5 Settlement Documents that Divorcing Business Owners Must Have
When business owners get divorced, their settlement may have profound consequences for the business and other owners. Often, one spouse “sells” or gives up a share of the business to the other spouse. Since most small business owners do not have enough cash to pay a lump sum for that share, they might have to make installment payments over months or years. It is critical to structure the divorce settlement properly with documents that will minimize tax consequences, quantify and secure the payments to be made to the spouse who is leaving the business, and preserve the company’s ability to operate and obtain financing. These are the top five documents that a business owner should have when finalizing a divorce where a spouse is “selling” his or her share of the business to the other spouse:
1. Marital Settlement Agreement. Divorce courts rarely issue orders containing sufficient detail to adequately protect business owners who are divorcing. Settlement provides the best opportunity to resolve important financial and tax issues that a divorce court might overlook. A settlement agreement should contain a clear description of the stock, partnership or LLC membership units, and other business interests being sold or waived, how much is being paid, when it is being paid, and what happens if the payments are not made in full and on time. Unincorporated associations are tricky because their assets and liabilities are often intertwined with the owners’ personal assets and liabilities, so be as clear as possible. When setting the price, the business owner must consider whether the price is consistent with the value reported to tax authorities for estate planning purposes. The spouse who is making payments might be required to maintain enough life insurance, retirement assets, or investments to pay off the obligation in full upon death or default. The other documents related to the sale of the business (installment note, security agreement, etc.) can be attached to the marital settlement agreement and signed at the same time.
2. Installment Note. The installment note states the price that a business owner must pay for a spouse’s share of the business, the timing and amount of each installment payment, and the consequences for late payments or default. If the payments will be made over a period of years, the note might include interest (particularly for late payments). An acceleration clause might make the entire balance due immediately upon sale of the business, death, bankruptcy, or other major events. In some jurisdictions, a confession of judgment clause might avoid the delay and expense of a collection lawsuit if there is a default. The majority owner might be required to provide a personal guarantee. The note can also be secured by a mortgage against real estate or lien on business assets, such as equipment and receivables.
3. Mortgage/Security Agreement. An installment note can be secured by a mortgage against real estate or lien on business assets, such as equipment and receivables. The lien against business assets can be recorded publicly by filing a UCC-1. In some cases, the business might want to subordinate the mortgage or security agreement so that trade creditors and lenders who demand higher priority will not withdraw their credit.
4. Pledge of Stock. A pledge agreement creates a lien on the stock of the business. The pledge agreement might contain representations and warranties about the financial condition of the business or give the selling spouse a right to vote the pledged stock or inspect the books until paid off. If dividends or distributions are paid, the pledge agreement might direct the proceeds to be paid toward the loan. The pledge can also restrict the sale, gifting or dilution of the stock.
5. Consent and Waiver. If the business owners have previously signed a buy-sell agreement or right of first refusal, giving the company or other owners a right to buy their shares, then they should probably obtain the consent of those other owners before transferring stock between themselves. A consent and waiver confirms that the company and other owners will not exercise their rights when divorcing spouses transfer their stock.