Almost 50 percent of all marriages end in divorce. That number rises to 60 percent for second marriages. Divorce can be devastating, with long-lasting negative effects on the individuals involved, as well as their children. By its very nature, the act of splitting up is destructive and, as such, divorce can bring out the worst in people. When love turns to hate, there can be a lot of collateral damage, including damage to the family business. Given that 90 percent of businesses in the United States are family businesses and divorce rates are so high, it should be no surprise that if protective steps aren’t taken in advance, divorce can result in not just the breakup of the family, but also of the family business.
A family business tends to be the most valuable asset of a marriage. Typically, it’s also inherently illiquid. That means that it’s difficult to divide in a divorce without either having a divorced spouse as a partner or having a forced sale at potentially fire sale prices. Neither of these results is ideal, but if planning isn’t done in advance of a divorce (and ideally before the marriage), they could become reality under the equitable distribution rules applicable to divorce in most states. Fortunately, a variety of advance planning techniques are available in the estate planner’s tool kit, including pre-marital agreements, trusts and buy-sell agreements. While none of these techniques is necessarily fool proof, they can be highly effective (particularly if used in combination) in protecting the family business in a divorce. Better to plan for the worst, and hope for the best. That’s what my great-uncle used to tell me, and he should know, since he was divorced three times.
How Property Passes in Divorce
Every state has now adopted the concepts of “no-fault divorce” and “equitable distribution,” although results can vary dramatically from state to state, depending on how each determines the “equitable share.” Generally, under equitable distribution, there are two basic types of property—separate property and marital property. Separate property is property owned by each spouse prior to the marriage, along with any appreciation on such property, as long as it’s not connected to the efforts of either spouse. Separate property also includes inheritances, even, in most states, if such inheritance was received during the marriage. Marital property typically includes property acquired or accumulated during the marriage. Separate property can be transformed into marital property either: (1) because of the active management of one of the spouses during the marriage (in which case, the appreciation on separate property becomes marital property), or (2) because separate property was commingled with marital property. Separate property typically isn’t up for grabs in a divorce, but it can be taken into consideration when determining the equitable distribution of the marital property.
Although the status of property as separate property won’t protect it from equitable distribution in every state, at the very minimum, an individual bringing an interest in a family business into a marriage should make sure that such property is treated as separate property (note that it’s likely that appreciation on the family business during the marriage will be considered marital property because of the efforts of one of the spouses). So how does one preserve separate property treatments? The key is not to commingle the separate property with marital property. Clear identification and documentation of ownership helps keep interests in family business separate property. Liquid assets need to be kept in a separate account. Using a revocable living trust to own the separate property can also be helpful. A good rule of thumb is that the other spouse shouldn’t be a trustee of the revocable living trust or have any powers over the trust under a power of attorney.
Properly structured, pre-marital agreements are among the most effective mechanisms for protecting family business interests in a divorce. They are, however, potentially problematic from an emotional point of view, particularly in the context of a first marriage. “Honey, I love you completely and want to share everything with you. Oh, by the way, I need you to sign this pre-marital agreement.” Not necessarily the best way to start a marriage. But what if the family business required all owners to enter into pre-marital agreements? That would seem far more palatable. Just make sure the policy is in place before the need for the particular pre-marital agreement, or the future spouse might take it personally.
Pre-marital agreements, which deal with what happens to property in the case of divorce or the death of a spouse (typically second marriages) became popular in the 1970s as the number of divorces exploded and courts began to recognize that managing economic expectations in a marriage by contract could actually support the public policy favoring lasting marriage. The landmark case, Posner v. Posner,1 was among the first to recognize the enforceability of pre-marital contracts in the event of a divorce. The Uniform Marriage and Divorce Act (UMDA), drafted in 1970, provides that a court “shall” consider pre-marital agreements when determining the appointment of property in a divorce. But for more than a decade after Posner and the UMDA, the enforceability of pre-marital agreements remained uncertain. This began to change in 1983 with the Uniform Premarital Agreement Act (UPAA), which sought to provide certainty and uniformity in enforcing pre-marital agreements.
