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Divorcing the Entrepreneur Webinar Part 2: What is the Asset and How is it Divided?

Michelle O'Neil:


Alright, welcome back. This is part two of the Divorcing the Business Owner or Entrepreneur webinar brought to you by OWLawyers. I'm Michelle O'Neil. I'm joined by Jere Hight and Ryan Segall, who are both attorneys at my firm. And we're also a happy to have Robert Bales, who is a CPA with Bales and Company and does forensic CPA work. So welcome gentlemen, welcome back to section two. So this one we're going to talk about what is the asset and how is it divided. So let's start with the entity theory. Jere, what, what is the entity theory of assets?

Jere Hight:


Well the entity theory is that it's a separate entity from the person, the owner. So you have different categories, sole proprietorship, which is not an entity, it is the owner. There's no distinction. And

Michelle O'Neil:


There's no like legal boundaries.

Jere Hight:


No, there is no legally created entity. And this is basically or one of the main reasons for this as to segregate liability of an owner and keep it with the business and not with the personal person. So that's one of the many reasons why you have this. But you have a sole proprietorship. Then you get into the entities that take creation that there has to be a filing to create. So corporations, whether your normal corporation or an S Corp, if you declare that. And then we have unlimited liability corporations, there's a lot of different ones. And then we have an entity which is partnership, which does not take a formal filing. We'll get into that more details, but those are your major ones.



Michelle O'Neil:


So let's talk about partnerships real quick so we can just kind of get some definition around these things. Does a partnership require a written agreement?



Jere Hight:


No.



Michelle O'Neil:


So one of the things that we see sometimes happen with divorce situations is you have what might otherwise be a sole proprietor, but both spouses are working in it. So is that a sole proprietorship or is that a partnership?

Jere Hight:


I mean when you need two or more people working to make a profit at some endeavor to have a partnership. So that could certainly be characterized as a partnership. A general partnership.

Michelle O'Neil:


Yeah but aren't there some ways that you could say no it's still a sole proprietor if you wanted to. I mean isn’t there kind of an argument that can be had in that.

Robert Bales:


I look at it from a tax perspective a lot. From a tax perspective, it is not a partnership. It's a sole proprietorship. It's just the way that the IRS looks at it. And normally you'll see the tax filings as a sole proprietorship, but from time to time we'll see partnerships with husband and wife as partners, so people operate them differently now. I'd be interested to hear what you guys have to say about whether those are really partnerships.



Michelle O'Neil:


I wonder what the benefits could be to somebody saying yes we're partners or no we're not partners.



Robert Bales:


Well the court can't do anything with the assets of a partnership because it's an entity, where the sole proprietorship assets are divided individually as opposed to the equity in the entity. So it was a big difference.


Michelle O'Neil:


Generally, we’ve got sole proprietorship, we've got corporations, we've got partnerships. And then under corporations we've got limited liability corporations, we've got S Corps and C Corps. Under partnerships we've got general partnerships, some maybe a limited partner, some family limited partners.

Robert Bales:


Well really the limited liability company stands on its own. It's a hybrid entity and it has different attributes from corporations and partnerships. You get a charging order against a limited liability company. You can't kick the management out. You end up with, in effect, an ass in the interest if you take an interest, but you can't kick the operator out of it. They’re much stronger from an asset protection perspective than a corporation. So they're a little bit different and we're seeing more and more use of those because of the advantageous asset protection attributes they have.


Michelle O'Neil:


And then what about, is it the same for partnerships where you have kind of the family limited partnerships or some of those different types of partnership entities?


Robert Bales:


Well, a family limited partnership is really just a limited partnership owned by family members. It's going to be governed by its partnership agreement, so it doesn't have asset protection for the limited partners if they don't take an active role in the participation of the business and the operation of the business and the general partner, which is normally nowadays a throw away entity, get a judgment against it. Who cares? It's got an unlimited liability, but my understanding is the charging order defenses are not as strong as the LLCs.

Michelle O'Neil:


So then we have professional corporations. So what's the purpose and what are the benefits of professional entities?

Robert Bales:


Well, the only benefit to a professional corporation is to those who would like to sue the people operating within the professional corporation because it provides the asset protection of a typical corporation, but for malpractice and it provides no shield for malpractice. So like in my case, my licensing board requires me, if I want to use a corporation, to use a professional corporation to make sure that there's no shield there for malpractice liability.

