How companies and businesses affect divorce settlements
Many clients’ matters involve business interests. There are many preconceptions surrounding business interests/ companies and divorce settlements, the most frequent being that the Courts will disregard the business when considering a settlement. Not so. Whilst the Courts are loathed to interfere with the smooth running of a business or change its ownership the business will, if material, form a key focus of the proceedings both in terms of its value and the income that it produces.
To properly advise clients it is necessary to understand how the business is owned, what it is worth, what income it has provided and can provide in the future, for purposes of assessing the appropriate level of maintenance.
The financial matters surrounding a business (or interest in it) are frequently an area of huge disagreement between divorcing parties and therefore merits close scrutiny.
Ownership / business structure
The first step to understanding a business is to establish the type of structure and how it is owned. There are many structures and in many cases we see a combination of these:
1 Sole trader
A single person owns, operates and controls the business for their personal benefit frequently using a distinct trading name. Staff may be employed. All assets are personally owned and all liabilities are personal debts. The owner and business are as one and the owner is assessed to tax on the profits made by the business each year.
A partnership can either be unincorporated (where personal ownership attaches to the assets and personal liability attaches to the debts) or incorporated, e.g. a Limited Liability Partnership (LLP). The distinction is important in terms of potential liability for partnership debts.
The partnership may be governed by a formal written deed or may be informal, e.g. usually between a small group or between Husband/ Wife. Again, a trading style may be used and staff employed.
The assets are owned by the partners (according to their shares) and in the case of an unincorporated partnership the partners are all jointly and severally liable for all of the partnership’s debts. It is as though the partnership is a collection of sole traders grouped together. Partners of an LLP may have limited (and not unlimited) liability for debts.
Partners are assessed to tax on their share of the profits made by the partnership each year.
3 Company, limited by shares
A company is a separate legal entity and is operated by its Directors on behalf of the shareholders. In many instances the Directors and shareholders are one and the same, usually Husband/ Wife or with other family members, for reasons of tax efficiency. Matters become more complex when unconnected persons are also shareholders as their wishes cannot be ignored.
All persons working for the company are employees (including the Directors) and will be paid under the PAYE regime. Shareholders may receive dividends, the amount of which is decided upon annually by the Directors. Whilst the annual profits of the company are taxed (corporation tax) the amount of profits earned in any year are not wholly allocated to the owners as income. The Directors decide when profits are paid out to the shareholders.
The income taken by director/ shareholders can therefore be manipulated/ structured to achieve the best tax efficiency. It is then necessary to consider what profits could be paid out rather than what income is paid out.
Where there is an issue over the value of a business a Court will ordinarily direct that an expert (most likely a suitably qualified accountant) be instructed jointly by both parties to value the business, to express a view on the income it can provide and the extent to which it can be used to assist with funding a settlement. Whilst this can be a useful exercise it can tie the hands of either party that may be unhappy with the accountant’s opinion, which is always too high or too low depending on their point of view. The Court will generally rely on the expert’s valuation, unless they are discredited. The accountant generally knows more than the Judge so why would the Judge change the valuation? A restriction on fees (the Court may direct the accountant providing the cheapest quote be used) can also have a detrimental effect on the extent of work the accountant can do in preparing his report. Valuations are mostly “desktop” in nature and not rigorous in the way that would be performed in the event of an actual sale of the business. The expert may not be able (for the fees authorised) to sufficiently investigate matters where it is alleged there has been manipulation of the figures. This is one of the reasons we have in-house forensic accountants here at the firm.
Regardless of the formal structure of the business, the valuation of it will generally proceed in the same way and is dependent on the type of business.
There are three main types of business to be considered in divorce proceedings, and each is approached differently:
1 Income stream
This type of business is usually a small sole trader type business perhaps (for reasons of tax efficiency) operated in the guise of a limited company. The business is usually a single person providing their own labour, whether as tradesman or professional services, e.g. consultant surgeon, to a variety of clients. There are no ongoing contracts and it is highly unlikely there would be any premium for a sale of the business to a third party, even if there was a business to sell.
In this instance the business is considered an income stream and its value is taken as the value of the net assets in the business.
2 Property/ investment based business
For a property/ investment based business it is the value of the property/ investment that is important as there is no underlying trade. Consideration has to be given to the value of each individual asset and any necessary revaluation of assets will be incorporated into a revised balance sheet to reach the overall value of the business.
To calculate the net value it will be necessary to consider both the potential amount of tax that would arise on a sale of the property as well as the tax that would arise on extraction of the funds from the business.
3 Trading business
Any business (other than income stream type) that is trading in nature with a view to making profits is usually valued according to its profits. The circumstances of the business are considered and a calculation is performed to assess the annual maintainable earnings. That figure is then multiplied by the price/ earnings ratio to get to the total value of the business and the value of an individual’s interest is then calculated relative to that total.
Adjustments may be required for factors such as debt, surplus assets or minority shareholder discount, dependent on the individual circumstances. A valuation will also be considered on an assets basis and the greater figure will generally be the value of the business.
The calculations performed to reach the maintainable earnings will also be relevant for consideration of the income the business can provide to its directors/ shareholders and will be relevant for consideration of spousal and child maintenance.
The potential incidence of Capital Gains Tax will also be a feature of the calculation of the (net of CGT) value of the parties’ interests in each business.
During the course of divorce proceedings emotions can run very high, and we find this particularly true when looking at the value of a business and the income that it produces. The party running the business may argue the business has no value, even when that is obviously untrue. Figures can be (and frequently are) manipulated and the state of the business misrepresented in order to achieve a lower (than should be the case) value and a fair, in the eyes of the business operator (but inequitable otherwise) outcome.
At the end of the day, and unless there is to be an overall capital and income clean break between the parties the business will be providing an income to both parties, whether directly (as salary/ dividends) or indirectly (via maintenance). Manipulation of figures during the course of proceedings is a false economy and can subsequently be exposed with the potential consequences of a reopening of the whole proceedings if a Court decides that fraudulent misrepresentation occurred during the original proceedings.
Companies and divorce, with both parties owning shares
The Courts prefer to achieve full separation between the parties, including of ownership of business interests. In the majority of cases this is achievable as it is usually only one of the parties who is actively involved in the running of the business. Hence, a transfer of a share of ownership from one party to the other is desirable, but that may have ramifications for both capital gains tax and the overall net income that can be taken from the business. It may also result in a distorted outcome.
Whilst Capital Gains Tax is not usually an issue, unless the transfer is of shares in an investment company or property, the change to routing of all income from a business through one party only can have significant income tax consequences through the loss of personal allowances and basic rate tax band. Thus, not only will the parties be running two households instead of one, they also face doing this from a reduced overall net income.
Company pension scheme
There may also be a company pension scheme in which both parties may be members and that pension scheme may own the property that the business trades from.
To speak to a specialist forensic accountant or family lawyer about a divorce or separation matter involving a company, then please call 0330 056 3171 or click here to send an email via our contact page.
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