Clients frequently ask if their LLCs are protected from divorce. There is a misconceived idea that a limited liability company is somehow automatically divorce-proof.
The general rule is that during a divorce, a spouse’s share of ownership in an LLC can often be divided or sold. There are a few exceptions to the general rule that I will get to later in the article.
To determine if your LLC will be safe from divorce, you and your spouse must determine if the LLC membership interest will be considered marital property, nonmarital property, or a mix of the two. How the membership interest is classified will determine whether your LLC is protected from a divorce.
Can an LLC Membership Interest be Considered Marital Property?
An LLC owner is referred to as a “member,” and the portion of the LLC they own is referred to as a “membership interest.” The membership interest is the personal property of the member. Because a membership interest is considered personal property, it can (but not always) be divided in a divorce.
When is an LLC Nonmarital Property?
If the LLC existed before the marriage, it would be classified as nonmarital property. If the LLC is classified as nonmarital property, the court will not include it in the marital estate, and the spouse who owned it before the marriage will be able to keep it after the divorce.
If your membership interest in an LLC is classified as nonmarital property, your LLC will be divorce-proof.
Please exercise caution here. If the nonmarital property is mixed with marital property, it can be reclassified as marital property. For example, if you change the name of your membership interest in the LLC by making your spouse a co-owner, the LLC will almost certainly be seen as the property of the couple.
In addition, there are some situations where an LLC owned before marriage can be determined to be part marital property and part nonmarital property. I will discuss that below in the heading “Hybrid Property.”
When is an LLC Marital Property?
If the LLC was formed during the marriage, it would almost certainly be considered marital property. Typically, all property acquired during a marriage is considered marital property, regardless of how it is titled. If a spouse starts an LLC after marriage, even if that spouse takes the membership interest in their name alone, it will still be classified as marital property.
Suppose a court classifies an LLC as marital property. In that case, the court has the authority to determine the value of the business and decide whether to award a portion of the company to each spouse, order the business to be sold, or order one spouse to pay the other spouse a set amount of money to buy out the other spouse.
If a membership interest in an LLC were acquired after marriage, it would be divided as part of the marital estate.
Hybrid Property – When an LLC can be Both Marital and Nonmarital Property
Even if one partner set up the LLC before the marriage, making it non-marital property, a part of the business could still be considered marital property in a divorce. Suppose that during the marriage, marital funds were invested in the company or that the other spouse worked for the business during the marriage without compensation.
In either of these cases, a court might decide that some of the LLC is nonmarital property and some of it is. Also, in many states, if the value of something you owned before you got married goes up while you were married, that increase can be considered marital property.
How to Use Prenuptial and Postnuptial Agreements to Protect a Limited Liability Company
There are several options for protecting your LLC ownership during a divorce. This can be done with a prenuptial or postnuptial Agreement.
Prenuptial Agreements and LLCs
A prenuptial agreement is a contract that both people sign before they get married. It says what their property rights are and what they expect, like alimony, if they get divorced. A well-drafted prenuptial agreement can supersede both Community Property and Equitable Distribution laws. Most state laws and courts will honor these contracts, which makes them a powerful way to protect your business.
A prenuptial agreement allows the parties to decide what property will be considered nonmarital property, what property will be regarded as marital property, and how that property will be divided in the event of a divorce.
A prenuptial agreement is one of the best and least expensive ways to protect your business from a future divorce.
Prenups can be rather tricky, so they must be well-drafted. Each prospective spouse should be represented by their own attorney to strengthen them. Prenuptial agreements should include the following essential elements in most jurisdictions:
- The agreement must be in writing, and both parties must sign voluntarily.
- Both parties must disclose all assets completely.
- The contract must be witnessed or notarized and cannot be unconscionable
Examine your prenuptial agreement with a family law attorney to see if a clause governs your divorce and LLC business. If your prenuptial agreement states that the LLC will remain your property in the event of a divorce, this may be enough to protect your ownership rights in the LLC.
