Serving Clients Across Texas

Divorcing the Entrepreneur Webinar Part 1: Beginning the Process


Michelle O’Neil:

Hi, welcome back. We are doing this divorcing the business owner and entrepreneur webinar. This is the first session of the webinar. We're going to talk about beginning the process, how to operate during divorce when there's a closely held small business. So I'm joined by Robert Bales who is a CPA, by Jere Hight who is a shareholder, a partner at our law firm and by Ryan Segall, who's an attorney at our law firm. And so we're just going to kind of start. Alright guys, chime in when you're ready. So start with preparation for divorce. You have somebody that that hollers out at you and says, Hey, I'm thinking about getting a divorce, but we've got this business. What's the first thing that you tell him to do, Robert?



Robert Bales:


Well, as a CPA. The first thing I tell them to do is get one of you guys.



Michelle O’Neil:


Oh, we love that. Call a lawyer.



Robert Bales:


But one thing I do encourage them to do is not operate their business any differently than they did when things were good in the marriage, to make sure they don't do anything inappropriate because there'll be orders associated with how they operate it.



Michelle O’Neil:


Sure, sure. What about you Jere? What's the first thing you tell somebody when they say, Hey, I might get a divorce and I've got a business?

Jere Hight:


Well, I have a lot of follow up questions of course, but the first thing I'd like from the client is some basic documentation to figure out when this business started, who owns this business and what nature of the business is it? Cause what I really worry about as a practitioner and want to advise them on are issues such as characterization and potential valuation problems. And until I get a little information from the client, I'm just firing in the dark. And so it's hard for me to advise them on what kind of case we're looking at until he gives me a little information up front.

Ryan Segall:

Sure. And so I'll take what Jere says and do it one further. What I always tell the clients is start to really categorize your expenditures with the business. I think that's very important because you're going to be dealing, especially in very small businesses where someone's maybe making personal expenses as well as business related expenses and dividing those is a nightmare. And they need to start getting that together so that they made sure, Hey we can classify these as personal expenses, these as business expenses. So when someone like Robert comes in and does a valuation of the business, those sort of things are classified already. So I think that's a good way to start off there.

Michelle O’Neil:


So taking kind of from what all three of you said, I think one of the most important things to me is to start out kind of from the informational standpoint of asking what type of business is it? Because for me, and I'm sure for you guys, what's the next question is different if it's a sole proprietorship versus if it's a corporation versus if it's a partnership versus if it's a professional corporation like a doctor or something else. I mean so for me, I think the first thing that I want to know is what type of business are we dealing with? Are we dealing with somebody who is a mechanic at their house and calls that a business, but it's really a sole proprietorship or we dealing with a partner in a law firm? What type of entity are we dealing with? Does that make sense?

Robert Bales:


Yes, it goes with a professional practice, doctor, dentist, attorney, tremendous personal goodwill factor and it's going to diminish the value of the equity in the entity and you need to know that. But on the flip side, if it's a company that has large profits, doesn't pay much cash out, large value, you're going to find out we've got something that's going to be very, very difficult to divide. And now that we've lost the alimony deduction, much more difficult to settle. So I think the nature and composition of the business is very important.

Michelle O’Neil:


Right? And I think we like with a sole proprietorship there's the operational is usually looser with the sole proprietorship. And so to me some concerns about how are we gonna make money going forward? How are we going to protect that source of income? If it's a closely held corporation, one of the first things I'm going to ask is, who all works there? Do you and your wife both run this thing together or are you partners with her brother or who is it that's involved in this? So you can kind of start getting a handle on the pieces because like this session of our webinar is about before you filed for divorce and so it's like trying to get your hands on like all these moving parts to get a sense of what's going on. What about Jere, what do you tell a client in that kind of initial informational session about how is the business gonna operate while we're getting a divorce?

