Specialty tag(s): Divorce for Business Owners, Property Division
Rob Frazer, Thomas P. Goranson | August 23, 2024
Today, it is not unusual to see a spouse operating a business in the form of a limited liability company or owning an interest in an investment that is a limited liability company (hereafter sometimes referred to as an LLC). In 1991, Texas became the seventh state to authorize the creation of limited liability companies. Since then, all 50 states and the District of Columbia have authorized them. They are very popular because:
As noted in SJ Medical Center LLC v. Estahbanati (418 S.W. 3d 867, 874 (Tex. App.-Houston [14th Dist.] 2013, no pet.)), “Limited liability companies have been said to offer ‘the best of both worlds: the limited liability of a corporation and the favorable tax treatment of a partnership.’ “
In a divorce action that deals with an LLC, experienced divorce lawyers will tell you the five most important questions are:
There are a number of very common uses for LLCs, and understanding their differences can be beneficial when dealing with an LLC in a divorce.
When a limited partnership is formed, there has to be a general partner. The general partner is the partner who manages the partnership but is also personally liable for the obligations of the limited partnership. The limited partners are just that: They have limited liability equal to their original contribution (and any subsequent required contributions) to the partnership when it begins its existence. Limited partners have no rights to day-to-day management of the partnership. It is quite normal for the general partner in a limited partnership to be an LLC. Thus, while the LLC is responsible for the liabilities of the limited partnership, the LLC members individually have limited their personal liability to a specific sum. It is quite normal for this type of LLC to own a very small portion of the limited liability company but have all of the liability as well as the right to manage the investment. To look at the formation scheme backward, the members can manage the LLC, which is the general partner and manager of the limited partnership.
Common investments that use this type of structure involve real estate or oil and gas development. Usually, the general partner owns less than 1% of the investment. Thus, if the LLC owned a 1% general partner interest in the limited partnership and the value of the whole limited partnership is $1,000,000, the LLC value would be no more than $10,000, assuming no additional discounts for lack of control or lack of marketability. If a member of the LLC owns only 1/3 of that LLC, then the value of that interest would be no more than $3,333.33, again subject to further reductions for lack of control and lack of marketability.
The testimony necessary to value this interest in a divorce could vary depending on the parameters an expert uses to make their determination, but for quick analysis purposes, simple math is enough to give a spouse (whether the owner spouse or the non-owner spouse) a general idea of what value this type of ownership has in the community estate. It is also common for one of the spouses to also be a limited partner, so you would have two types of ownership interest to analyze and value.
It is common to see many investments take the form of a limited liability company. In these investments, the owners make a commitment to contribute a certain sum of money into the business, either all at the beginning or over a period of years (for example, a $100,000 original investment and a commitment to contribute $50,000 for the next three years, for a total investment of $250,000). Normally, these investments are not too restrictive in the transfer of ownership for a number of reasons. If the investment exists in an LLC, divorce attorneys recommend finding out from the managers of the LLC what it takes to transfer all or part of an interest. Also, determine if any additional capital requirements are required. Get a copy of the company agreement, as this will explain how membership interests can be transferred.
These investments can be very difficult to value because it is not uncommon for them to own a number of investments, many of which are themselves LLCs. For example, what if the LLC owned a minority interest in a portfolio of real estate mortgages? The effort it would take to value such an investment might exceed the value of the LLC interest owned. Joint ownership may be the only answer, if that is possible based on the transfer rules of the company agreement.
The next type of LLC is one that is actually set up and run for one or two special reasons; a shoe store or a computer software developer would be typical examples. It is possible for this type of LLC to have only one member. If there is only one member, then it is easy to manipulate the ownership rules. This can be done in a destructive fashion if that is the desire of the member. But a spouse owes a fiduciary duty to the community estate, and with such a duty, it is not recommended that a member (owner) conduct their business that way. Since it is the duty of the trial court to divide the community estate in a manner that is just and right, flexibility in modifying the terms of the company agreement can be very useful in resolving a marital property dispute. The value of this type of LLC is similar to valuing any other small business in Dallas, Plano, or Austin, Texas. If there is only one owner, it is not particularly difficult to divide the ownership interest between the two spouses. The real question is whether it is a good idea to divide the interest versus having one spouse awarded the LLC and the other spouse awarded either assets of equal value or a payout over a period of time.
