Divorce’s Impact When One or Both Spouses Own a Business
Let’s look at what happens during a divorce in Arizona when one or both spouses own a business. You can also learn about dividing your family business during a divorce in AZ here.
Defining Arizona Community & Separate Property
Arizona is what’s known as a “community property” state. Thus, under Arizona state law, when a married couple is divorcing, their assets are divided into two categories, “separate property” and “community property.”
“Separate property” is anything that one spouse owned before the couple married. When the couple divorces, they each keep their separate property. This applies to real property (i.e., land and buildings) and personal property (i.e., more fungible items, including cars, cash, stocks, and jewelry)—and separate property also includes anything a spouse received as a gift or inheritance during the marriage (including any increase in value that occurs during the marriage).
“Community property” is anything that the spouses acquired during the marriage. For these items, the spouses share ownership during the marriage, and—at the time of divorce—the items must be divided equally. This doesn’t mean that every divorcing couple must halve every piece of community property. They could if they wanted to, but, instead, usually, each ex-spouse receives half of the cash value of the community property. To do that, couples may sell items and divide the proceeds, or they can negotiate as to who takes what. And if there is an item one ex-spouse wants to keep, they can pay the other the value of the other share—basically buying the other spouse’s interest.
In theory, categorizing property as either separate or community property seems straightforward, since it is based on the time of acquisition. But this identification can be surprisingly complicated in practice. For example, say a husband might bring a house he owned into the marriage, while the couple made improvements to the house while they were married. The house then increased in value because of the upgrades. After the couple’s divorce, the house would be the husband’s separate property, but the improvements are community property. Therefore, the increase in the house’s value would be community property.
Defining Arizona Community & Separate Property in a Business Context
While the Arizona requirements relating to community and separate property arise out of state statutes, the courts have expressly applied these standards to divorce cases involving spousal ownership of businesses.
Once again, start with the basic concept that a spouse’s pre-existing business would be separate property at the time of the divorce, and the determinant is the time of acquisition. If either spouse created or acquired a company during the marriage, the company is community property—unless there is a clear reason why that rule should not apply (e.g., the business was inherited).
But businesses aren’t static over time, so what about the growth of the business? The courts follow a pattern similar to the example of the house scenario: When determining what is separate property, the courts split the decision into two—examining the status of the business and then reviewing the increase in value, profitability, or profits themselves.
Cockrill v. Cockrill, 124 Ariz. 50, 52 (1979) is an early Arizona Supreme Court case that still informs today’s decisions. In that case, the husband owned a commercial farm before getting married. He and his spouse were married for only two years and ten months, but the farm increased in value $79,000 during that period (adjusting for inflation, that would be $308,726.78 in today’s market). Since the farm was the husband’s separate property, the husband argued that the recent increase in value should also be his separate property.
The state supreme court explained that, when deciding if profits (or an increase in value) should be community or separate property, the test should be whether the profits are “the result of the individual toil and the application of a spouse or the inherent qualities of the business itself.” If the growth was because of the nature of the business, then the profit should be separate property. But if the profits were because of the spouse’s work, then the profits are community property.
The burden for proving what should be separate property falls on the person claiming that separate status, while courts presume that the items at issue are community property. But the courts don’t use an “all-or-nothing” approach to decide what is the fairest division—they can look at the relevant facts to make a determination, as they did in Cockrill.
While the result in Cockrill may seem counter-intuitive—and perhaps a disincentive to keep working at one’s own company—the courts see the profits as akin to a salary earned during a marriage. And salary earned during the marriage is community property.
In Cockrill, the business owner was the same spouse who worked at the farm during the marriage. But think about what would have happened if his wife had started working at the farm after they were married. The same rule applies, and the post-marriage profits would be community property.
Now, what if the wife worked for the business, and the business paid her a market-rate salary? Then courts have held the business and its profits remain the husband’s separate property because she already received sufficient compensation for her effort.
And what if the debate was not limited to the business’ profit but to ownership of the business itself? Are there ways in which a separate business can become community property?
If community funds were used in the course of the business to the point that the assets become commingled, this can turn separate property into community property. This doesn’t mean that any use of community funds will turn a business into community property. Instead, the court will ask if the community sustained an actual loss on behalf of the business. If so, is there a way to deduct that loss and restore those funds to the community property?