Jere Hight:


Well, I think courts and I advise them to do this, not always followed and kind of what Robert said earlier, maintain the status quo. I don't all of a sudden take a hard left or right because you're in divorce or thinking about divorce land. One court's going to hold it against you if all of a sudden you start radically doing different things than you were doing two weeks prior to filing for divorce and then during the divorce you want to maintain it as an operating and going business. I don't feel comfortable ever advising your client. I will turn down a business opportunity because you don't want to we want to have a lower value on this business. I mean that'll come back to haunt you. That opportunity might never come back for that person. So keep running it like you've been running it. Keep going along the same. Don't clean house. Don't start firing employees. Where I find it trickiest is when the two spouses meaningfully share roles in the business, because as their personal lives fall apart, it's very hard for people not to start having that strain in the business as well. And that's where I've had hearings where you're determining let's go to court and figure out who's going to run this thing for the next six to nine months. It's normally that situation. It's where you have two people who have a legitimate claim to saying, I can run this myself. We can't agree on the color of the sky right now. We can't do it together. And that's kinda where you have a flashpoint.

Michelle O’Neil:


So take that situation where you've got both husband and wife operating the business, dividing duties of whatever's going on in the business. What do you tell one or the other of them when they come to talk to you about before the divorce and divorce preparation. What do you talk about? What are your talking points?

Jere Hight:


Well, I tell them if they both operate the business, but one has a better understanding of the finances of the business and that's that other spouses role. I tell them you need to become very knowledgeable about the finances of this business. Sometimes they come in and complain well, I think money's being siphoned off or I think inappropriate expenses and so forth are being paid through the business. That can all be cleaned up, but not until the person I'm meeting with has some idea of what's happening more so than just here's last year's income statement for the business. I mean more of a here's cashflow on a month to month basis and what's happening. And when I start hearing what's going on and to get more details, that's when you have to make some decisions. Do we need to get some injunctions in place to limit what these people are doing with this business? Do we need to try to move somebody out of the business if we think that what they're doing is fraudulent on behalf of the other spouse? And so it's kind of triaging are we going to have an emergency situation where we need to be prepared to immediately approach the court to try to lock things down and maintain control.

Ryan Segall:

And one thing that I've, that we were talking about earlier actually is the fact that you don't want to change anything, especially when talking about legal agreements. You don't want to be entering it to a shareholder's agreement three days before you filed for divorce. And that's going to lead to some sort of fraud situation in which the court will probably hammer you for it. And it can certainly be construed as fraud one way or the other, whether it be actual or constructive. But you don't want to get into those situations and you want to make sure that as both of these guys said, you want to continue with what's been happening and you don't want to change anything, whether it be doing legal documents or not because that would fall in fact raise some questions for the court.

Michelle O’Neil:


What about the spouse? Let set up the scenario. Like you have the spouse and it's their company. And just for purposes of putting some labels on it, we'll say the man owns the company and the wife is an employee but not an owner of the company, although it is community property and she kind of runs the office staff and keeps the books and that type of thing but he's the one that's earning the goodwill. Maybe he's a realtor or a doctor or dentist or we've had all of those scenarios. Starting with the husband who owns the company, any different advice you'd give him then you'd give to her about the pre divorce about to file process?

Robert Segall:


In the scenario you just described what I always tell them, get all the financial records archived that you possibly can.

Michelle O’Neil:

And that’s advice either way, right? Either spouse.

Robert Bales:

Either way.

Michelle O’Neil:

Gather financials.

Robert Bales:

They tend to migrate. And I think if you can go ahead and get back ups of the accounting software, copies of bank statements, things of that nature, you're going to be way ahead of the game once the process starts. So you don't have to try to go get it through discovery sometimes unsuccessfully.

Michelle O’Neil:


Sure. And so for either spouse, the gathering of information, I think for me that's one of the keys even if there's not a business, but in that pre divorce what are things that I can do to get ready for divorce? To me that's one of the important ones is gathering your information, especially about finances and assets and debts and all of that. So for a business, I guess when you own a business it'd be even more important. And would that be a time when it would be helpful to know like in advance, these are the list of documents that the CPA is going to want to when they start through the valuation process?

Robert Bales:


Yes. Valuation or tracing, whether it's the characterization. In fact lately it's not unusual for us to be engaged pre divorce and come up with tracing and valuation conclusions before they ever filed the divorce. So they know what to expect when they get into it.

Michelle O’Neil:


Yeah. And I've done some of that too, especially where you represent the business owner because you can anticipate and you have access to all the information needed for evaluation like that where you can do an early valuation to try to keep the lid a little bit more on the divorce process. Possibly, if that's possible.

