Protect your practice

Yours, mine or ours? What business owners should know and do to protect their assets in the event of a personal relationship breakdown.

John* always knew he wanted to become an entrepreneur and operate his own business. In his early 20s, he realized that goal when he launched a promotional products company in Toronto. Like most entrepreneurs in the early stages of growing a business, he put in long hours, doing everything from initiating sales calls to packing and shipping orders. When he got married, he brought his wife, Mary, into the business as an equal partner. She was eager to be involved and helped handle the bookkeeping and human resources functions.

In 2013, after 13 years of building their relationship and the business, they separated. It became awkward for Mary to be around the office and she slowly exited — but not without conflict. The problem: they did not have any sort of agreement in place that outlined what would happen to the business if they divorced. The result: they fought about the value of the business, who would replace Mary and at what salary, whether or not John could increase his management fees and what share of future profits Mary would get. Two years, a failed mediation and almost $40,000 in fees later, the couple reached a deal that will see Mary transfer her shares in the business to John.

From the outside looking in, Brian, a partner in a successful law firm, and his wife, Catherine, owner of a small flower shop/decoration business that is more of a creative outlet than an income source, seemed to have it all: two children, a lovely home in an upscale neighbourhood, beach vacations. The reality could not have been further from that carefully crafted facade. They struggled for years but stayed together largely for the benefit of their children. Finally, 16 years into the marriage they decided to separate. Brian says the stress of having to appear strong and confident for his children while meeting billing targets for his firm and coming to terms with the breakdown of his marriage caused revenue to plummet. With no prenuptial agreement to provide a way forward, it took them years to reach an interim parenting and financial plan. In 2012, they announced their separation and both are in the process of trying to rebuild. They still have not finalized the divorce.

Such situations are all too common. Entrepreneurs and professionals who devote their lives to creating a thriving business are often ill-prepared for family breakdown. When it comes — a stark reality for many — the aftermath can ruin a lifetime of hard work and devastate their most valuable asset. This article will explain the rules governing property division in divorce and provide effective tools and strategies that could help protect your business from the negative impacts of a marital breakdown.

YOURS, MINE AND OURS

While the federal government has the constitutional authority to sanction a divorce under the Divorce Act, the provinces and territories handle the division of a married couple’s assets subject to provincial and territorial statutes. In Ontario, for example, that statute is the Family Law Act. In Alberta, it’s the Matrimonial Property Act.

Regardless of where you live in Canada, marriages are viewed as economic partnerships and for the most part assets you acquire while married are viewed as community property. Some exceptions include gifts or inheritances received from third parties during the marriage, property received as damages for personal injuries and property that the couple has chosen to exclude in a domestic contract.

Word to the wise: sometimes these exceptions will no longer be considered separate if mixed or commingled with marital property. For example, in Ontario, if you use the inheritance from your parents to pay down the joint mortgage, then that money is now considered commingled and becomes part of the community property to be shared equally should you separate.

Family law statutes do not assign ownership of the assets, so the province or territory will not be deciding who gets what. Rather, family laws ensure that spouses end up with equal net family assets, with the spouse who has more making an equalization payment to the spouse who has less. What is included as an asset varies by jurisdiction (i.e. different provinces/territories). In some provinces, business assets are not shared.

For example, on separation in Ontario, spouse A owns a business worth $400,000 and has $100,000 in savings. Spouse B has $100,000 in savings. To equalize these assets, spouse B is entitled to half of the difference of their net family holdings or $200,000 [($400,000 + $100,000 - $100,000)/2 = $200,000].

Family laws in Canada take a spouse’s obligation to equalize assets very seriously. If a spouse who has title to a business is not compliant or there is suspicion that a business owner is trying to hide or transfer assets to a third party or is inflating expenses to minimize the value of the company, depending on the jurisdiction the courts can step in and transfer or vest assets into the name of the non-title spouse, order the payment to come from company profits, freeze operations or order the sale of the business.

COMMON LAW COUPLES

Generally, once a couple has lived together in a conjugal relationship for more than two or in some jurisdictions three years, the two are deemed by the provinces and territories to be common law spouses for the purposes of division of property. This is important because in some provinces (Saskatchewan and Manitoba, for example) common law couples have the same rights as married couples when it comes to dividing their assets if the union breaks down.

Common law couples in a number of provinces (including Ontario and New Brunswick), on the other hand, do not enjoy the same right to equalize assets when the relationship ends, which means division of property can become even more complicated than it is for married couples. Typically, each common law spouse keeps assets in his or her own name. However, when there is a relationship breakdown, a non-title common law spouse may be able to make a claim against the assets of the other so long as it can be established that he or she made some contribution toward the value of those assets. Assets may include a stake in a business or professional practice owned by the other common law spouse.

HOW YOU CAN PROTECT YOUR BUSINESS

Domestic agreements (prenups and postnups) In a nutshell, a prenup or postnup is a legal contract signed by both parties that outlines property rights and expectations (including alimony/support payments) upon divorce and takes precedence over provincial statutes on this front. Agreements drafted and entered into when a couple starts to live together, and before the wedding, are prenuptial agreements. If the agreement is entered into after the I dos or during the relationship, it’s known as a postnuptial agreement. Pre- and postnups carry the same weight in the eyes of the court.

To prepare a strong pre- or postnup agreement, each party should be represented by his or her own legal counsel.  In most regions, parties can detail what property will be considered separate and how community property should be divided.

