New Risks to Business Ownership

family owned businessWhether the traditional family business ownership or assets such as real estate ventures owned jointly by family members in limited partnerships, corporate or LLC forms.

Traditional risks to business ownership and the economic sustainability of the family enterprise include the death or the divorce of a shareholder if proper planning is not in place.

The new risk to business ownership is the increasing attack by the courts on the family business when allocating assets in a divorce. In some states, known as equitable division states, gifted and inherited assets are divisible in a divorce. This does not just include what the about-to-be divorcing family member owns when married; it also includes the expectancy of what that divorcing family member will receive in the future.

Those expectancies are taken into account when determining the allocation of assets between the couple about to be divorced. As an example of the division of gifted/inherited assets in an equitable division case consider the 1981 Massachusetts court case, Vaughan v. Vaughan. In that case the parents of the son gave the couple (who were in their 30s without children) the annual exclusion gift of $10,000 a year for a period of years. The daughter-in-law sued the son for divorce and her attorney subpoenaed his parents asking that as part of the divorce the parents turn over copies of their estate planning documents, the date they were last amended and an approximation of their net worth (plus or minus $500,000).

The rationale for doing so was that the pattern of gift giving was inextricably interwoven into the lives of the son and daughter-in-law and it was “was what allowed the daughter-in-law not to work.” The expectancy of what the son will receive when his parents die is a factor that is taken into account in determining how the assets of the couple are to be divided in the divorce. The parents refused to provide these documents, but the Judge ordered them to do so. The parents then appealed that order all the way up to the Supreme Judicial Court in Massachusetts (the highest court in Massachusetts).

In a Single Justice decision, the court agreed with the daughter-in-law and ordered the parents to comply with the court order or face jail for contempt. The gifting of cash in annual exclusion amounts is easy to value – what if instead that gift had not been of cash but had been of an interest in a family owned business or an LLC, or investment in a family limited partnership? Then not only would the asset be considered an expectancy but the valuation of that asset would be part of the son’s divorce proceeding. That adversary valuation may do serious damage to the estate plan of the older generation. Placing the assets in trust does not necessarily take them off the table – it may only affect the valuation of those assets in a divorce.

In addition to the allocation of assets, there is an increased risk for the allocation of alimony. Many family businesses or co-owned assets have phantom income or Subchapter S income – income that is earned during the course of the marriage which shows up on the tax return and is plowed back into the family business. At issue is how that phantom income should be treated for alimony purposes.

If it was earned during the marriage, is it marital income taken into account for alimony and child support purposes even though not actually received?  When thinking about these risks, it is important to remember that it is not the law or the court in the jurisdiction of the parent or grandparent that will control these decisions; it is the law and the court in the jurisdiction of the divorcing spouse that will control these decisions. These risks can be mitigated by a well negotiated pre-nuptial agreement or post-nuptial agreement.

Prenuptial agreements are not new.  Court records show that a James Young and a Susan Huffman entered into a premarital agreement in Page County, Virginia in 1844.  Prenuptials are also not just for celebrity couples like Jackie Kennedy and Aristotle Onassis, Michael Douglas and Catherine Zeta-Jones, Madonna and Guy Ritchie, and Paul McCartney and Heather Mills.  Increasing numbers of women today remarrying in their 30s, 40s, 50s, 60s, 70s and 80s consider these agreements an important part of secure financial planning.

That’s because a prenuptial agreement can safeguard assets, protect family members, keep a business in the family, and in certain circumstances, even cover such specific details as how the mortgage and daily expenses are to be are to be paid if and when a marriage ends. They can be as broad or as limited as the parties decide.

Perhaps there is concern about being saddled with a fiancée’s business debts.  Or with the demands of an ex-spouse. Or concern about how much you will have to contribute to the support of a spouse’s children.   A well-drafted prenuptial agreement can handle all of these issues.  If the person is giving up a career or a lucrative job to get married, a prenuptial agreement can also set forth compensation for sacrifice if the marriage fails. A main reason to ask your children and grandchildren to enter into a pre-nuptial agreement (or a post nuptial agreement) is to protect what you chose to give them during your lifetime or at death.

A pre-nuptial agreement can address the division of assets at various stages in the marriage.  Many prenuptial agreements specify that if the marriage lasts less than two years, the division may be minimal or nonexistent, but that the payout portion will increase as the length of the marriage increases.

A prenuptial can address the issue of alimony in the case of divorce, assuring the wealthier spouse that the financial impact of a divorce will be controlled, and at the same time assuring the less wealthy spouse that she or he will be provided for adequately.

