Whose Business is it Anyway? A Business Succession Case Study

Cartoon businessman looking a gap  in walkway

Three Ward and Smith attorneys provided an overview of succession planning, estate planning, divorce, and the separation of assets.

The seminar — A Business Succession Case Study — used an interactive presentation and a variety of hypothetical scenarios involving the fictional Rookie Family to help participants understand the nuances of succession planning, estate planning, and the disbursement of assets in the event of divorce.

Session presenters included Paige Inman, a recently named North Carolina Board Certified Specialist in Family Law, Richard Crow, a business attorney, and Matt Thompson, a North Carolina Board Certified Specialist in Estate Planning and Probate Law.

The attorneys tackled several potential legal scenarios involving Rookie’s Construction Company, which Cheryl and Wayne Rookie founded. To begin, the attorneys provided background information on several important dates and events about the fictional owners, their families, and the company.

The first item of interest occurred when Cheryl and Wayne’s children, Joel and Tiffany, were gifted stock in the company when they graduated from high school. Both were unmarried at the time, and neither gift included a signed shareholder agreement.

In 2010, Joel married Natalie with no premarital agreement. They were married for five years and had two children together. During the marriage, Joel’s primary employment was with Rookie’s Construction Company as a project manager. Over the years, he worked his way up the chain of command. In 2015, Natalie filed for divorce.

Potential Risks to Business After Divorce

Through Ward and Smith’s interactive polling feature, seminar participants were asked to share their opinions on the business's potential risks upon Joel and Natalie’s divorce. In regard to what would happen to the business, participants were asked to pick one of the following options:

  1. Joel had an interest in the business prior to his marriage, and therefore Natalie receives nothing.
  2. The business has to turn over financial information over a five-year period to ascertain the value of Joel’s ownership interest in the business. Joel retains his ownership interest but has to pay Natalie to retain his interest.
  3. The business is joined as a party to the lawsuit between Natalie and Joel. The Court can direct and order the business to take or refrain from action and can distribute ownership to Natalie or order the business to make distributions to Joel to pay Natalie.

“Before we dive into this, I want to provide a little background on how a disgruntled ex-spouse can get their hands on your business,” said Inman. North Carolina recognizes equitable distribution, a claim that is filed to divide marital property and marital debt upon separation.

Even if one of the spouses does not do any work, either with or for the business, equitable distribution recognizes marriage as a partnership and recognizes both spouses as contributing to the marriage. This means that title to property is not a controlling factor as to whether or not that property is going to be classified as marital.  Therefore, actual ownership interest in the property is distinguishable from the development of a marital property interest by virtue of the marriage.

Inman provided further detail:  “The presumption in North Carolina is that all marital property, which is defined as all property that’s acquired from the date of marriage to the date of separation, will be divided equally between the spouses. North Carolina also recognizes protection for separate property, which is defined as property that you are bringing to the marriage and any property that you acquired during the marriage by inheritance or gift, including gifts from family members.”

In regard to the scenario involving Joel and Natalie, Joel’s ownership interest in the company was acquired prior to the marriage, which makes it a separate property. However, the law recognizes that Natalie should be entitled to half of the appreciation in the value of the business for the time she was married to Joel if the appreciation of the business was due to Joel's active efforts during the marriage.

“Upon their separation, the company will have to be valued as of 2010, when the parties were married, and valued as of 2015, when the parties were separated,” noted Inman. “Natalie is entitled to a share of that increase in value, if it is shown that Joel’s active work caused, or was part of the cause, of that increase in value.”

A potential issue that could be raised in litigation would be to question how much Joel’s work vs. the work of a third party contributed to the appreciation in value. The amount of effort required to determine that could result in a significant amount of expense to both Joel and Natalie.

As far as the question responses, Inman explained that, “If appreciation has occurred, Response A is not going to happen unless Natalie decides she is going to walk away from the business and receive nothing, and I assure you, most disgruntled ex-spouses are not going to do that if they are being told that they can be compensated.”

Response B would be essentially guaranteed, but an important item to note would be that both Joel and Natalie would potentially need to hire their own experts to appropriately value the business. Response C is something that is currently developing in North Carolina.

“In this situation, the business is a mixed asset, and there is case law in North Carolina, that gives the court the authority to distribute a mixed asset to a non-owning spouse,” added Inman. “Now, I assure you most district court judges are not going to do that, because they understand a disgruntled ex is not going to serve any valuable purpose in making sure the business continues to function. But you do need to know that it is possible.”

