Michelle O'Neil:
All right. Welcome back. We're on section four of the divorcing of business
owner or entrepreneur webinar brought to you by O'Neil Wysocki. My name
is Michelle O'Neil and I am joined by Jere Height and Ryan Segall, who
are both attorneys at my law firm. And we're also honored to have Robert
Bales CPA with us today. So this last section we're talking about post-divorce
issues and how to move forward when you represent a business owner. So
there's some things that are kind of going on that are new and interesting.
So Robert, kick us off on what's going on, new and interesting in the
post-divorce business owner world.
Robert Bales:
Well, new and sad I think is the way I would refer to it. The tax reform
act had a provision in it that's really made it more difficult for us
to settle a case involving small businesses. Prior to the passage of the
act, we could use contractual alimony contracts to move pretax income
from one spouse to the other to move the value of the business over.
Michelle O'Neil:
So in other words, just so in case there's some young whippersnapper out
there that that wasn't around before the tax act, we would commonly award
the owner of the business, the business and then award the other spouse,
some contractual alimony instead of like a payout or a loan, but used
contractual alimony to offset the asset. The major asset.
Robert Bales:
Correct, the business owner could deduct it and the recipient would report
it as income for tax purposes, which made it much easier for the business
owner to pay it. And because of the differential and tax rates that normally
occurred, had the government ended up paying part of our settlements. Right.
Michelle O'Neil:
And it was an incentive to business owners.
Robert Bales:
It was a huge incentive and probably the most common way we settle these
cases. The tax act did away with that for all divorces after December
31st of 17 or 18.
Michelle O'Neil:
18 yeah. So starting January 1st of 2019 there is no more tax deductible
alimony. You can still have alimony. You just can't deduct it.
Robert Bales:
Unless you were grandfathered in. So if you're grandfathered in,
Michelle O'Neil:
Grandfathered in is any divorce that was finalized before January 1st of
2019. And there was supposedly a rush across the country and states that
had alimony rules than ours in Texas of getting divorces finalized to
take the advantage of that grandfathered in.
Robert Bales:
There was a rush in my practice, I know that.
Michelle O'Neil:
So now in 2019 under the new rules, we can no longer use tax deductible
alimony payments to offset that type of dividing of the asset.
Robert Bales:
Correct. And the business owners having to use after tax dollars at a very
high rate normally. And it's making it much more difficult to equalize
these estates.
Michelle O'Neil:
So what are some things that people are doing with that?
Robert Bales:
Well, the riskiest thing I see, and I'll let you all speak to legally,
is continuing the own the business post-divorce together.
Michelle O’Neil:
So Jere, how do you go about that? Let's say that there is this business,
it's community property, maybe even joint, jointly owned, but it doesn't
have to be and you're trying to get this case settled businesses the main
asset. And you just can't agree on selling it or dividing it. So we're
all going to own it together. Going forward. How do you do that?
Jere Hight:
The simplest way to do it is you simply award a 50% ownership interest
in the entity to each spouse. Now that gets the job done and dividing
the ownership entity, unfortunately it doesn't address any of the headaches
and are going to come up down the road. And I mean, if I was going to
do that, I think I would negotiate an operating agreement as to what this
new businesses going to look like, so everyone's staying in their lane
and I would contractually create some obligations between the parties
so that their fiduciary is of each other going forward because of the
fiduciary relationship between the spouses ends at time of divorce and
if it's a corporation, the shareholders don't have a fiduciary obligation
to each other legally.
Michelle O’Neil:
So let's walk through that a little bit more precisely. So spouses when
you're married owe a fiduciary relationship to each other, right? When
you start in the divorce, probably no fiduciary relationship in the divorce
process, but it's a little bit of a gray area. And then at the conclusion
of the divorce, the spousal fiduciary ends. So what you're saying is that
then there's also no fiduciary relationship shareholder to shareholder
in a corporation. The shareholder owes a fiduciary relationship to the
corporation itself to the entity, but not to have a joint shareholder.