Without a prenuptial agreement in place it is up to the laws of the state in which the divorcing person is domiciled (and, in certain cases, the states in which the divorcing person owns real estate) to determine what assets or income the spouse is entitled to keep in a divorce and which assets will pass to the spouse at death. In most states, without a prenuptial agreement, a surviving spouse has the right to inherit one-third to one-half of the decedent’s probate assets. It is important to remember if you are the parent or the grandparent, it is not the law of the state in which you are domiciled that controls the division of the gifts/inheritances that the child/grandchild receives or is expects to receive – it is the law of the domicile of the child/grandchild when divorcing that controls.

A prenuptial agreement can override that and make sure that the property you owned prior to the marriage is given to your children from your prior marriage at your death. It can also specify that assets you do decide to leave to your spouse will not be left outright, but will remain in trust for the duration of the spouse’s lifetime, and then pass to the children when both of you die.

It is important to remember when having that vital conversation with the next generation that a pre-nuptial agreement is a shield – in a good marriage it can be overruled by transferring assets to the other party or into joint names or by an estate plan which leaves them to the spouse. The goal of a pre-nuptial agreement is to protect the assets if the spouse wants them and you don’t want to give them.

If you live in one of the nine community property states – Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin – without a prenuptial agreement, the law says that property accumulated during the marriage will be equally divided. In all other “equitable distribution states,” assets are divided according to what a judge determines to be fair or equitable (which does not necessarily mean equal). In making that decision the judge takes into consideration factors such as the length of the marriage, whether or not there are children, and the couple’s age, health, and job skills. Alaska is different.  It is an equitable distribution state but allows the parties to enter into a community property agreement.

Typically, a prenuptial agreement will address several categories of assets: those assets acquired and owned prior to the date of marriage, all income and appreciation on property owned and acquired prior to the marriage, all property earned and acquired by either spouse during the marriage, all appreciation in the value of assets acquired during the marriage, and all assets received by gift or inheritance during the marriage.

If each party has assets of comparable value, it may make sense to establish the what is mine is mine and what is your is yours type of agreement, specifying that the assets I bring to this marriage (and any appreciation during the course of the marriage on those assets) is mine, the assets you bring to the marriage (and any appreciation during the course of the marriage on those assets) is yours.  Any assets we acquire together during the marriage will be put in joint names and will pass to the surviving spouse at death – or split equally if we divorce.

A mine is mine and yours is yours agreement may not be fair if one party entering in the marriage has very little net worth.   In that type of case, a smart move may be to guarantee the less wealthy a specific amount of money, either when the contract is entered into or when the marriage ends. That helps make the agreement enforceable.

After re-marrying, you may decide to live in your home, or in his home. You may both sell your homes and purchase a new one together. In second marriage situations the home is an asset with strong emotions… and who has the title is an important issue to address in a prenuptial agreement. In many states, ownership of a primary residence is based on survivorship:  if one spouse dies, the ownership passes by law to the surviving spouse. In a second marriage, that could mean that the children of the first spouse to die lose inheritance rights to the house they grew up in.

An alternative is for the re-marrying couple to hold the property as tenants in common, a form of joint ownership without a survivorship right. Each person’s percentage in the home would pass through his or her will (or trust if probate had been avoided) to those persons that the spouse has selected. In such situations it’s common to have the deceased spouse’s interest in the home held in trust for the duration of the surviving spouse’s life, then at the death of both of them, the home would pass to the deceased spouse’s children.

The surviving spouse could even be the sole trustee during his or her lifetime, which gives him or her flexibility to sell the home and reinvest the proceeds in a smaller condominium or a home in another state. It also guarantees that although the surviving spouse has that flexibility, at the death of both spouses whatever the assets have been invested in – the current home, proceeds of the sale of the home or a new home –will pass under the terms of the deceased spouse’s estate plan to his or her children.

There are certain issues that cannot be legally agreed to in a prenuptial agreement. For example, parties cannot contract what child support would be if the marriage ends in divorce. Under current law, they also can’t contract for child-related issues such as custody or visitation. Many parties will, however, include language which states their intent on those issues when the agreement is entered into. Parties also cannot stipulate that they will not be responsible for their new spouse’s medical care.  That is against public policy.

Prenuptial agreements can be challenged – at the time of divorce and at death. One of the key issues the court considers in reviewing the agreement’s validity is how honest the parties were in disclosing their finances.  After all, a party to an agreement can only knowingly waive rights to an asset if she has sufficient information about what the asset’s true value is. “Assets” include tangibles like heirlooms, houses, and finances, and intangibles like intellectual properties, copyrights, royalties, medical licenses, and law degrees.

The court also considers whether both parties had competent legal counsel. Director Steven Spielberg’s wife, Amy Irving, walked away with half their net worth because their prenuptial agreement was scribbled on a napkin, and she was not represented by an attorney.

