Small Business Owners and Divorce - Potential Traps to Avoid

Client Scenario:

Dina and Don have been married for 20 years and have two kids in private school. A few years after they got married, Don took over his family’s business, a successful Greek-style taverna with three locations throughout New York City. Dina left her career in accounting when she and Don got pregnant and has since been the primary caretaker while helping Don run the back-office of the restaurants. Their marriage has been strained for several years, and now that the children are older, the couple is ready to pursue a divorce. They would prefer to resolve their differences amicably, but they are in conflict over the value of the business and how much income it generates for the family. A long, protracted litigation would be costly and would eat through the small balance of liquid assets the couple owns. The best thing for everyone would be to resolve the issues out-of-court, but depending upon your situation, this may or may not be possible.

A quick primer:

(1) Spousal and child support calculations are based on income, and in the absence of accurately reported income, then the courts can utilize a standard of living analysis.

(2) Marital assets are divided equitably in NYS, based on the fair market value of the assets acquired during marriage, which includes the appreciation of value in premarital assets due to the active contributions of money or labor by either spouse during the marriage.

In some divorce cases, a couple’s financial situation is relatively cut and dry - you can easily identify and value assets for division, and calculate income for support. In other cases, like Dina and Don, it can be quite complicated. When there is a closely-held or cash business involved, determining a true valuation of the business and how much income it generates can be inherently challenging. Are all cash receipts counted? Are personal expenses run through the business? Does a viable buy/sell market for the business exist? What about valuing goodwill and excess earnings? 

It’s easy to get intimidated by these issues and finding the answers can be a lot of work. However, not digging into the weeds and instead opting for an “easier” solution is likely to leave you regretting your decision down the line. You could end up overpaying or leaving a significant amount of money on the table. 

When you’re looking at closely-held and cash businesses in the context of a divorce, there are two primary concerns: 

  1. How much is the business worth? 

  2. How much income does the business generate?

The answers to these questions will dictate how marital assets will get divided and how much support, if any, should be paid. 

As a small business owner, it can be tempting to try and come up with alternatives to hiring a team of professionals in order to save money up front, but this is often a “penny-wise, pound-foolish” approach, fraught with avoidable traps. 

Trap #1 - Double-dipping.“Double dipping” occurs when the valuation of the business as an asset includes the projected income of the business, and then that same income is used in calculating support. That income should not be counted twice, but often it is and on a number of occasions the process of backing out of that valuation becomes much more expensive than it would be if it were properly done with experienced counsel and a forensic accounting expert.

Trap #2 - Triggering an IRS audit. We’ve heard this line on more than one occasion from the non-owner spouse: “If you don’t agree to what I’m asking, I’ll report you to the IRS.” This is an interesting threat. In a contested divorce, when you are before a judge, they do have the duty to report crimes such as not declaring income on your tax return. However, there is a catch. If you’ve filed joint tax returns, then you’re dealing with joint liability. Unless there is proof that the signature on the return was forged, then both parties are presumed to have known what was being reported as income. No one wants an IRS audit on top of a nasty divorce. This situation brings us right back to trap #1...just hire the forensic accountant. That professional will save you a lot of headache and money in the end.

Trap #3 - Getting caught without a prenup or postnup.Whether you are going into a marriage already owning a small business or if you start a small business after already being married, we always advise clients that the best way to avoid an entanglement down the road and keep that business interest protected is to get a prenuptial or postnuptial agreement. This doesn't necessarily mean that the other spouse is left out in the cold. To the contrary, clearly outlining expectations often includes the other spouse protecting their interests as well. The huge advantage comes by way of having clarity and taking the matter into your own hands, rather than allowing a judge to decide for you. Getting a prenup or postnup can protect both parties and fully outline issues such as anti-liquidation clauses, valuation methods, installment methods for buyouts and more. 

While a prenuptial or postnuptial may seem like a difficult topic to broach, framing it around your desire to protect partners and employees in order to maintain business integrity may help to open the discussion. 

Divorce is never easy, but when you layer in factors that may cause you to dig further under the surface of any aspect of your life, your first reaction may be to push back. In the end though, pulling those layers back with the proper professional support and without cutting corners will help you reach a sustainable outcome and you will fare better both emotionally and financially. 

Contact us if we can help you avoid traps from the beginning or help you dig out of ones that were unintentionally created in the past.

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