Wisconsin Lawyer: Business Owners in Divorce: A Basic Overview:

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June 06, 2008

Business Owners in Divorce: A Basic Overview

Unique issues arise when a business owner is a party in a divorce action, including valuing the business and determining income available for support or maintenance. Here is a basic overview of the issues for attorneys representing either the business owner or the nonmanaging spouse.

Christopher S. Krimmer

Business Owners in Divorce: A Basic Overview

by Christopher S. Krimmer

divorce is difficult and emotional for most individuals going through the process. A person who owns a business has the additional anxiety of not knowing what will happen to his or her business in the divorce. An attorney must know how to competently and effectively deal with division of this very important asset, whether representing the business owner or his or her spouse. This article provides a basic overview of the issues unique to a divorce when a party is a business owner.

The most significant issue for both spouses' attorneys is to determine the value of the business. A business that is publicly traded is easy to value. The attorneys can merely pick up the business section of the newspaper and locate the appropriate stock tables. The same is not true when the spouse owns an interest in a closely-held business. The attorneys will need to rely on experts to give an opinion on the fair market value of the business.

Confidentiality of Business Records

The first step is for the attorney who represents the nonmanaging spouse to request certain business documents using discovery tools. The attorney will want to request any articles of incorporation, records of distributions, applications and payment records for business loans, descriptions of real estate holdings, balance sheets, profit and loss statements, buy-sell agreements, shareholders' agreements, and the corporate tax returns for at least the past five years.

These business records will contain sensitive information about the health and direction of the business. The attorney who represents the managing spouse will want to make sure that the information remains unavailable to the public and potential and actual business competitors. Although discovery documents are not available for public inspection, nothing prevents a party from disclosing the information to the public or a competitor.¹ To protect the privacy of the business records, the parties may want to enter into a confidentiality agreement in the form of a stipulated order.

Christopher S. Krimmer, U.W. 1997 cum laude, practices family law with Balisle & Roberson S.C., Madison. He is an adjunct professor of law at Marquette University Law School.

This order can include provisions that identify all the documents being released and state who may receive the information (usually parties, attorneys, and experts only), how the documents will be stored by the attorneys and experts, and whether the documents will be returned to the business after the divorce. For example, the stipulation could state that neither party will retain a copy of the documents, and that each party will view them only in the office of his or her attorney or expert.

It is always a good idea to stamp each page of the documents "Confidential" and to Bates stamp each page so that the documents stay in chronological order and can be easily identified at trial. If the divorce action goes to contested trial, the confidentiality agreement cannot extend to evidence submitted in court. There is a strong presumption that most documents that have been introduced into evidence are open for inspection. This includes business documents cited as a basis for the valuation of the business and relied on by the experts.²

The Legal Standard: Fair Market Value

One of the most difficult concepts a business owner must grasp in a divorce is that his or her business may have more than one value. The business can have one value for a refinance, a different value for a business sale to a competitor, yet another value under the terms of a buy-sell agreement, and finally, a different value in the context of a divorce.

The divorce court will divide property on the basis of the fair market value of the assets. The Wisconsin Court of Appeals has adopted the IRS definition of fair market value to mean the price that property will bring when it is offered for sale by a person who desires but is not obligated to sell and is bought by a person who is willing but not obligated to buy.³

The attorney will need to consult with a reputable expert to determine the fair market value of the business. Certified public accountants commonly perform this function, although for complex or large businesses, the attorney may wish to consult with a certified business appraiser. Four professional associations provide education and accreditation for experts who conduct business valuations: the American Society of Appraisers, the National Association of Certified Valuation Analysts, the Institute of Business Appraisers, and the American Institute of Certified Public Accountants.⁴

Discounts

A variety of discounts may be applied in determining the fair market value of the business. A client may be inclined to take the gross value of the business and determine the marital interest by looking at his or her share of the entire business. For example, if a business is valued at $1 million and the owning spouse has a 20 percent interest in the business, the parties might assume that their interest is worth $200,000. This is incorrect. Since the owning spouse does not have a majority interest sufficient to control the direction of the business, his or her interest should be discounted for "lack of control" or a minority interest discount.

