Texas is the number one state in the nation to start a business in, according to a recent study by WalletHub. This is great news for entrepreneurs relocating to Texas to avoid state income taxes and take advantage of a lower cost of living. However, complex issues can arise for business owners going through a divorce. With this realization, it’s important to hire experienced counsel to help protect what is likely a spouse’s most valuable asset when ending a marriage.
Property owned by spouses during marriage is characterized as either community or separate property for purposes of division upon divorce. Only assets deemed community property are divisible by the Court upon divorce. Property determined to be the separate property of a spouse shall be confirmed and awarded to the spouse who has ownership of the asset at the time of divorce. All property on hand during the pendency of the divorce is legally presumed to be community property subject to a just and right division. The burden shifts to the party claiming separate property to prove by clear and convincing evidence that an asset is his or her separate property.
It’s important to first ascertain the type of business when characterizing business interests in a divorce, whether it be a corporation, partnership, or sole proprietorship. Generally speaking, corporate and partnership interests are deemed separate or community depending upon the date of formation. This is the “inception of title” rule. If the entity was formed prior to marriage, the interest is separate property, and if it was formed during marriage, typically the interest is community, unless the entity was funded during marriage with separate assets, or assets acquired by gift or inheritance.
Further, Texas adheres to the “entity theory,” which means the assets owned by the corporation or partnership belong to the entity itself, rather than the individual partners or spouses owning the entity. So, the only interest subject to division upon divorce is a community interest in the corporation or partnership itself, not the individual assets held within the company. Said another way, the only asset subject to characterization by the court is a spouse’s interest in the partnership or corporation, and not the assets owned by the company.
This is not true for sole proprietorships, however. A sole proprietorship is the most basic business entity in Texas, and the person running the business actually owns each asset within the company. Therefore, the individual assets of the business are characterized as either separate or community depending upon the time each asset was acquired.
Although corporate or partnership interests may be deemed the separate property of a spouse, any profits or distributions received from these entities during marriage are considered community property.
If the corporate or partnership interest is deemed community property, it is then necessary to determine the fair market value of that asset so the court can ensure it is divided in a just and right manner. Fair market value is defined as the amount of money a willing buyer who desires to buy but is not required to buy, will pay to a willing seller who desires to sell but is under no obligation to sell.
In complex divorces, parties typically engage competing business valuation experts to calculate the fair market value of each business interest at stake. Many factors come into play when valuing business interests, including the terms of the formation documents, which may include buy-sell provisions; professional and personal goodwill; and discounts applied for minority ownership and lack of marketability. These discounts can significantly diminish the value of the business interest sought to be divided.
Management and Control During Divorce
Generally speaking, management and control of business entities is dictated by the entities’ formation and governance documents. For large business entities, this does not necessarily change during a divorce if one spouse owns an interest. In the case of a closely held entity in which both spouses have ownership interests, however, it may well cause understandable tension and hasten poor management decisions.
In the closely held entity, both spouses involved in a divorce should maintain an interest in maximizing value and ensuring the marital estate is protected. Thus, the spouses should be encouraged to engage business law counsel in order to cooperate in the management pending divorce. Also, some LLC and partnership agreements may have provisions for what happens in the case of divorce. Therefore, the entities’ governance documents must be carefully reviewed.
If the management of the business entity is truly in peril, one option is to seek a receiver for the company, if only on a temporary basis, to keep management steady and to maximize value for all parties.
Because of the Texas Family Code’s perceived relaxation of the requirements for appointment of a receiver, spouses often seek the appointment of a receiver over business entities involved in the divorce. This is sometimes employed as a tactic to gain leverage in the divorce and it can have serious implications for the business upon appointment.
The critical difference in divorces is due to the fact divorce courts are courts of equity, and the Texas Family Code affords a family judge more discretion to appoint a receiver than is normally available in a civil proceeding. Indeed, some practitioners seek a receiver even when there is no allegation of impropriety. Technically, a receiver should still only be appointed when property is in danger of being lost, removed or materially injured. But this doesn’t stop parties in a divorce from seeking a receiver for leverage when the practical effect is to bring the business entity (and the spouse owning interests in the entity) to a grinding halt.
When seeking a receivership, it’s very important to consider whether the spouse’s business interest is community or separate property (i.e., via a partition agreement or pre-marital acquisition of the interest.) Similarly, another consideration is whether the receiver should be appointed over the business entity itself, or only the spouse’s interest in the entity.
There are many potential negative consequences following the appointment of a receiver. One is that often the appointment of a receiver over an entity, or over a partner’s interest in an entity, may cause a technical default on lending arrangements, and may trigger a withdrawal provision in a partnership agreement. Also, less experienced counsel may quickly push for a receiver based on the broad discretion of the family court solely to gain leverage in the divorce, which not only negatively affects the business but costs the parties thousands of dollars in unnecessary legal fees. These consequences must be carefully weighed to avoid a tactical backfire and must be brought to the attention of the court when appointment is sought.
In sum, receiverships should not be sought without careful consideration or full understanding of the characterization of the business entities themselves or effects of an appointment. It is recommended parties to a divorce each consult with experienced business law attorneys in addition to divorce counsel concerning the potential impacts and arguments to be advanced. Indeed, the business entities themselves may need to engage separate counsel and appear in the proceedings themselves.
Carson Epes Steinbauer, Worthy Walker, and David Elrod are partners with Shackelford, Bowen, McKinley & Norton, LLP. Ms. Steinbauer is Board Certified in Family Law, and regularly represents clients in high net worth divorces, custody suits, interstate jurisdictional disputes, prenuptial and postnuptial agreement drafting and litigation, and termination and adoption cases. Mr. Walker and Mr. Elrod are both experienced trial lawyers who handle complex business and divorce litigation, and energy, banking, finance and trust litigation.