Robert Bales:


Another piece of his advice I would give them that maybe different than what you guys would give them because I see the world differently.

Ryan Segall:


That’s why you’re with us at the table.



Robert Bales:


If you're going to owe some tax, pay it before the divorce is filed so you don't have some kind of standing order that prevents you or makes it more difficult for you to get things of that nature taken care of.

Michelle O’Neil:


And I like that cause that kind of leads me into heading toward our next topic in this, which is okay, we're about to file for divorce. What should they expect? And so in many of the counties in Texas, we have what's called a standing order. And that is what I'd call a do right list of orders that courts enter automatically when a divorce petition is filed. And they apply to both parties equally. In counties that don't have a standing order, we have the standard temporary restraining order that's provided for in the family code. And ideally those both a standing order in the standard TRO should be relatively the same, but it kind of has some specific requirements about don't go paying unnecessary debt, don't go running up the credit cards, don't go to Neiman's and buy off the store, don't go buy a new bass boat. But it also at the end says you can still you pay but reasonable and necessary business expenses, reasonable and necessary living expenses and attorney's fees. So what you're saying is that you advise people to kind of go ahead and pay the taxes or pay some of these things that need paying before the divorce is filed in the standing orders are in place.

Robert Bales:


One of the reasons I say that is I've seen a lot of judges and I will make mention no names who go a little bit beyond the standing order and make it impossible to pay these bills with some draconian orders during the pendency of the divorce and if you get stuck with a court that’s looking at it from that perspective, you could end up with some trouble and the way you operate your business and how you deal with the IRS and other things.

Jere Hight:


Yeah, I agree. I don't think the standing order prohibits paying taxes for your business. It's the temporary orders where the judge looks at cash flow and says you have all, you're obligated to do all these things and paying business taxes and one of them. And so they don't get paid. That's, that's a real concern.

Michelle O’Neil:


Would you recommend they pay other debts?



Robert Bales:


I would recommend paying anything you think that possibly that court might prevent you from paying and to consult with your attorney who's gonna know the judge because all the judges tend to have different views of this. And if you've got a judge that really puts the screws down tight on the money, you need to get anything taken care of you possibly can before that thing's filed.

Ryan Segall:


Because what's going to happen is my client's not going to pay those debts. They're going to have their temporary orders hearing and there's going to be a pot of cash, which is supposed to go to the debt and now it's going to having to take care of two different households and that's going to be your problem.

Michelle O’Neil:


Right, and just to be clear, let's say that the corporation or the business has a pot of cash, also known as retained earnings, and it's sitting in the business. I mean technically the judge is not supposed to be able to touch that, but the judge can order the spouse who is in control of the business to pay spousal support and child support and bills and this and that and the other that will take the availability of that money away from the availability to pay the debts. So that's where it can create the problem is kind of the pot of cash problem and if you need to pay your debts or you've been saving it for your taxes or your 941’s or something, you need to go ahead and take care of that before you have the pot of cash sitting there for grabs in the temporary orders hearing.

Robert Bales:


Yeah. Another thing we see a lot is people in cyclical businesses that have a pot of cash ready for the next cycle that's going to eat money and they need to go ahead and prepay whatever need they need to prepay to get through that cycle so the court can't create a problem for that.

Michelle O’Neil:


Yeah absolutely. What if you were advising the other spouse, the non-business owner spouse who has access to some financial information and says, Hey I think there's a pot of cash there and how do we preserve the pot of cash in the business so that we can have it available for him to take out and support me with.

Jere Hight:


File.

Ryan Segall:

File away. I mean in all reality, that's what it has to happen.



Michelle O’Neil:


And TROs. I mean, that probably to me would go beyond a standard TRO.

Ryan Segall:

I would agree.

Michelle O’Neil:

I mean that might be a place to include the business as a party.



Jere Hight:


Well, certainly if you have any evidence that there's been some odd financial transfers and you can share that to the court, I would go and I'd see the business and try to lock the whole thing down.



Michelle O’Neil:


Yeah. And so lock the whole thing down is short words for get a TRO, sue the business, get an injunction against the business and the owner that would prevent them from whatever you can think of to preserve the cash as much as possible.