Michelle O'Neil:


All right. So characterization questions. So now that we know that we have an entity, it's not a sole proprietorship, it's an entity, it's a corporation or a partnership. What are the things that you want to look for to determine is it community property or separate property?

Ryan Segall:


Well, certainly when it was started and whether it's a corporation, when things were filed with the secretary of state is always something to look at. But I mean that's number one thing that I ask a client when they come in is when was this business started? So because if it started during the marriage, then you got to community assets and if not then you've got to separate property assets and then things going to be a little different.

Robert Bales:

If you can trace the inception of title for the capital that was contributed, you can have a mutation and it can be separate property if it was formed the day before the divorce.

Jere Hight:

That's what I was going to say.



Michelle O'Neil:


Well, and I was gonna ask you that question cause you and I've had this discussion before. Is this question of inception of title with a corporation. So how, I guess I always believe in starting at the very beginning, I'm not going to sing the song. So starting at the very beginning, how is a corporation begun? Is it begun with the signing of an agreement? Is it begun with capitalization? How does a corporation begin?



Robert Bales:

Purchase a stock and stock can be acquired by contribution of cash, services or property.



Jere Hight:


To be hyper-technical, I'll disagree a little bit with what he's saying. The corporation is created when the secretary of state does its filing, but what's more important for tracing is the inception of title to that person, is when they actually purchased some stock to pay some money.

Robert Bales:

Totally agree.



Michelle O'Neil:


Well and that's why we have these discussions. So the corporation may be created by the filings with secretary of state, but the person wouldn't necessarily own it.

Jere Hight:


Question one was, when was the company started? Question two is when did you pay to get some stock in this company?

Robert Bales:

And what did you use to acquire?


Michelle O'Neil:


And so most of the time do you find that people use a check that they write to the company or does it just kind of get created?



Robert Bales:


I think that poof created is probably the most common approach because people normally don't follow the intricate details that their lawyers give them in written instructions to follow up. Every now and then you'll find one where someone actually wrote a check for their stock. But in most cases it's going to be property or services as opposed to someone writing a check to get their stock on a in a closely held environment.

Michelle O'Neil:


Right, right, right. So if you've got one that maybe was the corporation was created during the marriage, but let's say it wasn't the poof method, it was actually the writing the check method and the check came from separate property. What do we do with that?



Robert Bales:


It's a mutation of separate property and it's separate property stock.



Michelle O'Neil:


And there's going to be a lot of litigation over that.



Robert Bales:


That's how we make our living.



Michelle O'Neil:


So there could be a difference between the simple rule of the company started during the marriage versus here's some evidence that I wrote the check to purchase my stock out of my inheritance account that I got from grandma.



Robert Bales:


Yes. And then you have to look at the inheritance account to see if there was any interest or dividends in it. And was it a straight separate property check or was it a mixed character check.



Michelle O'Neil:


And so what standard would you apply to that tracing?



Robert Bales:


Well normally we just do community out first and if there happened to be some community in there, then it bought some of this.



Michelle O'Neil:


I always think of the community out first rule is like a glass and if you put a penny in this glass, it's gonna sink to the bottom. So the separate property sinks to the bottom and then whatever's on top of it is the community. And so you drink the community out first.



Robert Bales:


I use the oil and water and I figured the separate is the water in the communities is the oil.

Ryan Segall:

Very thirsty after this conversation.



Michelle O'Neil:


What if it was a contribution of stuff in exchange for your interest? Like let's say I owned some computers and my contribution to starting the business was here company, here's all my computers.

Robert Bales:


If the computers were your separate property is a mutation of your separate property and it makes it separate property stock.

Michelle O'Neil:


Do you find that most corporations would have written documentation of that type of transaction?

Robert Bales:


No.

Michelle O'Neil:

Thus the proof problem.

Robert Bales:

It requires, you have to find other sources to prove it up. A lot of times testimony of other unrelated parties that were involved in the transaction, but it's not unusual to have that happen where, well I just threw in this land or I threw in some computers or I had some accounts receivable and



Michelle O'Neil:


or a client list.



Robert Bales:


Or whatever it was. You really at that point need to go to the other owners or the attorney that was involved in the transaction and get some testimony to back up what happened.