It is also possible for the LLC to have two, three, or four members. As the number of members increases, the form of the company agreement may go through a number of changes. It is not unreasonable that the complexity of the ownership rules will change during this process. If the entity has a number of members who have joined and then left the LLC, that can create a pattern of how membership interests are bought, transferred, and even sold. This history is important in looking at one’s options in resolving the divorce and LLC ownership.
If a family has created a large business or a number of businesses, it is common for them to use a combination of business entities, including LLCs. They can be for investment purposes, to control how the family businesses are run, to limit liability, or for many other legitimate business or estate planning reasons. It is quite common for there to be many restrictions on who can become a member of these entities. It is common for the entities to be stacked on top of one another. The reason for such complex dealings is to make sure that the family business stays that way and that the ownership interests cannot be diluted by divorce. For example, if Grandma was instrumental in creating a successful business, such as an oil and gas pipeline or a computer business, she might clearly want to make sure that only her descendants own the business in the future. As the generations pass, this becomes more and more difficult, but the use of LLCs can make it easier to accomplish no matter how small the investments become from the dilution of passing generations.
It is common for many professional businesses, like a medical practice or a law firm, to be set up as an LLC. These entities even have their own special name: professional limited liability companies, or PLLCs. If this is true, there are special rules that apply to who can own them; for example, if it’s a law firm, only a licensed attorney could be a member of the LLC.
The most important document in the creation of an LLC is the company agreement (sometimes called the operating agreement). This document states how an LLC is operated, what payments are permitted to members or obligations are to be paid by the members, and who can be a member. Except for a very few statutory requirements, the operating agreement is binding on the members and any restrictions on transfer are strictly enforced. Most company agreements regulate how the ownership can be transferred. It is not uncommon that the operating agreement states that the ownership interest can only be transferred in very limited circumstances, like to a trust created by a member without the approval of all other members or only with the approval of the other members of the LLC.
Many LLC owners have the same questions when their marriage comes to an end. Is a limited company protected from divorce? How is an LLC treated in a divorce? The answers to these questions can be complicated, as there is very little case law that deals with divorce and limited liability company interests. Based on current Texas statutory law, “on the divorce of a member, the member’s spouse, to the extent of the spouse’s membership interest, if any, is an assignee of the membership interest” (Texas Business Organization Code, §101.1115: “Effect of Death or Divorce on Membership Interest”).
An assignee does not have the right to participate in the management or affairs of the LLC. An assignee does not have the right to become a member of the LLC. An assignee does not have the right to exercise any rights of a member. All that an assignee has is the right to be allocated income, gain, loss, deduction, credit, or similar items and to receive distributions to which the assignor (the owner spouse) was entitled, to the extent that those items are assigned. In addition, the assignee acquires the right for any proper purpose to require reasonable information or an account of transactions of the LLC and to make reasonable inspection of the LLC’s books and records.
As case law regarding limited liability companies in a divorce continues to develop through the courts of appeals, a good place to find analogous situations regarding LLC and divorce in Texas is in closely held corporations and in partnership law. The statutory scheme for partnership interests is very similar to that of a limited liability interest. Texas case law regarding partnerships is quite clear: A divorce court can only award the non-partner spouse the rights of an assignee. If the analysis was that of a closely held corporation, perhaps the situation would be different; in Earthman’s Inc. v. Earthman (526 S.W. 2d 192 (Tex. Civ. App.-Houston [1st Dist.] 1975, no writ)), the non-shareholder wife was awarded the shareholder husband’s stock in a family corporation. The corporation, pursuant to their shareholders’ agreement, redeemed the stock awarded to the wife and offered to pay, pursuant to the shareholders’ agreement actually signed previous to the divorce by the now ex-wife, the book value of the stock (book value of an asset is seldom any indication of actual value and is most likely greatly less than actual market value). The appellate court decided that since the corporation was formed in a community property state and the stock was community property, the wife could own the stock subject to the provisions of the shareholders’ agreement, basically meaning that she could own the stock but if she wanted to sell it, she had to comply with the shareholders’ agreement.