Robert Bales:


And see, I would look at it strictly as a CPA. I would tell them, don't screw up the golden goose and don't be taking cash out of this thing that's going to be worth a lot of money. And if you make it to where it cannot operate properly, you're not going to get the value for it that you would otherwise. So you gotta be careful when you start going after that pot of cash.

Michelle O’Neil:


Right, because it reduces the ultimate value of the business.

Robert Bales:

Correct.

Michelle O’Neil:

I think that's an important kind of long term strategy, short term versus long term strategy that may have some dichotomy there in advising the non-owner spouse because it's a question of do you want to grab cash now or do you want it to be worth more in the long run so that you get a bigger settlement or a bigger division at the end?

Jere Hight:


Oh definitely.

Michelle O’Neil:

Yeah.

Jere Hight:

There just they're so fact intensive because the nature of the entity is going to determine a lot of this.

Michelle O’Neil:

Sure.

Jere Hight:

The ownership interest is going to turn a lot of this. A control determines a lot of this. So how big do you need to open the door? It depends on is this a 100% owned family type business, whether sole proprietorship where everything's on the table assets included or like an S Corp or is it other 10 partners and his own partners give you some comfort that he's not going to upset the apple cart cause they'll sue him.

Robert Bales:


Unless partner’s dad.

Jere Hight:

That’s right, that’s true.

Robert Bales:

So, like you say, the dynamics are different in every case. And if it's a family owned business with dad involved.

Robert Bales:

There's probably not a lot you can do.



Michelle O’Neil:


Right. So we mentioned a little bit about the temporary orders hearing. What do you guys think the judge has the authority to do with the corporation, if the corporation is not a party at the temporary orders hearing?

Ryan Segall:


I don't think he can do much. I mean the court certainly has jurisdiction over the parties to the suit, no question about that. But as far as making orders as to what the actual corporation can do, not too much as now, especially if it is a larger corporation. Sole proprietorships, I think it's a little bit of a different story because the court can certainly order the parties to act in the ways in the normal course of business, things like that. But for larger businesses, especially ones with partners, if the court even tries to do something like that the corporation is just going to say, you don't have jurisdiction over this.

Michelle O’Neil:


Right. In other words, so the judge at a temporary orders hearing can't look at the spouse that owns the corporation and say, sir you're going to go to your corporation and you're going to withdraw those retained earnings and you're going to give that money to your wife. Can’t do it.

Jere Hight:

Can’t do that. All they can do is order him to make a lot of payments where the result will be. He's going to have to go to that account and do it. But to go a little more detailed about a sole proprietorship, I mean that's a completely different animal. It's not really a business entity. So if it's established in the court's clear that it's a sole proprietorship, any asset of the business, it's just like an has of the party. So it's fair game and the court can order anything to be done with any bank accounts or personal property of the business or anything like that.

Michelle O’Neil:


Right. Because it's not really a separate entity, but with a corporation or a partnership, and we'll talk about this a little bit more in the next section, but it's a separate legal entity. And so unless it is sued as a party to the lawsuit, it can't be ordered to do anything.

Jere Hight:

Right, court has no control.

Michelle O’Neil:

What about if the non-owning spouse is an employee, can the judge at the temporary orders hearing order that the wife continue to be paid as an employee?

Jere Hight:


Well, do you want the legal answer or what I’ve seen judges do before?

Michelle O’Neil:

Both! And the ethics question that exists in this.

Jere Hight:

The answer is no. The court cannot tell a corporation that's not a party how to operate its business, but I've seen judges do just that tell them to continue to employ the person and rather than temporary support, keep paying that person their salary. And sometimes when you have family members, they're not even particularly active employees. It's another way to get money out of the corporation to the family.

Michelle O’Neil:


And I've seen that happen with health insurance, especially where a spouse is an employee so that they're on the health insurance benefits of the company, which I think presents quite an ethical quandary if the judge starts trying to mess with making the company maintain that employee for health insurance purposes.



Robert Bales:


Absolutely, of course that's a danger in itself because if they're not working 30 hours a week or whatever the health insurance contract requires, they could get claims denied anyway where they're being covered under the group or not.

Michelle O’Neil:


So what about, let's say we've now kind of filed the divorce. We're in the very early stages of divorce. How do we maintain the confidentiality of the business? Maybe it's a medical practice or a law practice and the customers, the clients of the practice don't want their business spread all around town. How do you keep the angry non-owner spouse who has some information about the practice from going and chatting it all up all over town at the chamber of commerce meeting?