Postnuptial Agreements and LLCs
If you didn’t get a prenuptial agreement, you might be able to get a postnuptial agreement. It’s like a prenuptial agreement, but it’s made and signed after the wedding, as the name suggests. To be legal, a postnuptial agreement needs to have the same key parts as a prenuptial agreement.
Be aware that some states still don’t recognize postnuptial agreements, and even when they do, courts challenge and throw out postnuptial agreements much more often than they do prenuptial agreements.
Postnuptial agreements are disfavored due to a concern over coercion. Before marriage, the parties enter into an arrangement similar to that of two businesspeople entering into a contract. Neither party has any legal family law rights over the other. In theory, if either party does not like the contract, they can walk away.
However, things change drastically after marriage. The married couple now has well-defined legal rights in support and property division. They are considered to be in a fiduciary relationship with each other, which means that each party must act in the best interests of the other. As a result, the courts will scrutinize any postnuptial agreements between them.
One person usually gives up some of these rights when negotiating a postnuptial agreement. This is why postnuptial agreements are usually held to a higher standard of fairness than prenuptial agreements. The theory is that individuals have less bargaining power once they are married.
If you don’t have a prenup, consider getting a postnup. It’s preferable to nothing. Just understand that a postnup is not nearly as ironclad as a prenup, and you never know how the courts will act if one spouse decides not to abide by the terms of the postnup.
How to Protect Your LLC During a Divorce by Using a Buy-Sell Agreement
An LLC divorce clause may be included in your operating agreement. Unlike the other options we’ve discussed, a divorce clause in an operating agreement protects the other LLC members rather than preserving your interest in the LLC against your spouse.
The divorce clause in the operating agreement will outline actions that the other members can take to prevent your spouse from becoming involved in the business. It may allow the other LLC members to buy out your membership interest in the LLC for a set amount of money.
An LLC operating agreement should include various provisions that protect the other owners’ interests if one of the owner’s divorces, such as:
- A requirement that unmarried shareholders provide the company with a prenup agreement before marriage, as well as a waiver of the owner’s future interest in the business by the owner’s spouse-to-be.
- A prohibition on transferring shares without the approval of the other partners or shareholders, as well as the right, but not the obligation, of the partners or shareholders to purchase the shares or interests of one or both of the divorcing parties for the other owners to retain control of the business.
How is an LLC Valued in a Divorce?
If your LLC is found to be part of your marital property, you will need to figure out how much it is worth. The valuation of LLCs can be tricky. Since most LLCs are private businesses that aren’t traded on a stock exchange, it can be hard to figure out how much they are worth.
There are three general approaches financial experts use to determine the fair market value of an LLC:
- A market valuation approach.
- An asset approach.
- An income approach.
To calculate the value of an LLC in most divorce cases, a forensic accountant, a certified business appraiser, or a CPA who is accredited in business valuations must be hired.
These experts help the parties determine the fair market value of the LLC. Often, each spouse will hire their own forensic accountant, and if the spouses end up in court, a judge will have to decide which expert is more credible when determining the company’s value.
What to Do With an LLC During a Divorce – Buyout, Sell or Continue to Own Together?
After determining the value of the business interests, the spouses must decide what should happen to the business interests after the marriage is dissolved. In general, the three options for dealing with a membership interest in an LLC in divorce are as follows:
- Purchasing the other spouse’s interest in the LLC.
- Remaining co-owners in the business.
- Sell the LLC to a third-party
How to Buyout a Spouse’s Interest in an LLC During a Divorce
The most common way to deal with an LLC in a divorce is for one spouse to buy out the other spouse’s ownership of the company.
For example, Jeff and Ashley own and manage a gardening center together. They agree that the center’s fair market value is $500,000.00, based on an independent forensic accountant’s valuation. After the divorce is finalized, Ashley intends to continue owning and operating the gardening center, while Jeff wants to relocate and become a school teacher.