Ryan Segall:
Now there is a fiduciary duty between partners.
Michelle O’Neil:
So the rules are different in partnership, but in a corporation, shareholder
to shareholder, no fiduciary relationship. Why is the fiduciary relationship
important?
Jere Hight:
Well to put it simply so you can sue the other shareholder for breach of
fiduciary duty and where it comes up is you have distributions. You have
an S Corp and let's say one party also is really doing most of the operating
and getting a salary out of this corporation and the other one is not,
or de minimus salary and is relying on distributions. That's the value
that person's going to get out of the corporation. Well it might be good
for the corporation not to distribute any of the money and to keep it
in and to purchase more asset, more equipment or whatever or make that
decision. Well, if that's the case and you're an S Corp, both parties
are going to have to recognize the income on their tax returns. They've
got to pay taxes on that money even though it never comes out of the corporation.
So you've got one party that has the ability to pay those taxes, their
salary and if that party can control whether it's distributions or not,
the other party has no income stream from it but does have the liability
of making those taxes. It's Phantom money and that's a terrible position
to have a client in. I mean, they're getting no benefit out of this ownership
interest and so you want to avoid that.
Michelle O’Neil:
So Bob, sorry Robert, what are some strategies that you recommend to people
that find themselves in this situation where we're going to have to co-own
a business after the divorce. What are some strategies that you can kind
of recommend to avoid as many problems as possible?
Robert Bales:
That's a tough one cause my experience with these arrangements has not
been good. The best thing you can do is make sure there's total transparency
in financial reporting.
Michelle O’Neil:
Maybe third party do the financing.
Robert Bales:
well, third party do the financials and make sure both sides see the financials,
that both sides see cash positions of the company, that general ledgers
are made available so you can see where the money went. And if you can't
read one, you can at least hire someone to read one for you. Oversights
are very, very important. What happens is one parties used to running
the business the way they have always run it and they're not used to having
partners is what my experience is and they don't make the transition well.
So you've got to have forced transparency so you can make sure they're
doing things appropriately. I would anticipate in most cases, something
inappropriate is gonna happen. And you're going to have to build in procedures
to take care of that.
Michelle O’Neil:
So when we were talking about the fiduciary duties, some of that is kind
of a trust, like how much can you trust somebody? So a fiduciary relationship
is designed to give you at least some comfort level that you ought to
be able to trust this person more than any old random person on the street.
Jere Hight:
They have a duty to deal with the failure fairly.
Ryan Segall:
Yeah. And one thing that I've done in the past is bring in the attorney
for the business itself because if you bring in that person, then you've
got another individual and you can talk about the agreements that you
make in a settlement or something like that. And they can help with that
aspect because not only will you have both sets of attorneys in the divorce,
but then you'll have a new quote, neutral third party that that's representing
the business that can help out with.
Michelle O’Neil:
And if the business is owned by both of these people, then that corporate
attorney really should be somewhat neutral. I mean better not be aligned
with either side or there's some problems. So what about strategies for
partnerships? You know, the rules are a little different for partnerships.
So what if we're going to continue to own a partnership going forward?
There some pitfalls to that.
Robert Bales:
Well, we have an old case that one of my former firms had been involved
in and they did an arrangement like that where the partnership and they
started out with lots of millions of dollars and she ended up with every
bit of it. About 25 years later, he ended up bankrupt in every case there
was a suit for breach of fiduciary duty and he lost every one of them.
So with the partnership, if you're the one that's running the business,
you better be careful because you do have that fiduciary relationship.
But again, I think you still have to have the transparency, the financial
transparency, so it can be monitored.
Michelle O’Neil:
Well and it just kind of the bottom line to me seems like if you couldn't
get along and do what was necessary to stay married, like how in the world
are you going to get along and be able to accomplish what needs to be
accomplished to run a business together.