According to the UPAA, a pre-marital agreement is defined as “an agreement between prospective spouses made in contemplation of marriage and to be effective upon marriage.” Section 2 of the UPAA provides that a pre-marital agreement must be in writing and signed by both parties. No additional consideration is needed for the agreement, as the UPAA provides that marriage itself is consideration for a pre-marital agreement. Section 3 of the UPAA provides, among other things, that the parties to a pre-marital agreement may enter into a contract regarding: (1) the rights and obligations of each of the parties and any of the property of either of them whenever and wherever acquired or located; (2) the disposition of property upon separation, marital dissolution, death or the occurrence or non-occurrence of any other event; and (3) any other matter, including their personal rights and obligations, not in violation of public policy or a statute imposing a criminal penalty. Section 4 provides that a pre-marital agreement becomes effective upon marriage and isn’t enforceable if the marriage doesn’t take place. Section 5 provides that a pre-marital agreement may be amended or revoked only by a written agreement signed by the parties.
Section 6 of the UPAA provides that a pre-marital agreement isn’t enforceable if the party against whom enforcement is sought proves that: (1) the party didn’t execute the agreement voluntarily; or (2) the agreement was unconscionable when it was executed and, before execution of the agreement, that party: (i) wasn’t provided a fair and reasonable disclosure of the property or financial obligations of the other party; (ii) didn’t voluntarily and expressly waive, in writing, any right to disclosure of the property or financial obligations of the other party beyond the disclosure provided; and (iii) didn’t have, or reasonably could have had, an adequate knowledge of the property or financial obligations of the other party. Although the UPAA doesn’t require each spouse to have independent legal representation, most states would take that into consideration when determining whether a party to the agreement was adequately informed.
A majority of states have adopted the UPAA, and pre-marital agreements are now extremely common, particularly in second marriages in which there are children from the first marriage. A pre-marital agreement that’s properly structured can go a long way to protect family business interests in divorce. It should be the first line of defense. But because of emotional factors, it’s not always possible to obtain a pre-marital agreement without threatening the marriage. As such, other approaches, such as trusts and buy-sell agreements, may need to be considered.
Post-nuptial agreements are marital agreements entered into after the marriage. Although initially frowned upon, post-nuptial agreements that follow the requirements of the UPAA are increasingly enforceable by courts. But, it should be noted that post-nuptial agreements are still in their legal infancy and are less reliable regarding enforceability than pre-marital agreements.
Trusts can be highly effective in protecting family business interests in the context of divorce. Such trusts fall into two broad categories—third-party spendthrift trusts and self-settled trusts (either domestic or offshore).
Third-party trusts are trusts set up by one person (the trustor, grantor or settlor) for the benefit of another individual or individuals (the beneficiary or beneficiaries). As such, the person who sets up the trust isn’t one of the beneficiaries. The spendthrift aspects of the third-party trusts give the trustee discretion regarding when and if distributions are made. This makes a spendthrift trust an extremely effective vehicle for family members with potential creditor problems, including divorce. For these reasons, in our practice we generally advise clients concerned about protecting gifted and inherited assets (including interests in family businesses) to make the gift or bequest to a discretionary trust for the benefit of the child. The trust should vest the trustee with complete discretion to make, or not make, distributions to the child and his descendants.
