What Happens to Business Interests in a Divorce?

Most people who own businesses set up a corporation or a partnership from which to operate the business. That gives the owner a layer of protection from liability arising out of the business and can result in some tax benefits as well. In law, a corporation or a limited liability partnership, or any other registered and formalized entity is a “person” entitled to the same due process rights as a living being. (No, this blog is not being written by Mitt Romney, but he was right about that!) The ownership interest in an entity is represented by the stock or the partnership interest stated in the entity formation documents. So the character – as separate property or community property – is determined by when and how the interest was acquired. If premarriage, then the entity will be owned by the spouse as his or her separate property. If postmarriage, the character will depend upon the character of the money or other assets given as consideration for acquisition of the stock or partnership interest. The initial contribution might consist of a spouse’s separate property money, in which case the interest in the entity would be owned by that spouse as separate property, if the claim were proven; or it might consist of community property money, in which case the interest in the entity would be owned by the community estate. It all just gets a lot more complicated from there. You may be driving around in a car owned by the business, you own the business, and you may think of the car as yours, but it’s not. The entity owns the car. The court has no power to award you that car, unless you have brought the entity into the divorce case as a party to the law suit, by alleging a cause of action against the entity and serving its registered agent (which might be you!) with notice of the suit in the form of a citation, requiring the entity to file an answer to your divorce case and consent to the overall resolution of your divorce case. If all of that happened, the court might order the entity to distribute the car to you, which would be a taxable event, reportable by the entity on its tax return and included in a K-1 to be reported on your personal income tax return. Otherwise, the only thing a court can do is award the interest in the business, not the underlying assets or money of the business. All sounding inexplicable to you so far, even ridiculous? Really, it is more than just a nefarious scheme by lawyers to validate and perpetuate their existence. Many benefits flow to owners from the entity theory of property: if somebody trips and falls in your office or shop, you are not responsible or liable; your employees have to look to the entity to resolve their issues; revenue gets passed through one or more entity returns in succession, usually resulting in a reduced overall amount of income taxes to pay, just to name a few. The fault is not with the entity theory of businesses, but with how it can best be made to fit with laws governing division of property at divorce so as to make the division just and right between the spouses. Toward that goal, many theories of recovery have developed over the years and become part of Texas family law by the body of case law which has grown up around the issues. Not surprisingly, there has been a lot of litigation on those theories of recovery. Those will be discussed individually in future blogs.