For example, the non-title spouse may agree to exclude the value of the business when it comes to divvying up the assets. Even if the non-title spouse does not agree to exclude the value of the business, he or she may agree to a number of helpful provisions, including the method used to value the business; waiving the right to seek an order to freeze the operations of the business; and how to best move forward with a legal separation (see How to separate below).

Anyone who is planning to start a business, buy shares in a corporation or become a partner in a professional practice should consider consulting with a family law lawyer.

Shareholders’ and buy-sell agreements: A shareholders’ agreement is a legal contract among the shareholders of a corporation. It sets out the rights and responsibilities of the shareholders, including how decisions are made, the situations in which shares can be sold, how the sale will be financed, under what circumstances a shareholder can be forced out, how disagreements are handled, who gets to sit on the board and more.

It can also address what happens in the case of a matrimonial breakup. For example, a shareholders’ agreement can stipulate that non-title spouses cannot become shareholders. Or the non-shareholder spouses can become parties to the shareholders’ agreement and indicate they are willing to ensure the shares never become subject to matrimonial property division. Or the shareholders’ agreement can require divorcing shareholders to sell their shares to the corporation or to the other shareholders.

Any corporation with more than one shareholder should have a shareholders’ agreement, says corporate commercial lawyer Diane Karnay of Wilson Vukelich LLP in Markham, Ont. If no shareholders’ agreement is in place and there is a conflict among the shareholders that cannot be resolved, then the consequence may be an inability to make decisions, causing the business to flounder and its value to erode.

“I was involved in the sale of a business owned by several shareholders,” says Karnay. “One of these shareholders was a corporation jointly owned by a husband and wife in the midst of a divorce. Let’s call this corporate shareholder Corporation A. To the fury of all the other shareholders who were trying to get this deal done, matrimonial issues ended up affecting the deal. Shareholder approval of the sale of Corporation A’s assets — its shares in the business being sold — was required and one of the spouses was withholding approval out of spite. The purchaser grew tired of waiting and the deal nearly imploded because of the delay caused by the warring spouses. After many weeks and growing legal expenses, the deal finally closed but it almost didn’t happen.”

This conflict could have been avoided if appropriate provisions had been spelled out in a shareholders’ agreement between the spouses and/or a shareholders’ agreement among the shareholders of the business being sold.

When a husband and wife jointly own shares of a corporation (as in the situation above), a shareholders’ agreement may provide that one spouse will have the first right and option to purchase the shares of the other in the event of a divorce, particularly where the spouse with this option is active in the business and the other spouse is not. If both spouses are active shareholders, the agreement may provide for a buy-sell or shotgun arrangement where one party initiates the sale and the other has 60 days to decide whether to buy out the spouse’s shares or sell his or her own at a given price.

Using excluded assets to acquire a business: In some jurisdictions some assets can be excluded from matrimonial division. For example, if you purchase shares in a business with excluded assets (an inheritance for example) that equity stake and any upside growth in the business is yours and yours alone even in a divorce.

HOW TO SEPARATE

Not all divorces have to be decided by a judge. In fact, court should be the last resort, especially when a business is involved because in court everything, including sensitive business information, is made public. Plus, the judge has the power to make decisions that can seriously disrupt operations.

There are six legal processes available to separating couples in Ontario: spouse-to-spouse negotiation; mediation; arbitration; collaborative lawyer-to-lawyer negotiation; traditional lawyer-to-lawyer negotiation; and court.

It’s not uncommon for those seeking a divorce to go to their lawyer with a list of issues discussed and agreed upon with their soon-to-be ex-spouse. Spouse-to-spouse negotiation, however, is only recommended in simple cases where there is a high degree of trust, respect and cooperation between the separating spouses.

Mediation and arbitration involve couples working with an independent third party to resolve issues around property division, custody and parenting and support.  The difference: in mediation participants have more say in the outcome because they get to discuss and craft their own agreement with the assistance of the mediator. Arbitration is more like a court case and the parties have to accept what the arbitrator says.

Collaborative divorce is well established across the country, particularly among high-net-worth couples because the negotiations are private and focused on finding constructive solutions to personal, business and financial issues. Collaborative law lawyers or mediators often recommend the use of jointly retained neutral professionals such as certified business valuators to limit disputes and keep fees in check.

In many ways collaborative negotiation is a kinder, gentler approach. That’s because, unlike traditional divorce lawyers, collaborative law lawyers are trained in interest-based negotiations — a form of negotiation inspired by a model developed at Harvard University — and are required to follow certain negotiation protocols that often lead to extremely sophisticated, creative solutions. There are no bullying tactics or the threat of prolonged costly court cases. In fact, to strengthen the spirit of cooperation, the collaborative process requires couples and their lawyers to sign an agreement that states if the process is not successful and they do end up headed for court, they will have to retain different lawyers to handle the litigation. Thankfully, this rarely happens.

Bottom line: no one wants to think about separating as you are about to enter into a committed relationship, but planning, particularly when a business is involved, can help you navigate through an  emotionally charged time and save what you have worked so hard to build.

*Names and some details have been changed to protect privacy.

About the Author

Nathalie Boutet


Nathalie Boutet is a family law lawyer and an expert in Ontario law (boutetfamilylaw.com).

comments powered by Disqus

Highlights

Update your knowledge and strengthen your network at this must-attend conference covering the most important issues and trends affecting audit committee members.

It’s probable that someone you know is deep in debt. If you are observant, you might see one of these seven signs.