Automatic Orders that Come with Business Owners’ Divorce

After being served with divorce papers, a business owner’s first step should be to retain an attorney who is experienced with business owners’ divorce and complex divorce cases.

In New York, when divorce papers are served, the defendant is notified of the existence of certain “automatic orders,” which impose certain restrictions for the purpose of maintaining and preserving the status quo of marital property. They include prohibitions against the transfer, removal, and/or withdrawal of any property owned by the parties, either individually or jointly, including bank and retirement account. However, there are exceptions, including hiring an attorney and paying normal business and personal expenses.

Additionally, automatic orders require that all insurance, including medical, life, homeowner’s, and automobile insurance, must remain in place during the divorce.

Once the business owner has retained an attorney, the attorney will discuss the possibility of requesting the court to modify one or more or the automatic orders, if and when necessary.

The Family Business: Additional Spousal Maintenance or Buyout?

Although it might seem like a smart plan from a tax perspective, it is not wise for a business owner to pay additional spousal maintenance in lieu of buying out their spouse’s interest in a family business.

In essence, it disguises the distribution of an asset as spousal support, or, what is now called “spousal maintenance,” or “maintenance” under New York law. On federal income tax returns, however, the term is still referred to as “alimony.”

In some instances, divorcing couples can consider doing an income tax rate arbitrage to have the IRS pay some of the maintenance disguised as equitable distribution. Tax rate arbitrage is the practice of profiting from the differences in the way transactions are treated for tax purposes. The complexity of tax codes often allows for many incentives, which drive individuals to restructure their transactions in the most advantageous way in an effort to pay the least amount of tax. Some forms of tax arbitrage are legal, while others are not; this is where a good tax attorney is useful.

Although we always work towards structuring our clients’ transactions in a manner most favorable to them, namely, where they are obligated to pay the least amount of tax as possible, we work with highly experienced tax attorneys to be absolutely certain that this structure is in fact legal.

More often than not, it is imprudent for divorcing spouses to continue joint ownership in a family business post-divorce, due to the likelihood of future disputes. In fact, such disputes could bring them back into court, the difference being, to dismantle a business relationship instead of a marital one.

There are many ways to buy out a spouse’s interest in a business that should be considered instead of paying additional maintenance.

When a Couple’s Children “Worked At” the Family Business

Company cell phones, cars, and paychecks for the children are non-essential business expenses that would be considered by a Fair Market Value (“FMV”) buyer and FMV seller in a hypothetical sale. A forensic accountant would add them back to cash flow in the Normalization Process.

The Normalization Process refers to adjustments made in business valuation methodology, the goal of which is to estimate future expected cash flow that a potential buyer can reasonably expect to receive in return for his or her investment and to present information that is on a basis similar to that of other companies in its peer group.

There are various categories of “normalization” adjustments that could be made, depending on the facts and circumstances of a case. For example, excess or deficient officers’ compensation or benefits, excess or below-market rent paid to a shareholder, or personal travel and entertainment expenses.

The Normalization Process allows a valuator to use normalized income to better reflect the true economic income of a particular business, and in turn, generate a more accurate comparison with other similar businesses and their respective values.

Should You Use the Company’s Accountant to Value the Business?

Although it may seem prudent at first to ask of the company’s accountant – who is undoubtedly very familiar with the business – to value the business, the following four important reasons suggest that hiring an outside professional is the wiser approach:

  1. If one party seeks to engage the company’s accountant, chances are the other spouse will have concerns about the integrity or objectivity of the process, and hire their own forensic accountant. Accordingly, not one, but two accountants would then need to be paid.
  2. If the valuation issues cannot be resolved with each side having engaged their own experts, and the case proceeds to trial, the loyalty of the company’s accountant to the business-owning spouse can have a significant impact on the perceived credibility of this expert witness, should he or she be required to take the witness stand. In that case, the parties may end up hiring a third or even a fourth accounting expert to take the witness stand.
  3. There is no confidentiality or privilege between the company’s accountant and a client. Everything is discoverable, unlike the attorney-client privilege, which protects confidentiality. If an attorney is engaged first, and the attorney brings in the forensic accountant, there are ways to include the financial professional within the scope of the attorney-client privilege.
  4. The most cost-efficient way to get a family business valued is through the use of a court-appointed, neutral forensic accountant. In this situation, the parties and their counsel agree upon one individual who has no allegiance to either party to perform an independent analysis of the value of a spouse’s interest in a business.

If the parties intend to sell the business and distribute the proceeds, it might not be necessary to hire a business valuator during a divorce proceeding. If, however, one spouse would like to buy out the other spouse, then the business interests must be valued by a valuator. In such instance, a professional valuation may be worthwhile, irrespective of the size of the business, or potential dollar value.