You’ve worked your whole life to build a successful business. You are delighted that your daughter has decided to join you in the business after her graduation from college. After she demonstrates a long-term commitment to the business, you decide to gift an ownership interest in the business to her. She gets married and convinces her husband to come to work at the company. He quickly learns the business and joins your daughter as they together take over the day–to-day management of the company, while you begin to enjoy some hard-earned time off in your golden years.
Then, one day, it happens. She comes to your house to tell you that she and her husband have decided to get a divorce. You are, understandably, concerned about your daughter and your grandchildren and the difficult time they are going to experience as they begin the divorce process. But then you panic — What will happen to the company? Can they continue to work together? Will your daughter’s ownership interest in the company be subject to equitable distribution as part of the divorce? Will you or your daughter need to buy your son-in-law out of the business?
These are all legitimate questions to ask yourself. But you also begin to think, “How did I let this happen to me? How did I let this happen to my daughter? How did I let this happen to my business?”
With the current Federal estate tax exemption now pegged at $5,340,000 ($10,680,00 for a married couple), we find ourselves, as legal advisers, counseling clients less and less about estate tax savings strategies, and more and more about family business succession strategies. By necessity, those issues usually include planning for a future divorce of a child, and the impact such an event can have on a family business. As with most business succession issues, the difference between a smooth inter-generational transition and a rocky one, comes down to planning.
Let’s go back to the fact pattern set forth above. How can we expect the divorce process to play out? First, it is necessary to understand basic New Jersey law as it pertains to how ownership interests in businesses are treated in the context of a divorce. Generally, if one spouse in a divorce action has an ownership interest in a business, that ownership interest can be deemed a marital asset subject to equitable distribution with the non-business owning spouse. Consequently, your son-in-law may indeed have a “marital interest” in the business. In general terms, a marital interest in a business is a financial interest that a spouse acquires as a result of having been married to the business-owning spouse for a period of time during which the business appreciated in value as a result of either spouse’s active efforts.
The amount of the marital interest can be affected by many considerations, including the extent to which the non-business-owning spouse contributed to the growth of the company, or the extent to which the non-business-owning spouse made sacrifices which allowed the business owning spouse the ability to grow the company.
The process of determining the value of the non-business owning souse’s marital interest will likely begin with having a forensic accounting firm value the entire business. This process is often expensive and arduous, and it can also be a distraction from the operation of the company.
In the fact pattern above, your son-in-law would likely have a significant marital interest in the appreciation in value of your daughter’s ownership interest in the company since the date she acquired her ownership interest. His marital interest would likely be significant because he directly contributed to the growth and success of the company. If your daughter had used marital funds to acquire her ownership interest, rather than receiving her interest as a gift, then your son-in-law’s marital interest would likely be even greater.
For these reasons, your daughter’s divorce litigation will likely result in an obligation that she pay your son-in-law an amount equal to the value of his marital interest in the company. If your daughter does not have adequate capital to pay the amount owed to your son-in-law, then she may have to negotiate a financed “buy-out” over time, in which case all or some of your daughter’s ownership interest in the company would likely be collateralized to secure the financed obligation. It is also possible that your daughter will have no option but to sell her ownership interest in the company in order to pay the amount she owes to your son-in-law.
Obviously, none of these potential consequences of your daughter’s divorce is desirable for you, and you certainly did not intend for such outcomes when you generously gifted an ownership interest in your company to your daughter. What then could you have done differently to protect your business and your daughter’s ownership interest from the potential outcomes of divorce litigation as described above?
Through the use of some effective estate planning techniques, it is possible to put your daughter, and your business, in a better position in the divorce negotiation. For example, the result would likely have been different if, instead of making an outright gift of an interest in the company to your daughter, you instead made a gift of such an interest to a trust for your daughter’s and grandchildren’s benefit. Since your daughter would not then own an interest in the business at the time of the divorce, there would be no asset in the marital estate to divide. Moreover, if the trust is properly designed, it is conceivable that your daughter’s interest could be so subject to the control of a fiduciary, that the value of any such interest could be deemed too speculative to even attribute to her.
While bringing your son-in-law into the business might have seemed like a good idea at the time, you would probably now be second-guessing that decision. Often, we counsel clients that are bringing a daughter-in-law or son-in-law into the business to enter into an employment agreement which is specific in its description of the manner in which she or he will be compensated. This could be useful in challenging any claim that the daughter-in-law or son-in-law contributed “sweat equity” to the business. In fact, it may even be prudent to have the company enter into an employment agreement with the child as well, to establish the amount of compensation received for services by the child. These employment agreements coupled with any company ownership being held in trust for the benefit of the child would certainly provide greater protection against any claims of the daughter-in-law or son-in-law.
There are several additional strategies that can be employed to provide greater protection for the family business. Each strategy is customized to accomplish a client’s particular goals. Whether one of the techniques discussed above is employed, or another technique is utilized, the most important thing to do is to plan. At Einhorn Harris we employ a multi-disciplinary approach to advising our business clients to protect their interests from divorce, estate/gift/income taxes and other circumstances that could prove dire to a business’ long term success.