Divorce for Business Owners

Divorce for Business Owners

Valuation and division of business interest

Valuing and dividing an interest in a business entity can be the most important and complex part of a divorce case. If a community interest in a business is not divided in kind, a professional business valuation may be needed to determine the amount of property needed to “equalize” the out-spouse for their interest in the business.

California law generally requires the court to value the business interest at fair market value (FMV) at the time of trial unless the parties can agree on a different arrangement. (See Fam. Code, § 2552.) FMV is the price a willing buyer and seller would pay without compulsion. (See E. Division of Community Estate Upon Dissolution, Legal Separation or Nullity, Cal. Prac. Guide Family L. Ch. 8-E.)

To value a business interest, courts must generally follow the IRS guidance in Revenue Ruling 59-60. (See, e.g.,  In re Marriage of Hewitson (1983) 142 Cal.App.3d 874, 888.)

Under Revenue Ruling 59-60 there is no single method to value a closely held business. Instead, the valuation may consider multiple factors to determine FMV for the community interest, including, among other things, the company’s:

• Historical earnings and financial condition
• The economic outlook for the industry in which the business operates
• Book value
• Goodwill and other intangible value
• Recent transactions for the business’ shares
• Recent transactions for shares in comparable businesses

(See Rev. Rul. 59-60.)

Expert valuation approaches may include an income approach (e.g., discounted cash flow or capitalization of earnings), a market approach, or an asset approach. Determining which approach is best is often highly fact-dependent and requires the expert testimony from a business valuation specialist.  

Effectively presenting business valuation evidence to the court (which can be dense and jargon-heavy) is essential.

Equitable apportionment of business interests

If an interest in a business entity is acquired before marriage, it is the separate property of the spouse who acquired it. (See Fam. Code, § 770.) However, if a spouse operates a separate property business that increases in value during marriage, the community may acquire an equitable interest in the appreciation. This is commonly referred to as  Pereira/ Van Camp apportionment, named after two seminal cases on the subject,  Pereira v. Pereira (1909) 156 Cal. 1 and  Van Camp v. Van Camp (1921) 53 Cal.App. 17.

If the judge determines that a spouse’s labor primarily caused the business to appreciate in value during marriage, then the court may employ the  Pereira approach. Under the  Pereira approach, the judge may equitably divide the appreciation in the business by assigning to the operating spouse a separate property interest equal to a rate of return on the value of the business at the date of marriage at a “well secured” rate, with the balance of the appreciation apportioned to the community. (See  Pereira v. Pereira, supra, 156 Cal. at p. 7.)  Pereira apportionment is generally favorable to the community.

However, if the judge determines that things other than a spouse’s marital efforts mainly caused the business to appreciate (e.g., market forces or the efforts of others within the business organization), then the judge may use the  Van Camp approach. Under the  Van Camp approach, the community is apportioned the reasonable value of the operation spouse’s marital services in support of the business, while the operating spouse is allocated the balance of the appreciation. (See  Van Camp v. Van Camp, supra, 53 Cal.App. 17 at p. 24-25.)  Van Camp apportionment is generally favorable to the operating spouse.

The judge has wide discretion to apportion appreciation in a business and need not follow either the  Pereira or  Van Camp approach. (See  Beam v. Bank of America (1971) 6 Cal.3d 12.) Having a knowledgeable attorney who can effectively apply the facts to the law and present a persuasive case to the court is important.

Stock options (ISOs, NSOs, and RSUs)

The Court has significant discretion in dividing stock options between the employee’s separate property and the community to achieve a fair result. How it divides the options may be highly fact-dependent. One key factor the Court may consider is the purpose for which the company granted the options to the employee (e.g., as deferred compensation for prior service rendered or as an incentive to retain the employee’s future services or both). (See  In re Marriage of Hug (1984) 154 Cal.App.3d 780.)

In cases where a company grants stock options before the date of separation but the options vest  after the date of separation, the options may be apportioned according to a “time rule” formula. (See  In re Marriage of Hug, supra, 154 Cal.App.3d at p. 780.) The inputs that the Court uses in a “time rule” formula to obtain the ratio of separate vs. community property are discretionary and may vary based on the facts.

Intellectual property

Business owners may also possess intellectual property (IP). IP is considered “personal property” that may be valued and divided by the court. (See Civ. Code, § 663.) For business owners, IP to be divided by the Court commonly includes copyrights, patents, trademarks, and trade secrets. However, it may also involve goodwill and even name, image, and likeness rights (NIL). The court may need expert testimony to assist it in valuing the IP assets.

Retirement accounts

Defined contribution plans like 401(k)s and defined benefit plans (pensions) may need to be specially divided by what’s called a qualified domestic relations order (QDRO). For other types of defined contribution plans like IRAs, a QDRO may not be necessary.