Protecting a Business Asset in the Event of a Divorce — Corporate Documents Alone Are Not Enough

Are you concerned about having your future ex-spouse become your business partner? You should be. In California, a spouse who works at their own business, whether the business was started prior to marriage or during marriage, most likely will have to pay a considerable amount of compensation to buy out their spouse in the event of a divorce.

So, what happens to business assets in a divorce? When a spouse brings a separate-property business into the marriage (either by bringing a pre-marriage business into the marriage or by starting or joining a business after marriage), upon dissolution of the marriage, a spouse’s separate property is confirmed to them and the community property is divided equally. But it is rarely that simple.

As an example, if the separate-property business increased in value during the marriage, that increase in value is considered a community-property asset and that increase would be divided. Also, if you didn’t pay yourself a competitive salary and instead reinvested profits back into the business, your spouse may claim that the community did not derive the benefit it deserved from your community efforts during the marriage because the money went back into your separate-property business instead of towards the community expenses or savings. In that case, part of the value of your business may be deemed community, regardless of any increase in value.

These are some, but not all, of the pitfalls that you may encounter without proper planning. And the common corporate/business documents you may have used, such as a spousal waiver, only pertain to the business’s relationship with your spouse, but not to your liability to your spouse for the value of the asset since the family code overrides those corporate documents and agreements. In addition, the Family Code and case law have strict requirements that must be followed for any agreement to be enforced in the event of a marital dissolution.

The burning question becomes how can someone protect their separate-property interest in a business – whether it be a professional corporation, a C corporation, an S corporation, an LLC, an LLP or any other business venture?

The only complete answer is to consult with a family law attorney before marriage and then during marriage whenever a business opportunity presents itself, because that attorney can address your specific situation and tailor an enforceable solution for your circumstances. That being said, the following are some basic steps you should think about taking along the way:

1. Prior to your marriage, you can enter into a premarital agreement (a “prenup”) confirming that your separate-property business will always remain your separate property. Family Code Section 1612 governs the requirements for a valid prenup. The requirements are broad and the terms must not violate public policy.

2. If you do not have a premarital agreement, you can enter into a post-marital agreement. Post-marital agreements are made after you are married and prior to divorce. They have even more stringent requirements than premarital agreements due to California law recognizing the existence of a fiduciary relationship between spouses as set forth in Family Code Sections 720 and 721. These agreements must be fair and withstand the scrutiny of the possibility of undue influence or duress. It is wise to enter into a post-marital agreement long before there is any hint of an impending divorce.

3. Pay yourself a competitive salary.

4. Make sure that your spouse’s employment is completely separate from your business. Should your spouse be employed by your business or if your spouse helped run the business, they may be entitled to a pro-rata share of the value due to their perceived contribution to the value of the business.

5. You can enter into a valid transmutation agreement which is an agreement that can change community property into separate property and/or separate property into community property. These agreements are governed by Family Code Section 852 which states that a transmutation agreement is not valid unless it was (a) made in writing; (b) an express declaration; and (c) accepted by the spouse whose interest in the property is adversely affected. A transmutation agreement is also subject to the strict requirements of a post-marital agreement and often is included as part of the post-marital agreement.

6. If there are other partners in your business, make sure you have a buy/sell agreement in place that would limit a divorcing spouse’s ability to acquire ownership or allow you or other partners to buy the spouse’s interest at a pre-determined price.

It is essential that any person who has a business and is married or is considering marriage take appropriate measures to protect their interest in that business in the event of a divorce. While no one relishes the idea of contemplating a divorce at the outset of a marriage, seeking a family law attorney’s advice to protect your business in the event of divorce would be wise planning. Encore’s Family Law Department can provide you more information and can advise you on how to do so effectively.

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