Michelle O'Neil:


Right, right, right. So let's move kind of to the division questions. So with corporations, we were talking about this during the break, so I want to make sure we get to it and give you time to talk about it, Robert. Salary versus distributions in corporations is there a new question about that?

Robert Bales:

There is, with pass through entities and what we find is most corporations in a closely held environment make S elections, which means the owners pay the tax on the income whether they take it out or not. It's called a flow through entity. When they pass the tax reform act it lowered the C Corp tax rate to 21%, they created a free deduction to flow through entities except for people like lawyers and CPAs and doctors who were statutorily excluded from this little benefit. But if you're not one of us, you get a free 20% deduction for whatever incomes attributed to you from a flow through entity, but your salary doesn't count on this deduction. So there's some tension created now between what you call salary, what you call distribution, so you can maximize this deduction. And the IRS is aware of this and they're going to be challenging salaries. But you're probably going to get used to seeing a different dance about what people call salary and distribution. And it's not because they're trying to defraud anybody, they're just trying to reduce their tax.

Ryan Segall:

And how does that effect the value of the business itself?

Robert Bales:

Well, when you're valuing the business, if you're valuing a controlling interest, and here normally in a closely hail environment you are. But if you're valuing an interest that can influence what salaries are, you don't really care what they're paying themselves. You go out and find out what a replacement costs would be to replace the party to the business and you're going to use that. So it really doesn't matter to you what they're paying themselves. A lot of what we do in that case is not only figure out what they're paying themselves, but what all the personal stuff is they're running through. So in the end you just have to, if you're trying to figure out what they're getting out of the business, you gotta look at the salaries and the distributions and you're probably gonna see a heavier weight toward the distributions for these companies that qualify for the 199 A deduction now.

Michelle O'Neil:

so was there anything else about the new tax reformat that has changed how you approach valuation?



Robert Bales:


Well the 21% are referred to as C Corps definitely increases the value of C Corps. I think there's an argument as to whether it should be applied to S Corps. And I can see both sides of that argument and not sure who's gonna win both sides of that argument. But if you recall right after the tax act was passed, the market jumped up and the reason the market jumped up is their tax expense dropped. There net earnings increased. So you apply those PE multiples to the new earnings, all of a sudden the stocks are worth more money. Well that's what's happened on private companies as well. The tax burden is not as large and people are willing to pay more. With a flow through entity, that's a more difficult question. To me it is the most likely buyer going to be an individual that's going to continue a flow through entity or is it going to be some public company? So I think there's some judgments you had to apply in what tax rate to use a closely held flow through entity.

Michelle O'Neil:

And then was there something that changed about depreciation and some of that that's affecting valuation?



Robert Bales:


It doesn't really affect valuation. It just affects the tax costs, but there were some errors made in the tax law that made things that were depreciable over a short period of time or immediately now to depreciable over 39 years. But Congress doesn't seem to be getting along well enough to do a technical corrections bill to fix it. But I don't think that depreciation really is changing the values because we normally value it without depreciation being considered. We're more worried about what's their capital expenditure expectation than how they write it off.



Michelle O'Neil:


And then what about the net operating loss? Is there something about that that's changed?



Robert Bales:


The net operating losses have been limited as far as how much of it can offset your income. And then also the carryback is no longer available. It's all carry forward. That impacts how you settle your cases in it might not be able to be used quite as quickly and without a carryback you can't get an immediate refund if you have a situation where they have a loss.

Michelle O'Neil:


So Jere, how do we divide a corporation or a partnership in a divorce, like physically? Do you go down and use a chainsaw to cut the business in half?

Jere Hight:

I hope not, have a good criminal attorney if you plan to do that.

Michelle O'Neil:

I had somebody one time the only thing these people had was a truck and literally she thought you'd take a chainsaw and go cut her half of the truck down.



Jere Hight:


If you have corporation, what you're dividing a stock, you're not dividing the assets of the corporation and you have, well you really only have a few options. You can divide it in kind, which means each party is going to get some stock. You can give all the stock to one party and balance that out with other assets. If there's not assets to balance that out, then you can, the court or you can agree to some type of money judgment, which hopefully you secure for your client so it actually gets paid. And kind of the fallback option, generally, is we can’t divide and kind and none of that's gonna work. So let's sell this thing and we'll divide the cash from the sale. But again, it's not the underlying assets of this entity. It's just the ownership interest that you're dividing.