The percentage of a minority interest discount can range from 15 percent to 30 percent, depending on the circumstances of the individual business, after considering factors such as the corporation's bylaws, the extent of risk for mismanagement, the relationship among the blocks of stock owned by different shareholders, and the degree of control, if any, the managing spouse has over the direction of the company.

An additional discount for lack of marketability also may be appropriate. A lack of marketability discount takes into account that there is no readily available market for the sale of the shares in the business. In contrast to the potentially large market of purchasers of publicly traded stocks, only a limited number of buyers generally are interested in purchasing a family-owned or closely-held business. This discount also can range from 15 percent to 30 percent.

Retained Earnings and Corporate Distributions

One of the most often litigated issues in divorce when a party owns a business is the income available for support. The attorney who represents the nonmanaging spouse might argue that retained earnings or corporate distributions constitute income. This analysis would seem to be supported by the definition of income under the Department of Workforce Development (DWD) child support enforcement standards.⁵ However, a more thorough analysis is required.

Retained earnings from a company should be considered income only if two conditions are met: 1) The payor must have the individual ability to exercise control over or access the undistributed earnings; and 2) the court must determine that there is no valid business reason to retain the earnings in the company.⁶ If the payor is a minority-interest owner or the retained earnings are necessary for the operation of the business, then the funds should not be considered income.

There is a danger of double counting in a divorce. If the expert uses an income-based approach in valuing the business interest, it is likely that the retained earnings will be incorporated into that value. If the other spouse were to receive one-half of the business interest in the property division and also receive a support award based on the same retained earnings, double-counting has occurred.⁷ In such a situation, an attorney should argue that to the extent support is based on the retained earnings, for purposes of the property division the value of the business interest should be decreased.

Corporate distributions also must be analyzed. Distributions received by a shareholder for the sole purpose of paying the tax on a pass-through corporation, such as an S-corporation, are not necessarily income available for support.⁸ The attorneys should determine what amount of the distribution was allocated to pay pass-through taxes.

At first glance, the managing spouse may appear to have far more income than what is actually available to him or her. It is important for both attorneys to understand how to fairly calculate actual income available for support.

Conclusion

The parties to a divorce action usually find the process to be confusing and emotionally exhausting. This anxiety is compounded when one of the parties owns a closely-held business. An attorney can best serve his or her client by informing the client of the unique steps and issues presented in his or her case and then properly addressing the legal and financial complexities involved in the valuation and division of the parties' business interest.

Endnotes

¹Mitsubishi Heavy Indus. Am. Inc. v. Circuit Ct. for Milwaukee County, 2000 WI 16, ¶ 26, 233 Wis. 2d 1, 605 N.W.2d 868.

²Wis. Stat. § 59.20(3).

³First Wisconsin Nat'l Bank v. Wilson, 121 Wis. 2d 505, 360 N.W.2d 548 (Ct. App. 1984).

⁴American Society of Appraisers, www.appraisers.org; National Association of Certified Valuation Analysts, www.nacva.com; Institute of Business Appraisers, www.go-iba.org; American Institute of Certified Public Accountants, www.aicpa.org.

⁵Gross income includes "[u]ndistributed income of a corporation, including a closely-held corporation, or any partnership, including a limited or a limited liability partnership, in which the parent has an ownership interest sufficient to individually exercise control or to access the earnings of a business, unless the income included is an asset under s. DWD 40.03(4)." Wis. Admin. Code § DWD 40.02(13)(a)9.

⁶Weis v. Weis, 215 Wis. 2d 135, 572 N.W.2d 123 (Ct. App. 1997).

⁷Kronforst v. Kronforst, 21 Wis. 2d 54, 64, 123 N.W.2d 523 (1963); Cook v. Cook, 208 Wis. 2d 166, 560 N.W.2d 246 (1997).

⁸Winters v. Winters, 2005 WI App 94, 281 Wis. 2d 798, 699 N.W.2d 229.

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