Since the limited liability company is a pass-through entity, what happens if the entity has taxable income but does not make a distribution? What happens is that the assignee has to report taxable income without receiving any funds to pay the income taxes. Typically, partnerships and limited liability companies make distributions to cover income taxes, but there is no guarantee that this will happen. And if one is in a family business situation or an entity where the other owners would rather reinvest the income of the entity rather than distribute it, the assignee has little or no recourse (unless the refusal to make a distribution was not for legitimate business purposes). As far as the IRS is concerned, the taxes attributable to the undistributed income will be due in the next year.
The fight to determine the legitimacy of a failure to make a distribution could take years to resolve. In a somewhat different situation, but one that has implications regarding the danger of suing the business entity during divorce, the case of Lifshutz v. Lifshutz (199 S.W. 3d 9 (Tex. App.-San Antonio 2006, pets. denied)) is informative. In that case, in the middle of a divorce action, the wife sued the husband’s family businesses claiming that she had been defrauded by her husband and his family. During the discovery in the case, the other family members learned that the husband and wife had taken monies out of the partnerships and corporations without authority. The case was tried three times and appealed twice over a nine-year period. The final results were that the husband and wife each owed the partnership considerable money and the wife did not appear to gain any appreciable amount of assets.
Another strategy depends on how the LLC is managed. In extreme situations, one can attempt to collapse the LLC in a process called reverse piercing the veil. There is a line of cases that permit a creditor to collapse the corporate veil so that the creditor can collect against the shareholders of a corporation. These cases have been used by courts to also collapse the LLC. The reverse piercing allows the spouse to claim that the assets of the LLC are not shielded by the LLC and belong to the member spouse. The normal reason for this type of result is that an LLC is claimed by the owner spouse as their separate property. No reported case has yet been successful in Texas (although that does not mean that they have not been tried without appeal or settled and subject to confidentiality agreements). These cases are very complex, time-consuming, and expensive to litigate.
A different strategy would be to simply value the limited liability interest even with discounts for lack of marketability and lack of control, then suggest to the court either (1) the whole interest be awarded to the owner spouse, with the non-owner spouse receiving other assets or (2) the owner spouse be ordered to modify the company agreement to allow for two or more owners or simply be an assignee for half or some other percentage of the LLC.
The suggestion to the court should also make clear that any income tax obligation resulting from the ownership of the asset should also be allocated to the owner spouse, irrespective of whose income tax return the taxable income is reported on. For icing on the cake, if any tax losses have accumulated, determine the amount and how the IRS Code allocates them; many times, they have to be allocated equally to each party depending on the type of loss. Sometimes, the loss follows the asset, so it is another valuable asset being “divided.”
Most property cases are settled in high-net-worth divorces. The most obvious reason for settlement is that in a settlement, one can carefully construct a division of property (including LLCs) that is creative and doable. In a settlement, everyone is purportedly in agreement, so obtaining concessions from other owners of the business entity or using devices such as a liquidating partnership or trust can make the division of property a more positive experience.
At the beginning of any divorce proceeding in which a spouse owns an interest in a limited liability company, our Texas divorce attorneys recommend that you get copies of the LLC’s:
If necessary, agree to a confidentiality order to protect the privacy rights of other members (and subsequently your privacy rights if the asset is allocated to you). Also, determine how and when the interest was acquired. Then, determine if the interest can be transferred so that the non-owner spouse can be accepted as a member into the LLC.
After determining if a transfer of LLC interest in the divorce is possible, the final step is to determine if one should attempt to value the LLC with the assistance of a qualified business appraiser. With this information, one can then determine what strategy works best within the framework of a division of property that is “just and right.”
As you can see, handling an LLC in divorce can be quite complex. At Goranson Bain Ausley, our divorce lawyers have the knowledge and experience necessary to assist you throughout this process.
Our attorneys are experienced in all aspects of family law and will guide you through each step of the process, ensuring you have the information you need to make wise decisions and prepare for the future.
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