Michelle O'Neil:

It's just the stock. What about a partnership? How do you divide a partnership?



Jere Hight:

Same basically. A partnership, again, you're not dividing the assets, you're dividing the ownership interest in that partnership and the options you have the corporation or the exact same with a partnership. And that's that.



Michelle O’Neil:


And Ryan, so how do you divide a sole proprietorship?



Ryan Segall:


Oh, I mean, that's just regular. It's just part of everything. I mean and going off to Jere's points on dividing some of the other things there, you can go with other routes. I mean, you could go with converting it to a different type of corporation or something like that. I've seen other cases where they've done some sort of split off or something like that where someone's getting some sort of types of shares, but maybe they'd be advisory shares or something like that where they're not involved in the day to day running of the business, but they still have a portion that they can continue to use. It just a lot is going to depend on what can be negotiated on that front.



Jere Hight:


And how these agreements are written, especially with partnership agreements. Normally you don't transfer a full partnership share. You have your partner who can get full shares and the other person's going to get an assignee share, the other spouse. And so they're not going to have any managing rights to that partnership.

Robert Bales:

Good luck getting a distribution.



Jere Hight:


That's right. We're gonna get to all the problems with doing it that way and then there's a lot.



Robert Bales:


And one of the mistakes I see made so frequently by attorneys dealing with these types of entities is you show up at the mediation or you read the inventory and they've got the corporate accounts listed with the other cash accounts. They've got the accounts receivable listed as an account receivable. And none of this is an asset of the community and it screws everything up. So I would encourage anyone listening, please….

Michelle O’Neil:

Make your inventory clean.

Robert Bales:

Yes. Keep your inventories clean and don't show up at mediation with a spreadsheet with those assets on them.


Ryan Segall:

But they should if it's a sole proprietor.

Robert Bales:

A sole proprietorship, absolutely, but an entity….



Michelle O’Neil:


If it’s a sole proprietorship you list every screwdriver and every tool and every bank account and everything. That's one of my pet peeves when we're drafting inventories around here and something that I think a lot of times clients don't understand and that comes because many business owners either don't know how or just don't respect the formality of the entity and they treat it more like a personal bank account than they should, which then gets everything a little mushy. And I find that a lot of times it's the non-controlling spouse who's not in control of the business and they tend to think, well that business account that has all that money in it, that that needs to go on my inventory cause that's where the retained earnings, the pot of money is. And it can be a little confusing. I even had a case recently where they had all the business income running through an account that was in this one spouse's name only, not even in an entity name.

Robert Bales:


I had one of those and we ended up doing an alter ego on that one, worked out quite well.



Michelle O’Neil:


In section three we will talk about alter ego and piercing the corporate vail or reverse piercing as it's technically known. But and I think this may even go back to kind of one of those beginning of the case kind of questions is are are we respecting the corporate entity or the partnership entity? Are we respecting kind of the formalities or is this one of these deals where it's just kind of a free for all? So that I think that's a real important question.



Jere Hight:


And I've had that, especially with partnerships, especially if they own a bunch of land. Sometimes they'll have a bunch of partnerships where they would land, but when you talk to the clients, that's not how they look at it. They look at, well I'm going to get this piece of land and you're going to get that piece of land and that's how they want it divided. And so a lot of times the end looks like a dissolution of a lot of partnerships and then that's tied in with what we're actually doing with other like assets because they can't think entity, they think asset and so sometimes you have to cater to the client's brains so that they can process it.