Robert Bales:


I think you would advise them that it's going to hurt them if they do that.

Michelle O’Neil:

Sure.

Robert Bales:

Although sometimes…



Michelle O’Neil:


They don't care, burn the house down. Is there any legal remedy you can have to keep the spouse from kind of harming the business by spreading information about it?

Jere Hight:


You can try to reach an agreement or certainly approach the court for some type of nondisclosure order where the private information of the company cannot be disseminated and can only be used in very narrow avenues, which is going to be for the purpose of the lawsuit. And then once the lawsuit's over, then any information they have is tangible, has to be returned and presumably to be destroyed. So in my experience, courts generally will put those in place. There's no good reason why someone should be able to run around town and talk bad about a business or give the information to the competitors or anything like that. So they're gonna be put in place as a general rule.

Michelle O’Neil:


And so kind of moving that ball just a smidge further down the road. Ryan, what about trade secrets? Is there a way that a business can protect their trade secrets?

Ryan Segall:


Glad you asked Michelle. So there's actually a rule of evidence, Texas rule of evidence 507, and it specifically deals with the trade secrets privilege. And it says person who has privilege to refuse to disclose and to prevent other persons from disclosing a trade secret owned by the person, unless the court finds that nondisclosure will tend to conceal fraud or otherwise work in justice. What does that mean? I think that just means if you've got some sort of trade secret out there, you can assert that privilege and you can assert that I believe anywhere that would be in court. I think in discovery you could assert it and just tell the courts, look this is something that is protected, and I've got to do something to protect it. And I think that that will certainly get you there.


Michelle O’Neil:


So let's say you were representing momma who owns the barbecue place and she has her grandma's favorite bean recipe and nobody else has this bean recipe. And it's so good. It's won all these awards and the husband is upset cause mama was having an affair and the husband says, well I'm going to go down here to Dickey's barbecue and I'm gonna give them your bean recipe.

Michelle O’Neil:

Is that a trade secret? Is that an example?



Ryan Segall:


Absolutely.

Michelle O’Neil:

Excellent.

Ryan Segall:

I would say it is I mean file whatever you need to, I would say file a protective order or something like that to prevent, or a TRO, just to prevent the disclosure of that sort of information because it's a trade secret however you look at it and it needs to be protected. And there's been case law, I don't know if you want to get into this now, but certainly the case law has supported that trade secret privilege when it applies to ownership of and discovery documents. A case I have is In Re Kuntz that's coming out of the Supreme Court of Texas in 2003 and the courts specified that because a minority owner did not or because the minority owner had access to documents that didn't mean that he had possession. And the company filed an Amicus brief in that case saying we can't give them what they're wanting and the courts they're exactly right because they were wanting these letters of recommendation that we're going to disclose trade secrets and when there's discovery being done in these cases and they're asking for these documents that are going to disclose these things, the person protecting those trade secrets, whether they be an owner or an employee, an agents, they have ways to stifle the disclosure of that.


Michelle O’Neil:


That's a good point. So just to make the point, I probably should've said this earlier, for all the paid attendees of this webinar, we will form a private Facebook group that you'll get an invitation to where we will post all of these supplemental materials that we have that we may refer to during this webinar. So we'll post the Kuntz opinion in there and we'll post the trade secrets evidentiary rule in there so you won't have to go searching for it. And any others that we think are informative for you, we'll post those in there too. So whenever you pay for this webinar, you'll get an invitation to that private group. So lets real briefly, we've got a couple of minutes left. Talk about buy, sell agreements and what effect that has on kind of the process from the beginning of the divorce. There's a reason I put it kind of in this little beginning process. So buy sell agreements, Robert?

Robert Bales:


Well buy sell agreements are typical when you have partners in the business. We encourage our clients to do that in a non-divorce environment. So when you see one that's very typical most buy sell agreements, we'll have a divorce revision in them. And most of the time the divorce provision only applies if the other spouse ends up with the interest. So there's many occasions where it doesn't really impact the value of the interest in the hands of the party that's operating the business. Sometimes it does, it just depends upon, you have to look very at the wording of those buy sell agreements. But they can give you some good ideas as to what the value might be. They'll have formulas or they'll have old appraisals or something that give you some indication.

