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Business as Marital Property by Ashley Miller

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in Blog
on 05 July 2016
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Things to know if you’re a business owner going through divorce.

If you’re going through a divorce, you’ve probably been told, “Texas is a community property state! Your spouse will get half of everything you’ve got!” As a business owner, this worries you.

While you should always hire professionals to help you in these matters (see Frye, Oaks, Benavidez, & O’Neil, PLLC), it can’t hurt knowing a few basic bits of information—types of businesses, how courts characterize property, when the community estate of your marriage may have a claim for reimbursement, what you can do to protect yourself, etc.

Types

 Businesses can be created as sole proprietorships, partnerships, corporations, or limited liability companies. Understanding the differences between each type can be a great start to protecting yourself and your business in the event of divorce.

1. A sole proprietorship is owned and operated by an individual or a married couple. The profits belong to the owner, the liability is unlimited (business debts are personal debts), and it ends upon death of the owner. While cheaper to start initially, there are risks associated with any business, so the unlimited liability of a sole proprietorship can be very dangerous.

2. A partnership is owned and operated by 2 or more people. The profits are shared, the liability can be general (unlimited liability) or limited (liability based on investment), and it ends upon death of or withdrawal by a partner. Note that the limited partner must play a passive role, otherwise the limited partner becomes a general partner with unlimited liability.

3. A corporation is a separate legal entity set up under state law that protects owner (shareholder) assets from creditor claims. Incorporating your business automatically makes you a regular, or “C” corporation. A C corporation is a separate taxpayer, with income and expenses taxed to the corporation and not owners. If corporate profits are then distributed to owners as dividends, owners must pay personal income tax on the distribution, creating “double taxation” (profits are taxed first at the corporate level and again at the personal level as dividends). Many small businesses do not opt for C corporations because of this tax feature. Once you’ve incorporated, you can elect S corporation status by filing a form with the IRS and with your state, if applicable, so that profits, losses, and other tax items pass through the corporation to you and are reported on your personal tax return (the S corporation does not pay tax).

4. A limited liability company is another business type formed under state law that creates limited liability. Tax-wise, business income and expenses are reported on your personal tax return. If you are the only owner of an LLC, you are viewed as a “disregarded” entity. This means you report the LLC’s income and expenses on Schedule C of Form 1040─the same schedule used by sole proprietors. For small business owners in Texas, single member LLC’s seem to be the most popular type of business.

 Characterization

 In addition to what type of business you have, the character of your business (separate or community) is crucial information upon divorce*. While separate property cannot be divided by the court, community property is subject to fair and just division.

To be separate property, the business needs to have been yours before marriage, inherited, gifted, or funded by (and traced from) your separate property. If you can prove any of these by clear and convincing evidence, you will beat the presumption that all property at divorce is community property. This does not, however, protect profits, rents, or interest earned from the business; those items can still be deemed part of the community estate.

*Other helpful information includes date of marriage, date of business foundation, source of funds used to start the business, and financial and labor related contributions of each spouse to the business during marriage.

 Reimbursement

 Once the type and character of your business and its income are determined, the community estate may have other interests in your separate property business. Claims for reimbursement to the community estate can arise from use of community funds to expand or invest in the business, increase in value of the business due to community efforts, and community time, toil, and talent expended by a spouse (if more than reasonably necessary to manage and preserve the business and to the detriment of the community estate). Although you have the burden to prove your business is separate property, your spouse will have the burden to plead and prove any claim to reimbursement.

 Protection

 Along with the various tax and liability protections each type of business may or may not offer, there are a few ways you can protect your business from the community property system.

1. Sign a prenuptial agreement or secure an early postnuptial agreement. Designate your business (and possibly the income from your business) as separate property early on. This will help you later when you need to prove that it isn’t community property or fight a claim for reimbursement.

2. Keep your personal accounts separate from your business accounts (and keep record of everything). It can become harder to prove your business is not community property if you commingle personal and business accounts (not to mention the tax consequences that come along with using your business as your own personal piggy bank). Commingling can prevent the court from being able to trace the separate funds you used to start the business and gives way to the concept of alter ego. For example, a corporation can only be divided up to the amount of the spouse’s interest, but if there can be no distinction between the owner and the business, it becomes the alter ego of that spouse. This allows the division of assets from that business beyond the spouse’s interest, defeating the protections normally afforded by piercing the corporate veil.

3. Place the business in a trust. Trusts are legal entities that exist to separate the legal ownership of property from equitable ownership. This means that property held in trust belongs to the trustee for the benefit of the trust beneficiaries. The business owner can be either the trustee or the sole beneficiary, but not both. Two of many types of trusts include revocable and irrevocable. Revocable trusts sound like the best option because they allow the trustmaker to modify, revoke, or take property from the trust, however, this type of trust doesn’t protect the property from creditors (such as an ex-spouse). Irrevocable trusts are a better option, despite not allowing the trustmaker control over the property, because this type of trust does protect property from creditors. (Of course, how effective a trust is will always depend on how well it is drafted.)

4. Create a buy-sell agreement. Upon, death, divorce, bad behavior, or voluntary departure, a buy-sell agreement requires that the business share is sold according to a predetermined formula to the company or the remaining members of the business; for a deceased partner, the decedent's estate must also agree to sell.Additionally, in

For assistance with your business (and other) needs, come see our attorneys at Frye, Oaks, Benavidez, & O’Neil, PLLC.

713 227-1717

About the author: Ashley Miller is a 3L law student at the University of Houston Law Center and the 2016 summer intern at Frye, Oaks, Benavidez & O'Neil, PLLC. As a law student she has researched and academically written on Texas Family Law, Marital Property, and Homestead in the foregoing blog post which is educational in nature only - at time of blog posting Ashley Miller is not a licensed Texas attorney and is not dispensing legal advice. This blog post should not be relied upon as legal advice by any prudent person under any circumstances at any time.