Robert Bales:
One thing I've seen and I sound so negative about this, but I do have an
active case we settled three years ago and it's working well and the husband
doesn't live near the business. The wife runs the business and there's
a third-party relative whose very, very savvy business person who is a
tie breaker. And I don't think they've had to use tie breaker yet, but
the knowledge the tie breakers there seems to make it work. So maybe you
bring in a third party tiebreaker and if you can find someone who's got
the guts to do that. And in this case it was kind of a natural but I think
it's working because husband's not physically nearby. And he's still getting
his cash flow.
Michelle O’Neil:
So he's kind of just the non-controlling profits interest and she's running
the business.
Robert Bales:
Yeah. Technically they have the same amount of control, but she runs the business.
Michelle O’Neil:
And she's obviously doing what she should do rightfully by him, so that's
a good thing. But that's just not, that's not super common. So you mentioned
bringing in the corporate attorney. A lot of times whenever you have these
situations where the business is going to go forward owned by both spouses,
I mean sometimes the corporation is already a party to the divorce lawsuit.
So sometimes you already have the corporate attorney. I've had a lot of
situations where we have the corporation coming in as a party and we as
the divorce lawyer maybe for the spouse who owns the business, have to
be careful that we don't get in a conflict situation by offering advice
to the corporation or to the individual as the corporate officer as opposed
to the individual as the individual. So having that third party corporate
attorney I think is a really, really good idea.
Jere Hight:
Absolutely.
Michelle O’Neil:
And they can also draft the paperwork.
Jere Hight:
They're going to do is docs. And as you pointed out before, if it does
and when I have the corporate attorney one of the things I have to fight
against if I don't have the client who runs the business is, well, they're
aligned. And in my experience, that's not normally the case. So having
them overcome that fear, but like you said as soon as that other person
gets an ownership interest in the corporation, you have the beauty of
another level of fiduciary duty owed by the attorney, which should give
some comfort.
Robert Bales:
So my experience there, in fact when we were at a break I shared with you
one I have going right now where we have a major problem and I'm the company
CPA and the company attorney and I are truly in the middle and he's not
taking any sides. I'm not taking any sense. And I think both sides trust
both of us and maybe we'll work through this problem. He's not taking
any side at all and I'm not seeing him…
Jere Hight:
Cause that's my experience. I mean normally they're not willing to risk their license or anything like that. And they usually try to do the best they can for everybody.
Ryan Segall:
The problem arises when you're taking apart their articles of incorporation or something that they drafted. And then they're trying to defend that.
Michelle O’Neil:
So what about receiverships? Sometimes we have situations where receivers
are appointed over businesses, both in the divorce context. And then I
think you could also have it in this type of context, so those can be
problematic right?
Robert Bales:
As one who has been receiver on several occasions, I would strongly suggest
not doing it unless it is the last resort.
Michelle O’Neil:
Right. Cause it's going to tank the value.
Robert Bales:
It's going to tank the business. It's probably going to trigger due on
sale clauses. It's probably going to have all the loans called in under
the nervous nelly causes in the loan agreements. Customers hate it, they
run for the hills. People don't pay the receivables because they know
it's a receiver. It's problematic.
Michelle O’Neil:
So let's say you have a couple, husband and wife, they go on this business,
they decide to exit the marriage but still co-own the business and you
get a year down the road and it's not working. So what are the alternatives?
Let's first assume that they are both 50/50 owners and they both are active
control. What are their options? What can you do?
Jere Hight:
So why don't you get drafted and buy out provisions for that?
Robert Bales:
And I would suggest to have a buy sell agreements going into the process.
Jere Hight:
Because most people realize trust is low at the end of divorce and it could blow up, so hopefully that's already in place. So then it's just as executing that, someone's got to buy the other person out.
Michelle O’Neil:
That could be a place where the value at the time of the divorce might've
been a valuable information to have, even if we're going to go forward
co-owning.
