By Michael Rhoades and Joy M. Feinberg
Family business owners endure the long hours, pain, stress and strain of building and growing a business so that they can provide their family with an environment of financial security and stability, with the ultimate hope of future generations running the business. When planning for the future, the family business owners want to ensure that the succession of the business is in accordance with their wishes, and they take steps to ensure that the wealth generated by the business stays within the family. But what happens when a family member divorces?
The best protection available to guard against wealth generated from a family business falling into the hands of a divorced spouse is to enter into a Premarital Agreement, provided such agreements are recognized in the state. This article explores the use of Premarital Agreements to protect your business interests from spousal rights in death and divorce in states that recognize such agreements, and recommends other protections in those states that do not recognize Premarital Agreements.
A Premarital Agreement is a legal contract designed to protect the property of individuals acquired prior to marriage. Premarital Agreements generally focus on two contingencies: death and divorce. Premarital Agreements are frequently used to release, waive or give up certain future spousal rights and interests. These spousal rights are normally acquired at the time of marriage and extend to retirement plan interests, income, property either owned before or acquired during the marriage, and other assets of the other spouse.
People frequently sign a Will and Trust to provide for their spouse and children and to minimize estate taxes due as a result of death. Most states permit a surviving spouse to elect a statutory percentage of a deceased spouse’s estate in lieu of receiving under the decedent’s Will. Premarital Agreements can modify or even eliminate the spousal statutory percentage so that a greater portion of the decedent’s estate (and even retirement plan assets) can pass to descendants or other desired heirs instead of a surviving spouse. Premarital Agreements are often used in second or subsequent marriage situations to delineate what, if anything, a surviving spouse is entitled to at death. When a family business interest is among the decedent’s assets, Premarital Agreements often require that the surviving spouse waive the right to the business interest.
Premarital Agreements can protect from the two most common concerns of a divorce (i) the division of pre-owned, gifted or inherited assets and (ii) the limitation or exclusion of a spouse from receipt of maintenance (also known as “alimony”). In the 25 states and jurisdictions which have enacted the Uniform Premarital Agreement Act (UPMAA), limitations on maintenance are valid so long as the spouse not entitled to maintenance is not left impoverished. An ex-spouse is impoverished if he or she, due to insufficient income, is eligible for support under a program of public assistance at the time of separation or marital dissolution. If this occurs, a court can require that the monied spouse pay to the impoverished spouse sufficient funds for that spouse to avoid eligibility for public assistance. This standard is a pittance of what the monied spouse would normally be required to pay in the absence of a Premarital Agreement.
Planning When Acquiring a Business Interest
Careful planning is necessary before the senior generation transfers any ownership interest in the family business to the next generation. When a business owner wants to transfer, gift or sell an ownership interest in the family business to a child, it is wise to do so in a manner that (i) protects the business interest from subsequent division, dilution or redemption by compensating payment to a non-family ex-spouse and (ii) avoids involvement of the family business in a divorce proceedings.
Lifetime Transfers. When lifetime transfers are contemplated, the business interest is transferred either by gift or by sale. Lifetime gifts are considered taxable gifts by the donor for Federal estate tax purposes based on the value at the time of transfer. Generally gifts made in trust can provide the donee family member the benefit of ownership, but will not result in the business interest being treated as marital property.
Alternatively, if the purchaser is married at the time of purchase of the business interest, the source of funds (from marital funds or non-marital funds) generally determines the character of the business interest. Care should be taken so as to avoid purchasing a business interest with marital funds.
At death transfers. If the business interest is transferred at death, the interest would be treated as the recipient’s separate non-marital property. Again, the safest way to transfer the interest is generally by transferring the interest to a trust created for the benefit of the desired family members.
Protections Provided by a Premarital Agreement
When a shareholder of a family business with pending nuptials signs a Premarital Agreement, other family shareholders receive a level of comfort in knowing that the future spouse will not have an interest in the family business. With this extra level of comfort, senior generations may be more inclined to begin or to continue to transfer additional shares to the family member to be wed.
Similarly, Premarital Agreements for the senior shareholders contemplating a second marriage provide the younger shareholders a level of comfort that the business will stay in the family. This becomes increasingly important as the younger generation invests a greater amount of time, money and energy in operating the business.
When To Discuss Premarital Agreements
As each family business and as each family unit is unique, there is no single right time to discuss Premarital Agreements. That said, the authors’ experience has been that the earlier the subject is discussed, the better. Generally it is the senior family member who encourages the younger family member to consider a Premarital Agreement. Although the senior family member often has the ability and the means to be very persuasive, one of the legal requirements for Premarital Agreements is that both parties enter the agreement voluntarily. The notion of a Premarital Agreement will be received much better if the Premarital Agreement is presented as a means to protect the family business and, as such, the entire family.
