What happens when a small business owner dies or gets divorced?

A client recently asked, what happens to small businesses upon the death or divorce of an owner?  What documents should be in place prior to those events to smooth an ownership transition?  These questions can have many different answers depending on the facts of a specific situation, but here’s a general overview of the process, consequences, and ways to control ownership of a business if a death or divorce occurs:

 What happens to a small business if an owner dies?

The answer depends on the type of business.  If the business is a sole proprietorship, it will terminate upon the owner’s death and its assets will become part of the owner’s estate.  General partnerships can survive the death of an owner in some cases, but that is determined by the choice of the surviving partners and any partnership agreement that may be in place.

If the business is a corporation, limited liability company, or other business entity, it will continue to exist and will maintain ownership of all business assets.  The deceased owner’s stock or other ownership interests will transfer in accordance with his or her Will or, if there is no Will, the Minnesota intestacy statutes.

What happens to a business ownership interest if one of the owners gets divorced?

Contrary to what many people believe, a business owner’s spouse is not a co-owner of the business just by virtue of marriage.  If a spouse doesn’t own a stake in the business (e.g. his own shares or her own partnership interest), that spouse is not an owner of the business.  If there’s a divorce, however, the value of the owner’s interest in the company will be counted as an asset, and the spouse could be entitled to half of that value.  When there aren’t enough other assets available, the ownership interests can get assigned to the spouse to fulfill the owner’s divorce obligations.

Consequences

When ownership interests transfer due to death or divorce, many problems can arise.  One problem is that the remaining owners may now find themselves in business with people that they don’t know or don’t want to be in business with.  This could be the ex-spouse of a former owner or a stranger who inherited shares and knows little or nothing about the company.

Another is figuring out how to determine a value for the deceased owner’s interest in the business.  There are many different ways to calculate the value of a business, and the results can vary widely depending on the method used.  Parties that receive ownership interests, such as ex-spouses or estate representatives will likely choose a method that provides the highest value if the remaining owners wish to buy the transferred interests.  Those remaining owners would generally argue for a lower value to make repurchasing interests possible.  Disputes regarding valuation can be expensive, time-consuming, and stressful for all involved.

What documents should a business owner have in place?

Though the consequences of transfers upon death or divorce are serious, there are steps that business owners can take to prevent issues and determine in advance exactly how these types of situations should be handled.

The most important step that business owners can take is to create a buy-sell agreement (“BSA”).  BSAs govern the transfer of business ownership interests and create a structure that ensures transfers occur in an organized and fair manner.  They allow owners to anticipate and control how a death or divorce will impact the business, reducing the likelihood of disputes.  For example, a BSA might require a party that acquires shares by involuntary means (such as death or divorce) to sell those shares back to the company at a set price.  They can also create ways to fund that repurchase, such as creating provisions for life insurance policies.

Another important document for business owners to create is a Will or other estate planning tool.  These documents can be drafted to comply with the provisions of a buy-sell and ensure that business interests are transferred or otherwise resolved in a way that meets the owner’s goals and ensures that only desired transfers occur.

No one wants to spend time planning for a death or divorce, but if you’re a small business owner, it’s especially important to have a plan for the distribution of your business ownership.  Otherwise, you risking setting yourself, your loved ones, and your business partners up for a terrible headache at a an already challenging time.

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