The trust shouldn’t contain provisions that may be construed as granting a right for the child to withdraw or receive funds from the trust. Our concern is that a court could conceivably order the assignment of all or a portion of such right to a divorcing spouse. Accordingly, the trust shouldn’t force out the income to the child, shouldn’t place standards on distributions from the trust and certainly shouldn’t provide that principal will be distributed, or will be subject to a right of withdrawal, by the child at a particular age or ages. And, in all events, the trust should include a spendthrift clause expressing the grantor’s intent that the child’s interest in the trust shall not be subject to assignment, whether voluntary or involuntary, to any creditor. The laws of some states provide automatic spendthrift protection for certain interests in a trust. However, the practitioner shouldn’t rely on these statutes, as they may contain exceptions for spousal claims. Some of our clients have provided that the child may have a withdrawal right over the trust subject to the proviso that if the child is married and doesn’t have a pre-marital or post-nuptial agreement in place, the withdrawal right becomes null and void. While we will do this at the client’s insistence, our usual advice is not to take this course. How does the trustee decide whether the marital agreement is effective? Is the trustee subject to liability if he makes a distribution relying on the effectiveness of the marital agreement if the distribution is later attached in a divorce? What protections does the clause really afford, since a child who knows about it could simply defer marriage until a date subsequent to the effective date of the withdrawal right?
Some states’ laws purport to protect assets held in an irrevocable trust from an individual’s creditors, even if the individual is the grantor of the trust. Perhaps the best known among these states are Alaska, Delaware and South Dakota, but many others have jumped on the bandwagon since those states passed their self-settled asset protection statutes. Do trusts established in these states protect assets from claims of a divorcing spouse? The answer appears to be “yes” if the trust was established prior to the marriage. Even if the trust is established prior to the marriage, the transfer to the trust must still pass muster under state fraudulent conveyance laws. However, even if the transfer is outside the fraudulent conveyance statute, it may be voided as against public policy, although we know of no case so holding. In addition, there appears to be one state—Nevada—that will protect a trust against spousal claims, even if the trust is established after the marriage. Practitioners attempting to use a trust in one of the states that permit self-settled asset protection trusts should seek the advice of experienced counsel in the applicable state.
Sometimes, individuals decide to set up offshore self-settled trusts in a location like the Cook Islands or Nevis, to gain more asset protection than a domestic self-settled asset protection trust. Again, this should only be done with the help of an expert. Finally, self-settled trusts are often combined with charging order entities, like limited liability companies, to add an additional layer of asset protection.
Many times, there are several owners of a family business and neither they nor the divorced owner want to go into business with the other spouse upon divorce. Without a pre-marital agreement or trust in place, this could potentially be the case. Fortunately, there’s another kind of agreement, known as a buy-sell agreement, which can prevent this from happening.
A buy-sell agreement is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder’s interest by: (1) other shareholders (in a cross-purchase agreement); (2) the business itself (in a redemption agreement); or (3) some combination of the other shareholders and the business (in the case of a hybrid agreement) upon the occurrence of certain events described in the agreement (so-called “triggering events”). The most important triggering event is the death of a shareholder, but others include the divorce, disability, retirement, withdrawal, termination of employment or bankruptcy of a shareholder.
A buy-sell agreement’s primary objective is to provide for the stability and continuity of the family business in a time of transition (like divorce) through the use of ownership transfer restrictions. Typically, such agreements prohibit the transfer to unwanted third parties (like divorcing spouses) by setting forth how, and to whom, shares of a family business may be transferred. The agreement also usually provides a mechanism for determining the sale price for the shares and how the purchase will be funded. Although the non-owner spouse typically isn’t a party to the buy-sell agreement, he should review the document and sign an acknowledgement that he’s aware of the agreement and has reviewed it. This will prevent a claim in divorce that the non-owner spouse wasn’t aware of the buy-sell agreement.
Combination of Methods
While keeping property separate during a marriage, pre-marital (and even post-nuptial) agreements, spendthrift trusts and certain self-settled trusts as well as buy-sell agreements can each be effective in protecting family business interests in a divorce, they’re more effective when used in combination. In fact, they can be so effective that it might not be considered fair to the spouse without the property. But then, history is written by the victors. Just ask Richard III, who was recently found buried under a parking lot in England. Was he really a tyrant who murdered his nephews to ascend the throne, or was that merely the story told by the victorious Tudors and their shill, Shakespeare? Heck, according to preliminary investigations of the skeleton, he might not have even been a hunchback, and he didn’t have a withered arm.
1. Posner v. Posner, 233 So.2d 381 (1970).