Robert Bales:
Yeah but in this case, you're going to be buying them out without regard
to the personal goodwill. It's a different value and you're probably,
and this is another thing to consider in the construction of your agreement,
you're probably gonna have it non-compete agreements and employment contracts
in place to protect the business, which nullifies this personal goodwill
problem. So the value is gonna typically be higher, but what you can do
is name the terms and conditions of how you pay it and pay it out of cash flow.
Ryan Segall:
You're still gonna have the problem though of a 50/50 ownership of who’s
going to be doing the buying out.
Robert Bales:
You got to have a buy sell agreement that allows that process to take place.
It could be a bidding process. I've seen them where it's a bidding process.
Michelle O’Neil:
Well and at that point if you're operating under the more normal non-divorced
method of valuing the business, I mean maybe it's just easier to value
it and sell it and everybody take their money and go do something else.
Speaker 3: (18:09)
Yeah. That, that happens.
Michelle O’Neil:
I understand why we're in this predicament because we now no longer have
this tax-deductible alimony option to deal with. And so we have people
that are just, there's maybe no choice, there's not enough cash, not enough
assets for one spouse to take the business and the other spouse to take
something else to get to just and right division so that you then still
have this co-ownership problem. But it just seems fraught with so many problems.
Robert Bales:
It is. Now one thing we did in a case recently, the couple had acquired
an interest in a business and additional interest in what they had and
they had some debt for that acquisition debt. So they were loaded up pretty
good with debt at the time of divorce. So what we did is we put a put
option in the agreement where not he, because he's running the business,
but she had the right to put it to him when that debt's paid off.
Michelle O’Neil:
So tell everybody what a put agreement is.
Robert Bales:
That means the owner can force the other owner to purchase their stock
at a predetermined value or based on some formula. And I think we had
to put option used, we had an appraise and I wouldn't do the appraisal
cause these people are accounting clients not litigation clients. So we
had another valuation person come in and do it. So in the put option,
that same company would put a value on it and she can put it back to him
at her will after the debt's repaid. So there are ways, you just got to
look at again, facts specific ways to get around that. But a good well
drafted by a sale where one can get the other one out, I think imperative.
Michelle O’Neil:
So what about another problem that of co-ownership after divorce seems
to me to be that there can be these shareholder type derivative claims
made against each other. And I mean it just seems like the litigation
could be just all encompassing forever and ever.
Robert Bales:
Yes.
Michelle O’Neil:
That's a simple answer. Yes.
Robert Bales:
Well, yeah, I mean you got Richie versus Ruby, which makes it makes it
harder to get an attorney to file one of those. Because it's really difficult
to get a shareholder derivative claim in Texas now.
Michelle O’Neil:
Tell us why that is.
Robert Bales:
The case pretty well made it very difficult for non-controlling shareholder
to have any say over anything or have any rights to anything.
Michelle O’Neil:
So the problem is now that that the non-controlling shareholders, they
just have to sit there and take it.
Robert Bales:
They're at the mercy of the controlling shareholder, but I know there are
a lot of attorneys out there that if they're offered a few to go harass
their ex-spouse, they'll take the fee to go harass her ex-spouse.
Michelle O’Neil:
It also seems to be counterproductive because the whole point of continuing to comb this business together was so that you didn't tank the value of the business, but if you continue to fight or talk bad about your husband in town or whatever, anything that you do to that affects the value is counterproductive to the point of having this agreement in the first place.
Jere Hight:
Unless the parties have a high level of trust at the end of their divorce,
which is rare, I just don't see it working. You might as well sell the thing.
Robert Bales:
Well, one thing I have seen where it does work is where there are non-controlling
shareholder or non-controlling partner and you're able to take an assany
interest, knowing someone else is making the distribution decisions, someone
else is making the operational decisions. Hospitals is a good example
of this. Typically a doctor owned hospitals run by a hospital corporation.
They're the ones deciding when to pay the money out. They're the ones
deciding how to make capital investments and do marketing everything else.