Michelle O’Neil:


So just kind of making sure that we've covered our basics before we go into section three and talk about kind of the more detailed valuation issues. In a divorce, in the division of property, the first question then is this a marital asset? In other words, does a husband or wife own it at all? Because like if it's the car and the car is in the company name, it's not even a marital asset. So identification of the marital assets, what actually do we own is kind of the first step in that basic approach. And then the second step is, is it community property that we earned that we've gotten during the marriage and therefore subject to division by the divorce court? Or is it separate property that was owned before the marriage or that we got through gift or inheritance that would not be subject to division by the divorce court. And then the third question then comes kind of where we start valuing things because the court ultimately has to divide the community property assets and adjust in right fashion, that's the standard in Texas. So identifying what are the community assets and then we have to put values on them because if you don't have values on them, you don't know if the judge has divided them fairly and rightly or justly and rightly at the end of the case without having actual dollar figures. And there's actually some case law that we'll post in the group that talks about it's actually the judge's responsibility, independent of the lawyers and the parties presenting evidence but it is the judge's responsibility to make sure that everybody presents sufficient evidence on value to him so that the judge has the information to base an opinion or base a ruling on. And there's actually case law that says if the judge doesn't receive sufficient information on value, the judge can refuse to rule. And we've seen that the couple of cases on pension plans where a lot of people don't actually go value their pension plans. But sometimes we see that even on business entities, I've seen a couple of cases in the last, I don't know, six months or so where lawyers don't hire CPAs, like Robert Bales to value the corporate entity. And they just kind of think, Oh well I don't even know what they're thinking. Like we'll just pretend like we don't have a value. I don't know. And nobody values the corporate entity, so you can't really get down to what is a just and right division of community property because this maybe big or maybe small asset doesn't have a number on it. Right? And so that is your purpose in life. Right?

Robert Bales:

I love it.

Michelle O’Neil:

Yes. So kind of getting those basics down, we've talked about how do you know if a corporation is community property? How do you know if it's separate property? What are some of those little intricate issues? How do we know if a partnership is community property or separate property? I mean, is it just kind of the poof when does the partnership start existing? Is it when the partnership agreement is signed or both? I don't know. What do you think?



Robert Bales:


Partnerships are more difficult than corporate and it is fact specific and what created the inception of title for that partnership interest. And I've seen cases where it was just contribution of an opportunity they had, where I had this opportunity I'll put it in the partnership and it's legit and tangible asset. Put in the partnership contribution, inception of title. But what the most common frustrating thing that occurs with partnerships, sometimes with corporations, is someone goes and opens up a bank account with $1,000 and they take $1000 bucks out of their checking account. Well, I just needed to open one up because we needed to have a bank account and then they put 1 million dollars of separate property into it the next week. So do you have a community property partnership with a million dollar reimbursement claim against it or do you ignore the thousand dollar, the minimus capital contribution? So it's very fact specific. I mean the beauty about not being an attorney is I get to come to you guys and say, what is your opinion with regard to the inception of title on this entity because I can't testify to that, you're going to have to argue it. And then you guys give me, but I'll try to give you as much guidance as I can, but that's where you guys had to make some calls and balls and strikes to determine based on the facts, and our job is to give you the facts, when was that inception of title. It's not always clear.

Michelle O’Neil:

And that's I think one of the struggles for clients is those times when it's not super clear. I mean the super clear ones, if it was an entity, a corporation started three years before the marriage with the contribution and the documentation with secretary and everything happened three years before we ever even met this person. I mean that's fairly clear, but all these things that can happen as life happens that creates kind of the muddy waters. Oh, the tax laws changed, so now the accountant recommends that we changed the entity format from this format to that format. And then all of a sudden what started before the marriage converts in the middle of the marriage to a something else. And then you've got a question you have to litigate.



Robert Bales:


Yeah. And was it a legal conversion or was it a liquidation and a reorganization?

Jere Hight:

And I mean there's case law that will break your heart.

Robert Bales:

Those can really hurt you if you don't do a true conversion.

Jere Hight:

I mean, there's a case where it distributed to himself and then transferred over to the business to start, community property business. All he had to do is do a conversion and it would have been separate property and that was millions of dollars they gave away.



Michelle O’Neil:


Sometimes they don't think about getting a divorce in advance. They think everything's hunky dory and they go on the advice of people that don't operate in divorce land and accountants or business lawyers are making the best decisions they can make for them, the way they see the world through their rose-colored glasses, without thinking about the future and the possibility of divorce. And then all of a sudden, we get involved and it's like, Oh wish we had been involved then, so we could have given you some better advice. All right, so that wraps up our section two on what is the asset and how does it get divided. The third section is going to be on valuation issues and we're going to talk about valuation methods and approaches and how do you put that dollar figure on the asset? So we will be right back after a short break and we'll start section three. So join us. Keep in mind 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.