The court will also consider whether or not the party was under duress when the agreement was signed, and “duress” can be something as simple as the fact that the prenuptial agreement was signed so close to the wedding date that a signing party did not have time to consider the consequences of the agreement. When Donald Trump filed for divorce from Marla Maples in 1997, three months after they separated, Maples fought the prenuptial agreement that allotted her $2,000,000 in the event of a divorce on the grounds that she had not read the prenuptial agreement before she signed it. They settled the case without a trial and her lawyer reported in the news that Trump promised to pay her more than what was stated in the contract.

The court may also determine if there was fraud involved during the negotiation and/or signing of the agreement.

Even though it is not required in many states, the court may also consider whether or not each party had separate and independent counsel. If you choose to waive the right to counsel in signing a prenuptial, you might want to state that in the document – that the right to retain independent counsel was explained and understood but the party chose to proceed anyway.

Finally, in many states, an agreement can be challenged on the grounds of its not being “fair and reasonable.” This can be a two pronged test: 1) whether the agreement was fair and reasonable when the marriage was entered into and 2) whether the agreement is fair and reasonable when the marriage terminates. In such cases the judge is asked to determine whether one spouse took advantage of the other.

Even though prenuptial agreements can be challenged, the trend in case law is to uphold the agreement. In California, for example, the Supreme Court unanimously upheld the premarital contract between San Francisco baseball star Barry Bonds and his wife, Sun. The couple met in Montreal in 1987 when Bonds was a fledgling baseball player for the Pittsburgh Pirates and his wife was studying to be a beautician. They were both 23 years old. They courted for three months and became engaged.  The baseball player had the counsel of two attorneys and a financial advisor. His wife, a Swedish immigrant, who had been told about the agreement a week before the wedding, had a friend from Sweden advising her.  She was told the day of her wedding that the wedding would be canceled if she did not sign the agreement. On the way to the Phoenix airport, where they were catching a plane for their wedding in Las Vegas, they stopped at Bonds’ lawyer’s office and signed an agreement she had seen for the first time only hours before. This agreement dramatically limited the amount of money she would receive upon divorce.

Why did the court declare this prenuptial agreement valid?  Because, the Judges said, Sun seemed happy, healthy and confident. The week prior, Bonds’ lawyer had suggested that she retain her own attorney and she chose not to do so. What is more, the wedding was so small and impromptu that Sun could have easily postponed it if she had decided to retain counsel to review the agreement. Other cases in various states have achieved similar results.

The lesson to be learned is that voluntarily entering into a prenuptial agreement as a consenting adult is entering into a contract you cannot easily walk away from later.

Today, it is also common for the prenuptial agreement to be reviewed after you have been married for several years. Prenuptial agreements can be amended.  If, for example, you have children in the course of the marriage, or if one of you becomes seriously ill, or if a significant amount of time has passed, or if there is a change in the tax, estate, or marital laws – all of these are good reasons to amend your prenuptial agreement.

If you do choose to amend it, then all of the same formalities – separate lawyers, full financial disclosure – apply as much to the amendment as they do to the original agreement. Sometimes, the agreement has a built-in “sunset clause” that specifies that the contract expires if the parties have been married for a certain length of time, which is frequently 10 years.

It is important to remember that a prenuptial agreement is the base upon which future planning can be built. In other words, it sets the stage for what each party agrees he or she is entitled to receive.

Sometimes a prenuptial agreement does not work in the family structure. There may be emotional reasons that make the topic difficult to discuss. The parties may not wish to reveal their financial information. Another technique to consider is the use of self-settled trusts to protect the family assets. Some jurisdictions such as Delaware (even if you are not domiciled there) allow an individual to establish a self-settled trust to protect assets from creditors (which include a spouse or a future spouse). A self-settled trust allows the person transferring the assets to remain a beneficiary of the trust.  To be valid, a Delaware self-settled trust must:

1)    be irrevocable;

2)    appoint a trustee with the discretion to administer the trust;

3)    must appoint a trustee, whether corporate or individual, that is a resident of the jurisdiction in which the trust is formed (so if a Delaware trust then there must be a Delaware trustee);

4)    Contain a spendthrift clause which restricts the beneficiary’s ability to transfer the trust property (whether voluntary or involuntary).

 

Patricia Annino is a sought after speaker and nationally recognized authority on women and estate planning.  She educates and empowers women to value themselves and their contributions in order to ACCOMPLISH GREAT THINGS in the world – and in so doing PROTECT THEMSELVES, those they love, and the organizations they care about.  Annino recently released an updated version of her successful book, Women and Money: A Practical Guide to Estate Planning to include recent changes in the laws that govern how we protect our assets during and beyond our lifetime.  To download Annino’s FREE eBook, Estate Planning 101 visit, http://www.patriciaannino.com.

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