran the business, was the face to all of the sales meetings and was generally known as the business man of the family. Martha had the idea for the business but preferred to stay behind the scenes and manage employees. Steve and Martha have always owned the 100 shares of stock 50/50. During divorce negotiations it became obvious that they were not going to both continue working in the business and so one should by the other’s interest. Since Steve was the face of the business and Martha had already set her heart on doing other things it was decided Steve would buy Martha’s interest in Divorce, Inc. at a total community property value of $2,000,000 after an appraisal was completed. There are a couple of ways to facilitate this transaction. This is where it becomes sticky.

 

1. Divorce, Inc. will write Martha a check for $1,000,000 to buy her 50 shares from her.
2. Martha will be keep other community assets (house, tax affected retirement accounts, brokerage account) worth $2,000,000 to offset the value of Divorce, Inc..
3. Divorce, Inc. will purchase Martha’s 50 shares of stock over time at set prices based on an agreed upon stock buy-back plan.
4. Steve will purchase Martha’s 50 shares of stock over time at price and on a timeline delineated in an agreement.
5. Steve will purchase all of Martha’s 50 shares today by structuring a promissory note to be paid over time.
6. Structure a buy-out payment over time to be payable as spousal support from Steve to Martha.

 

The result?

As you can tell you have options if you are negotiating the sale of a business interest pursuant to your divorce. Litigating your divorce removes many of these options as a judge is unlikely to create a situation that requires the couple to remain attached for long periods of time after the divorce. This means options #3 and #4 are thrown out. If there are no significant other assets in the estate option #2 goes away. If there is not a significant cash position on the books of the corporation option #1 goes away leaving only option #5. A court is not really allowed to be creative which rules out most of these on it’s own.

Each of these options also has complicated tax considerations to be incorporated when deciding how to structure a buy-out. Many tax professionals believe the only way to guarantee a clear understanding of how a tax court would rule is to ask for a private ruling. Some believe structuring a transfer of the stock inside of the Section 1041 six year requirement covers you. What is fairly clear is that forcing a Divorce, Inc. to purchase shares from Martha would result in some form of a taxable event so it may be best to consider options involving immediate offset with other assets or structuring a collateralized promissory note. Consult with your Divorce Financial Planning expert and Tax expert before deciding what works best for you before making a decision.

 

 

Wellspring Divorce Advisors helps individuals and couples address the financial aspects of divorce in a civilized, equitable, and efficient manner by providing expert divorce financial planning and advice.

Contact us to find out how we can help you through this process.