If there is no way to separate out the community funds, then (on rare occasions), a business could become community property.
Factors Used to Determine Community & Separate Property in Arizona
To summarize, here are some common factors courts will review when they are addressing the division of a business’ ownership, profits, and related interests:
- When was the property acquired?
- How was the property acquired?
- Was the property the result of an inheritance or other gift to one of the spouses?
- Was there any commingling of the separate and community property?
- Are filings relating to title or acquisition stating if the property is solely or jointly held?
- What documents support the administration as sole or jointly-held property?
Are There Any Relevant Agreements That Impact the Division?
While the statutes and case law establish the laws relating to community and separate property, another element can dramatically impact the business: If there is an agreement in place that specifies who gets what and why.
In the context of businesses, these agreements can specify how company ownership can be transferred. They can address both the tangible assets (e.g., real estate, manufacturing equipment) and the intangibles (such as intellectual property and company reputation). They can set out plans for the company’s day-to-day management, succession plans, and expectations for future growth and earnings. (An agreement might also be useful on a purely evidentiary matter, as it would detail the company’s valuation and its plans for a given time.)
Both prenuptial and postnuptial agreements can be binding in Arizona.
Prenuptial agreements (or “prenups” as they’re commonly known), i.e., contracts that specify divorce terms that are executed by the couple before they get married, are enforceable under Arizona law if they meet specific requirements. (And unlike other types of contracts, prenups do not require consideration—that both parties must give up something of value before the contract is enforceable.)
For a prenup to be valid, Arizona state statute requires:
- The agreement must be in writing and signed by both parties
- The agreement becomes valid when the couple marries
On the other hand, a prenup is invalid if:
- If a spouse did not voluntarily execute the agreement
- If a spouse did not provide a fair, reasonable disclosure of their financial resources or obligations before the other signed the agreement
- If a spouse didn’t have an accurate knowledge of the other’s financial resources or obligations
- To the extent that the prenup’s provisions mean that a spouse, upon divorce, would have to rely on public assistance instead of spousal support
Postnuptial agreements may also be valid and enforceable in Arizona, even if the couple executed the agreement while already contemplating divorce. The validity of a postnuptial agreement arises out of Arizona case law, with requirements such as:
- The agreement must be in writing and signed by both spouses
- Both spouses agreed voluntarily
- Both spouses were aware of the true nature of their assets and liabilities and the legal repercussions of the agreement
- The terms of the agreement (including the division of property and determination of spousal support) must be fair and reasonable
- The terms cannot violate relevant state law (this can invalidate the agreement in whole or in part)
What Can Divorcing Couples With Businesses Do in Arizona?
For those couples seeking a divorce, and one or both control a business that is community property, it’s useful to consider options before deciding how and what to litigate.
Dissolution: If small companies are community property, particularly those that are sole proprietorships, the most expedient option may be to dissolve the company and divide the receipts from the sale. (It’s important to review tax repercussions before doing so, of course.) This would need to be a true ending of the company. If either spouse thought they could simply close the business in name only, and then pursue the same ideas, customers, and so on to avoid paying their spouse, that strategy would probably result in later litigation.
Sell the Company: Another option for the couple would be to sell the company, in whole or in part, and divide the proceeds as they would any other asset.
Buy Out the Other’s Interest: Again, if one spouse wants to continue to operate the business, a buyout might be the best approach. Properly structured, it can resolve past, present, and future conflicts.
Run It Together: If the hope is that a married couple can continue to work together after a divorce, the former spouses still need to work out an agreement in terms of ownership, management, succession plans, and provisions if ongoing collaboration turns out to be unsustainable.
Businesses & Divorce Are Complicated
If you are getting divorced, and you or your spouse own a business, the issues are complicated. Discussions about the ownership and running of the business will be contemporaneous with discussions about spousal support and other family assets.
But the repercussions of the company division don’t just impact the ex-spouses’ current finances—they impact your ability to create future wealth as well.
Given the complexity of these issues, make sure you hire qualified counsel familiar with both family and business law. To review your case, or ask questions you may have about how relocation may impact your child custody, contact our office (by phone at: 602-548-3400) for a confidential consultation with one of our family law attorneys. Don’t wait. Call today.