For Jeff to receive half of the business’s value as part of the divorce or settlement agreement, Ashley could purchase Jeff’s interest for up to $250,000.00.
Property transfers between spouses, or transfers “incident to divorce,” are generally tax-free. This fact is frequently overlooked in family and divorce law. A transfer is considered “incidental to divorce” if the transfer occurs within one year of the marriage’s dissolution and the transfer is “related” to the divorce. This generally means that the divorce or separation agreement requires the transfer, and the transfer occurs within six years of the divorce.
A critical factor in the buyout option is having sufficient cash or other liquid assets to buy out the other spouse. The purchasing spouse may obtain financing from a bank or third-party lender to generate the money necessary to purchase the other spouse’s interest.
Borrowing can be a tax-effective strategy, particularly in low-interest-rate environments. Alternatively, instead of cash, the purchasing spouse may wish to offer a non-pro rata division of other marital assets, such as allowing the selling spouse to retain full ownership of the marital home or other assets of equivalent value.
For example, after agreeing on a fair market value of $500,000.00 for the garden center and discussing the tax consequences of a future sale of the company, Jeff and Ashley agree that Ashley will purchase Jeff’s interest in the company for $200,000.00, which is the same after-tax amount that Ashley would have received if the business were sold to a third party.
Ashely does not have enough cash to pay Jeff $200,000 in cash. As a result, a bank may be willing to lend Ashely the funds at a reasonable interest rate for Ashley to buy out Jeff’s interest in the garden center.
Sell the LLC to a Third Party.
If a business buyout is not viable for both spouses, another option is to sell the business and divide the proceeds.
For example, after months of negotiating, Jeff and Ashley decided that selling the business to a third party and splitting the proceeds equally was the best option. Fortunately, the garden center has been profitable and is in a good location.
A purchaser agrees to buy the garden center for $500,000.00, equal to the forensic accountant’s valuation. As a result, Jeff and Ashley will each receive 50% of the net proceeds from the business’s sale.
Even if both parties agree to sell the company, finding a purchaser for a business can be difficult and may take many years. Also, the spouses need to think about how they will continue to run and manage the business while it is for sale.
Moreover, the spouses may disagree about the price offered by a third-party purchaser, mainly if it is less than the independent valuation prepared during the divorce proceedings.
Continue to Run the LLC as Co-Owners After the Divorce
While uncommon, a third option for the spouses is to continue jointly owning the company after the divorce. While there may be emotional and psychological difficulties, amicable spouses can co-own and operate the business even after the divorce is final.
Alternatively, the spouses could agree that they will co-own the business, but only one spouse will manage it. The other spouse will be given a percentage of the future business’s profits to satisfy their share of the marital assets. By maintaining co-ownership of the business, each spouse risks receiving more or fewer assets depending on the company’s future success.
For example, instead of Ashley purchasing Jeff’s’ stake in the company, Ashley and Jeff agree that Ashley will retain primary responsibility for running the company and that Jeff will be entitled to 50% of the company’s net profits until the business is eventually sold. If the company makes $50,000 this year, Jeff will be entitled to $25,000.
Because many spouses cannot maintain a cordial working relationship after divorce, co-ownership is not a popular way to deal with a private business in a divorce. Assume the spouses are still co-owners after the divorce. In that case, a formal written operating agreement must be in place to address their future business relationship as if they were unrelated independent investors.
Conclusion
Finally, while the three methods discussed above are the most common ways for spouses to deal with an LLC during a divorce, they are not the only options. Navigating the sale of a membership interest in an LLC during a divorce requires examining all of the circumstances, including any debts on the business, other owners of the company, and any agreements that may exist between them.
Before agreeing to and implementing any specific strategy, a spouse should discuss the pros and cons of dividing an LLC with their family law attorney, tax advisor, wealth manager, and other advisors.