In larger families the idea of a Premarital Agreement can be presented by the senior generation during an annual board meeting (if all family) or during a family meeting. If discussed before nuptials are contemplated, no specific family member feels singled-out or that the selection of that member’s spouse necessitated the discussion of a Premarital Agreement. This can temper feelings and ultimately permit the process to proceed smoothly, as a forethought rather than an afterthought. Additionally or alternatively, lawyers can lead the discussion about the need to consider a Premarital Agreement, and, by being an outside party, can reduce some of the friction of the process. If friction does occur, the lawyer should take the heat – after all, the lawyer will not be the in-law.
Protection for the Family Business
A Premarital Agreement can be drafted to avoid having any ownership interest of the family business transferred to the ex-spouse. The last thing that any family wants is the ex-spouse non-family member as a shareholder of a family business, thereby granting the ex-spouse shareholder certain legal rights, including the ability to attend shareholder meetings. If an ex-spouse obtains an ownership interest in a family business, the cost of purchasing the interest can result in financial hardship to the family and to the business as well as being an emotional “thorn” in everyone’s side.
If a divorce occurs and the family business interest is marital property, the interest must be valued. Each party will hire an appraiser to review the family business’ financial information and assets to determine the value of the business. Not only is this process very disruptive to the family business, but a soon to be ex-spouse will obtain very confidential information, some of which may become part of the court record. As court records are generally available to the public, the business’ confidential information may be obtainable by its competitors. In such cases, it is wise to demand a “Protective Order” or such other device designed to keep vital information confidential.
In a divorce proceeding if an interest in the family business were marital property, the non-family member would secure appraisers in an effort to value the interest at the highest possible value. This high value may undercut valuations that other family members may be claiming for gift tax purposes or for estate tax purposes.
No Surprises. The eve of a marriage can be a tense time. Emotions often run high. A shareholder of a family business should mention the need for a Premarital Agreement to his or her intended before the engagement is announced. The Premarital Agreement should be negotiated and signed well before the wedding day. Although there is a tendency to wait until the wedding is close at hand, the entire process is much less stressful if the agreement can be signed at least several months before the wedding.
One size does NOT fit all. Premarital Agreements can be entered into by couples in their twenties or couples in their eighties. Each Premarital Agreement must be tailored to the parties’ needs, concerns and assets. Although some jurisdictions permit the modification of Premarital Agreement after a wedding, in the event of a divorce, post-marriage modifications usually receive a higher level of scrutiny when enforcement is sought.
Experience. The authors suggest that clients inquire about their lawyer’s experience in this field. Clients should know how many Premarital Agreements the lawyer drafts each year and how many times the lawyer has successfully defended and defeated such agreements. The lawyer should possess both a strong legal background in these areas of law and the negotiation experience that comes with drafting numerous Premarital Agreements.
Business Succession Planning in Lieu of or In Addition to Premarital Agreements
As mentioned above, the senior generation should carefully consider the manner in which a family business interest is transferred to the younger generation. The use of trusts may avoid having any value of the family business be included as marital property.
Restrictive Buy-Sell Agreements provide additional assurances to keep the ownership of a family business in the family. Some family businesses create two classes of stock, voting and non-voting. By exercising greater care in the transfer of voting stock, it becomes less likely that a non-family member will acquire voting rights. This can solve some, but not all, of the problems mentioned above. The creation of voting trusts is another means to keep voting rights in the family.
Given all of the possibilities, it is imperative to engage an experienced corporate and estate planning attorney who is very familiar with family law, or a matrimonial practitioner experienced with drafting and defending Premarital Agreements. The law of each state must be considered. In those states where UPMAA does not exist, or where Premarital Agreements are not recognized, you will need to understand how your state categorizes property as either “marital”, (subject to division at divorce) or “non-marital” (not subject to division at divorce) and plan accordingly.
Armed with such knowledge, planning through the use of gifts and documenting those gifts may keep the property separate and safe from non-family members. Assuring that the stock transfers to couples are not in the joint names of both the family member and non-family member helps maintain a “separate” character to the stock. Buy-Sell Agreements can prevent unwanted transfers of the stock by first allowing the company and/or the other shareholders to approve the proposed transfer. Buy-Sell Agreements can also permit the stock to be purchased at a price substantially below “fair market value.” Transferring family business interests to a trust solely for the benefit of a family member may also help in keeping the business interest separate, as well as clearly defining, in writing, that the property is solely intended for the direct descendant and not the spouse, which is always helpful in the event of divorce.
Many planning opportunities exist. To take advantage of these planning opportunities in a manner that minimizes family conflict and protects the family business, consult your corporate and estate planning attorneys and prepare your upcoming generation with these concepts long before they enter into serious relationships.