As with all other property, family-owned businesses undergo a two-step evaluation process during divorce. This process is comprised of (1) characterization and (2) valuation. Through characterization, the business is determined to be either community or separate property. Community property is that which is owned jointly by both spouses and, consequently, must be divided in a divorce. By contrast, separate property is owned by one spouse and remains that spouse’s property following a divorce. Valuation is the process by which the economic value of a business is ascertained by measuring things such as its income, assets, expenses, and predicted future income. This value will affect how a community-property business is divided in a divorce.
Characterization
All marital property, including a family business, may be characterized as either separate or community property. Eggemeyer v. Eggemeyer, 554 S.W.2d 137, 142 (Tex. 1977). Separate property is acquired or created by one spouse apart from the marriage and courts are prohibited from assigning the separate property of one spouse to the other in a divorce. Cameron v. Cameron, 641 S.W.2d 210, 219-20 (Tex. 1982). Community property includes anything acquired or created during the marriage by either spouse, and it must be divided by the court in a “just and right” manner during a divorce. Tex. Fam. Code § 7.001. Courts presume that any property possessed by either spouse at the time of a divorce or annulment is community property. Tex. Fam. Code § 3.003(a). Parties seeking to characterize marital property as separate must prove that characterization by clear and convincing evidence. Id. at § 3.003(b).
The most common methods of overcoming the community-property presumption include the Inception-of-Title Rule, tracing, and agreement. Under the Inception-of-Title Rule, the character of the property is determined by the time in which and manner by which the interest in the property was first acquired. If one spouse shows that the interest in a property was acquired either (1) before the marriage, or (2) during the marriage by gift, devise, or descent, then that property is separate. Tex. Fam. Code § 3.001. For example: if one spouse started a business before marrying, or inherited a business from her parents while married, that business would be separate property.
Additionally, separate property includes property that was acquired in exchange for other separate property, even if it was acquired during the marriage. Matter of Marriage of Douthit, 573 S.W.3d 927, 930 (Tex. App.—Amarillo, 2019, no pet. h.) (citing Ridgell v. Ridgell, 960 S.W.2d 144, 148 (Tex. App. — Corpus Christi 1997, no pet.) (citing Dixon v. Sanderson, 72 Tex. 359, 10 S.W. 535, 536 (1888)).
Tracing refers to the method of connecting property that is owned during a marriage to separate property that was used to obtain it. Marriage of Douthit, 573 S.W.3d at 930-32 (characterizing a tract of land as separate property because it was conveyed in exchange for land that was acquired before the marriage, even though the conveyance occurred during the marriage). For example: if one spouse purchased a business during the marriage, but can prove that she purchased it with separate funds, that business will be considered her separate property.
Finally, if the spouses formed a valid pre or post-marital agreement concerning the property’s characterization, that agreement will govern the property during a divorce. See, e.g., Beal Bank v. Gilbert, 417 S.W.3d 704, 711-12 (Tex. App.—Dallas 2013, no pet.) (post-marital agreement upheld); Dewey v. Dewey, 745 S.W.2d 514, 517 (Tex. App.—Corpus Christi 1988, writ den.) (pre-marital agreement upheld). It is important to note that, even if the business is separate property, the non-owning spouse may be entitled to a reimbursement for any financial contributions they made to the property.
If neither spouse can prove that the business is their separate property, then they have three options: (1) continue to operate the business unchanged, with both spouses retaining their ownership interests; (2) sell the business and divide the profits; or (3) have one spouse “buy-out” the other’s share of the business and operate it alone. Take note, however, that ownership over certain kinds of businesses require a professional license. For instance: in Texas, the Corporate Practice of Medicine doctrine prevents anyone who does not have a medical license from practicing medicine. In divorce, this means that a spouse without a medical license cannot receive shares of any medical practice and cannot have joint-ownership of the practice.
Given the typical relationship between divorcing parties and the sentimental value of a family-owned business, many times a buyout is the parties’ best option. The purchasing party may offer separate funds, their share of community properties, and/or a long-term payment program to buy-out their spouse. Regardless of which path is ultimately chosen, the spouses should conduct a valuation of the business before finalizing their divorce.
Valuation
Valuing a private business can be an intricate process and is usually completed by a qualified accountant or a business valuation expert selected by the attorneys. The business valuator typically applies one of three approaches in ascertaining the fair market value of the business: the (1) asset approach; (2) market approach; or (3) income approach.
The asset approach to valuation focuses on the fair market value of the business’s assets after subtracting liabilities. By contrast, the market approach determines the business’s value by comparing it with similar businesses in comparable markets and then deciding what a buyer would likely pay for the business in the current market. Lastly, the income approach focuses on the future potential of the business. Through this approach, the future earnings of the business are established by projecting the business’s earnings and then adjusting them for changes in growth rate, cost structure, etc.
For purposes of a divorce valuation, the real property of a business (i.e., office space, brick and mortar shop, etc.) may be assessed by (1) analyzing comparable sales in the area, or (2) analyzing income that the property generates. See State v. Whataburger, 60 S.W.3d 256, 262 (Tex. App.—Hous. [14th Dist.] 2001, pet. denied). The personal property of a business (i.e., computers, inventory, etc.) may be assessed by the same methods. See, e.g., Exxon Corp. v. Middleton, 613 S.W.2d 240, 246-47 (Tex. 1981) (using comparable sales approach). To prepare for a business valuation, business owners should prepare a list of the business’s income, liabilities, and assets.
One of the most significant assets of many businesses is goodwill, or a positive reputation with the public. While this asset is difficult to quantify, a business with 500 five-star reviews would likely be worth more than a similar business with 200 two-star reviews because of its goodwill. Additionally, goodwill comes in two forms: personal and enterprise. Personal goodwill is associated specifically with one person at the business, as seen when patients prefer to visit “their” doctor in a multi-doctor practice. If one of the spouses has significant personal goodwill with the business, the assessors may apply a discount to the fair market value to reflect the value of the business if that spouse were not associated with it. Enterprise goodwill is not associated with only one member of a business, but attaches to the business at-large, as seen when shoppers prefer certain grocery stores regardless of who works there. Enterprise goodwill is considered community property and will be split between divorcing spouses.
Divorcing as a business owner involves all of the traditional challenges of a divorce and many challenges specifically related to owning a business. In a business divorce, there likely will be disputes as to which assets belong to the business, what the source of the business’s goodwill is, and how much either spouse has contributed to the businesses’ success.
Understanding the intricacies of dividing a business during a Texas divorce is pivotal for any business owners confronting divorce. Knowledge of both your business as well as the evaluation process is a pivotal component to business owners being competent and confident participants in the division of their business upon divorce.