Michelle O’Neil:


So in the couple of cases that I read preparing for this, it seemed like there were kind of two concerns or two kind of competing approaches to buy sell agreements and whether the valuation in a buy sell agreement was effective as to the business valuation in the divorce. On the one hand, the Mandel case kind of upheld the buy sell agreement, but it looked like the facts that were important in that case were that there were other times where a person had withdrawn from the corporation and that buy sell agreement value had been used. Where in the Miller case it looked like there was some constructive fraud issues because the spouse wasn't advised of the buy sell and so there was some fraud questions about that. What do you think about kind of those competing issues?

Robert Bales:


Well, I just think they're all very fact specific, they're all different. All the businesses are different and I totally agree. We do see a lot of cases, particularly with doctors owning interest in hospitals where there are lots of transactions done under the buy sell. And to me that’s your number. You've got willing buyers willing sellers trading those interest on a regular basis .

Michelle O’Neil:


And in those that would be a very restricted group of people who can even buy it.

Robert Bales:

Correct.

Michelle O’Neil:

Because it can't be sold on the market.



Robert Bales:


You've got to be a doctor practice in that hospital. You can't own it.

Robert Bales:

But outside of that, a lot of times the valuations are punitive. If you want to get out, you get out for book value, which normally is nothing. So a lot of times they don't really, I think it's very fact specific to see how was that buy, sell constructed and is it reasonable or not?

Ryan Segall:

Robert, real quick. So when you're valuing a business and there's a buy sell provision in there for a divorce, do you use that when you're valuing it or do you use the full thing?

Robert Bales:

Depends on the facts. Just depends on the facts.

Michelle O’Neil:

Depends on who you’re representing?



Robert Bales:


No.

Michelle O’Neil:

I said that intentionally!



Robert Bales:


I've been doing this a long time. I learned a long time ago I'm going to give the same number to whichever side hires me, but I do look at the facts.

Michelle O’Neil:


And that’s why I like you.



Robert Bales:


Well I appreciate that. But in practice a lot of times they're not appropriate. A lot of times you just gotta look at the facts of the buy sell.

Jere Hight:

A distinction I've seen and looking at buy sells are big entities treat the value the same for buying out a partner in a non-divorced context, terms of valuation as they do buying out the spouse in the divorce context. And I think those are going to be upheld every time.

Robert Bales:

Yeah, I agree with that.

Jere Hight:

I think where you have the problem is you have this special category, which is this is what we do to the non-partner spouse when we buy them out. And I think that is very fact intensive and it's just how punitive is it?

Ryan Segall:

So I had a case in which they had a buy sell agreement and the buy sell agreement had valued essentially valued the business at a pretty low value of if it was just at that buy sell agreement wasn't any of that thing would have been let's just say $1 million. And I think it valued it at about a hundred thousand. And what was interesting in that case was kind of to Robert's point that the judge said, well I'm not gonna touch the business and I'm just going, but I'll use the valuation. But without the buy sell agreement basically. So he says if I don't touch the business, then that buy sells never triggered. So therefore I'm going to use the bigger value.

Robert Bales:

And that is the normal buy sell agreement.

Ryan Segall:

And so in that case he just awarded a bunch of other assets. And that's how I split it up.

Michelle O’Neil:


You get the business but it her number, right? Yeah. Alright, well that's our 30 minutes on the first section of the divorcing the business owner or entrepreneur webinar. So we will be right back with section two which is talking about what is the asset and how does it get divided. We'll be right back.

Michelle O’Neil:


Keep in mind that this is a webinar that's aimed at attorneys. This is for continuing legal education. If you're out there watching this webinar and you're not an attorney, we welcome you to watch it. But remember that we are not giving you any specific legal advice. We cannot comment on any specific case or situation without knowing all the facts. So if you need legal advice, this webinar is not a substitute for legal advice. Please, please seek the advice of a lawyer as to your specific situation and get specific advice to that. Because if you rely on just what we're talking about here, we're being general, we're talking about general legal principles that may not actually apply to your situation. This is for continuing legal education only, and we cannot create an attorney client relationship just through the video camera. Okay. Thanks.