And if you have a well drafted agreement to where you put them in as fiduciary
role of those funds, funds get paid to the spouse, spouse has to pay the
funds out and you put some tax language in to move the tax over. That
works because they're not controlling that. And done several of them,
but it's a lot harder when they're the one running the business.
Ryan Segall:
I've had cases where we've had multiple corporations involved and we've given them some sort of shares that don't have any voting rights or anything like that. And that way they just sit there, they get their checks and that's that. And that works out because they don't do anything. They've got fiduciary duties that everybody else in there. And that's that.
Michelle O’Neil:
So some sort of assany interest or if you can create that fiduciary relationship associated.
Robert Bales:
with that assany interest and whoever the spouse is isn't in control of
anything. It works great. It's that control that creates the problem.
Michelle O’Neil:
All right. So what about the situation where you have maybe a corporation
where one spouse owns part of it with a person, not the other spouse?
In other words, husband owns 50% with his brother and then after divorce,
husband and wife now own 50% 25 each and brother owns 50% there's some
problems fraught with even that type of co-ownership.
Robert Bales:
I've seen a lot of stuff, but I haven't seen anyone that had the guts to
do that yet.
Michelle O’Neil:
There would be problems with that, that's why.
Robert Bales:
Okay, well the other brother isn’t gonna let it happen.
Michelle O’Neil:
Other brother would object to owning something with the brother's ex-wife.
And then there's also the risk of who gets mad at who in the family dynamics.
Robert Bales:
well and if you put yourself in in the non-working spouses role, all they
have to do is increase their salaries and you have this flow through income
and you'll never get it a dollar.
Michelle O’Neil:
So what are some strategies that you would recommend to people in dealing
with this problem of the businesses? The major asset of the divorce and
we no longer can shift pretax money via contractual alimony and we don't
want to own it together. What are some other creative ways to deal with that?
Robert Bales:
I think what you're going to find is the payout is longer to buy the spouse
out because of the tax issue. And I haven't come up with any great creative
solutions outside of that.
Michelle O’Neil:
Well, and the problem with the payout is that it's bankruptable.
Robert Bales:
Correct.
Ryann Segall:
Yeah. You've got to secure it somehow, but if there's no assets then…
Robert Bales:
You secure it with a business, the business goes under. That doesn't help you a lot.
Michelle O’Neil:
So what do we do?
Robert Bales:
Write a good CYA letter I guess.
Michelle O’Neil:
And I guess that kind of falls into the category of we're just lawyers.
We aren't miracle workers. We can't solve every problem that exists in
the universe. And this is one of the problems that exists in the universe
as of January 1st, 2019. It's just hard to solve and co-owning a business
together isn't a great solution. And a payout over time isn't really a
great solution for either side and so there's just not really great solutions.
Ryan Segall:
Right. If I’m the attorney representing the non-operating spouse, there's no way I take the pay out over time, but at the same time….
Robert Bales:
You got that or a judgment, you can't collect.
Michelle O’Neil:
Well, you hope that there's other assets. I guess the best-case scenario
would be that there's a company worth $1 million and $1 million in a retirement
account. And although apples aren't necessarily equal to apples, the burden,
the hand of money, even if it is tied up in a retirement account, is better
than having some hope of a payout. And that would be about the best solution
that you could hope for.
Robert Bales:
And that works on the smaller businesses. But when you get a business where
it, a lot of these successful entrepreneurs are illiquid, they keep their
money in their business because that's where they make their most money.
So you have a business worth $10 million and you got a house worth $750,000
and a half million in a retirement account. You got no choice but to finance
the purchase of that business interest.
Michelle O’Neill:
I mean, there's just no other assets.
Robert Bales:
And we see a lot of that because successful entrepreneurs are not typically liquid.
Michelle O’Neil:
I mean, why would they be? If they can make more money having their business
be more successful. All right, well that wraps us up for the divorcing
the business owner entrepreneur webinar. Thank you all for joining us.
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