Premarital Agreements

Having a premarital agreement can help to prevent some of these issues and safeguard a business. In general, premarital agreements can be:

  • Limited in nature in order to address certain specific items of property, i.e.:
    • An agreement that addresses a specific prohibition that the business cannot be distributed to ex-spouse; or
    • An agreement that addresses the appreciation of the business and ensures that an ex-spouse cannot share in the value of the appreciation.
  • Broad in nature such that they address multiple items of property, up to all items of property that could or would be acquired during the marriage.

The bottom line is that premarital agreements do not have to be the scary, argument-causing document that causes issues between potential spouses.  Instead, they can be limited in nature to address specific items of property and provide peace of mind that a well-established family business is not subjected to certain risks as a result of marriage.

Including a clause within a shareholder agreement that requires a premarital agreement could be an effective tactic for alleviating a spouse’s concerns over signing a premarital agreement and to aid in the conversation regarding signing one.  It can also add protection for the spouses in scenarios where additional family members are acquiring ownership interest as it ensures that the business will not be tied up in divorce-related litigation related to other family members as well.  In general, it is a good idea to work out the details and protective provisions within a shareholder agreement prior to gifting the stock, as doing so makes things easier in a variety of ways.

Limiting the transfer of stock is an obvious provision that often gets included. “Most of my clients love their in-laws and their spouses, but they don’t want to be in business with them,” said Crow. “We cover that by including a clause that allows a shareholder to buy stock back in the event of something like an involuntary transfer resulting from an equitable distribution.”

Succession Planning

After the divorce, Cheryl and Wayne opt to include a clause in the shareholder agreement that restricts the transfer of shares to any non-blood relatives. The years have passed quickly; Cheryl and Wayne are now in their late 60s and considering what to do with the family business. Joel is heavily involved as the COO and Tiffany is not involved, but her husband Oscar serves as the senior manager of finance.

To reward Joel for his hard work, Cheryl and Wayne want to give him their remaining shares of stock in the company. The stock represents over half the total value of all the assets in Cheryl and Wayne’s estate. “As an estate planning attorney, my job is to help our clients provide for the people and causes they care about, maintain business continuity if possible, and reduce or eliminate tax liability,” commented Thompson.

There are three major exceptions to estate tax rules that reduce or eliminate state tax liability:

  • Marital deduction – husband and wife can leave an unlimited amount to each other, free from gift and estate taxes
  • Charitable deduction – can leave unlimited amount to charity with no tax obligations
  • Estate tax rule – first $12 million in assets tax-free

Many with closely held businesses opt to split the company equally between their children. “There’s no law, however, that says you have to treat your kids equally,” explained Thompson.

Someone like Tiffany, who is not involved in the business, may prefer cash over an interest in the company, even if the numbers aren’t equal. “I always encourage our clients to sit down and talk with their children if they can,” said Thompson. “Then they can adopt a strategy based on what their business does and create a plan that fits with their particular family circumstances.”

As Cheryl and Wayne get closer to retirement, they start to notice that Joel has become increasingly distracted by his new girlfriend and his leadership is not very strong.

Selling the business may be preferable. Thompson explained that in many instances, the parents depend on the continued successful operations of the company for income in retirement. This only adds to the difficulty of decision-making.

Choosing to sell the business to an outside party could allow for capital preservation while at the same time allowing Joel to keep his job. Another option could be to liquidate the company by selling off different divisions.

Passing the business on to an internal stakeholder or high-value employee would be a good choice, though not available to the Rookies as they are only nine months away from retirement. “Recruiting, incentivizing, and retaining the right people has to start early,” added Crow.

Identifying the talent that will move up the chain helps to ensure that inexperienced people do not end up in management in the event of an emergency. Many business owners want to incentivize employees such that they behave like owners, without actually giving them any equity.

“There are many other incentive plans we can do that don’t involve equity, to make sure they feel like an owner,” noted Crow. “If you give them an opportunity to experience some increase in their own net worth because of what they do for your business, they’re more likely to stay with you.”

It’s also critical to start considering the options well before retirement. “There’s a proving ground, there’s training and things take time to evolve, so what we really encourage our clients to do is plan for the transition years in advance,” concluded Thompson.

© 2024 Ward and Smith, P.A. For further information regarding the issues described above, please contact Jane Francis Nowell.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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