Pasternak & Fidis Reporter

July 30, 2012

Premarital Agreements and the Business Owner

Some people planning to marry want to enter into a premarital agreement. A business owner may have particular concerns that may cause him or her to consider a premarital agreement. There are a variety of issues the lawyer for the business owner needs to pay special attention to.

Why a business owner may seek a premarital agreement. A business owner may want a premarital agreement to protect his or her exclusive rights to the business if the marriage fails, and to control the disposition of the business after his or her death. At divorce, whether appreciation in the value of a premarital business is marital property can become the subject of an expensive court fight. Similarly, the value of the good will of a business can be disputed, with competing expert witnesses and substantial risk for the owner. A premarital agreement can take the business out of the pool of assets that may be divided at divorce. It can also allow the owner to pass the business on to a child from a prior marriage at his or her death free of a spousal claim.

Criteria for validity. The standards for validity of a premarital agreement are the same for a business owner as for anyone else. The agreement must be executed voluntarily, not as a result of duress. Parties should make a fair financial disclosure. However, they can waive disclosure so long as the waiver is voluntary.

A premarital agreement need not be fair. However, a spouse who is entitled to very little at the end of a marriage has an incentive to challenge validity. Even when the proponent wins, in the reported cases, the winning proponent had to pay for a trial and at least one appeal. We don’t know about the cases that settled out of court because the process was flawed and the proponent did not want the risk or expense of a trial. Moreover, in those cases where the proponent won, he or she may have been forced to grant access to business records in discovery, something the agreement may have been designed to avert.

Best practices. When there is a disparity in resources at the outset, and even when parties are in comparable circumstances, it is in the interest of the business owner to follow best practices in the negotiations leading to the signing of a premarital agreement. These include:

  • Timing. The proponent should present the proposed agreement to his or her fiancé(e) well before the wedding. How long depends on many factors. Better still is presenting the proposed agreement before setting a date for the wedding.
  • Actual negotiation. Courts have recognized that an actual negotiation is a transaction between equals which equates to a voluntary agreement. The stronger party should be open to considering proposed changes and should agree to     some.
  • Access to counsel. When both parties are represented by counsel, it is almost impossible to get a court to throw out a premarital agreement. When there is a significant disparity in resources, the stronger party should consider paying the
    weaker party’s legal fees. Doing so furthers the stronger party’s interest in validity.
  • Financial disclosure. A good financial disclosure, so that a weaker party knows what he or she is giving up claims to, is an important key to validity.
  • Substantive fairness. The laws of Virginia, Maryland and the District of Columbia (and the majority of other states) permit premarital agreements that are very unfair to an economically weaker party so long as the process of getting the agreement was fair. However, when there is a big disparity in resources, the stronger party is usually better served by an agreement that makes adequate provisions for the financial security of his or her future spouse.

Disclosure issues of special concern to the business owner. Disclosure of the value of an interest in a closely held business or professional services practice presents a special challenge. The value may not be readily ascertainable, the owner may be reluctant to disclose information that could be of interest to competitors, or the owner’s partners may not wish to have such information shared.

It is a mistake for the owner to assume that the other party’s knowledge of the existence of the business is tantamount to an understanding of its value.

The gold standard for a disclosure in connection with a premarital agreement is a written statement appended to the agreement identifying all significant assets and providing a reasonable statement of values. However, a business owner may want to consider other options, such as:

  • A statement of net worth without a breakdown.
  • A detailed statement of nonbusiness assets and their values coupled with a different sort of disclosure for the business.

The problem of stating the value of a closely held business. There are several challenges in creating a financial disclosure for a business owner that will stand up against attack. The value may not be readily ascertainable. Yet a statement that understates value or is misleading or incomplete puts the validity of the agreement at risk. There is no obligation to engage an expert appraiser to appraise a business for purposes of a premarital agreement. In the absence of a formal appraisal, the owner, and his or her lawyer, should take precautions in the disclosure of value. There are various standards of value, including book value and fair market value. The owner may use book value, but should qualify the statement if he or she does so. For example, in a 1984 Maryland case, Head v. Head, the husband stated the value of his business, the company that made the Prince tennis racket, at book value, but qualified the statement by saying actual value could be much higher. The appeals court held the agreement was valid even after the husband sold the company for 17 times book.

Another approach to disclosing the value of a business is for the owner to provide known data – e.g., gross revenues for a three-period; the amount the owner took out in compensation over the same three-year period; a balance sheet; a profit and loss statement; the business tax return or the Schedule C for a sole proprietorship; a narrative statement of the history of the business, what it sells, who founded it, how long it has been in operation, and other background facts that can help the weaker party understand what he or she is giving up a claim to. Courts have upheld premarital agreements that have taken this approach to disclosure.

The lawyer for the business owner should make some inquiries to make sure that there are no problems relating to disclosure lurking in the background, including:

  • Does the business have key person insurance and, if so, what is the amount of the death benefit? The owner’s statement of value should not contradict any statement of value made to the insurance company, or should be explained.
  • Has the owner made a statement of his/her opinion of value, e.g., in an application for life insurance, a loan application, or in another place where criminal penalties may apply? A disclosure for a premarital agreement should not contradict such a statement, or should explain the discrepancy.
  • Has the business been valued recently for the client’s divorce, or for a divorce of one of the other owners of the business, or in connection with a probate of the estate of a deceased owner? If the valuation is fairly recent, the lawyer should get a copy of the valuation report. If the disclosure for the premarital agreement contradicts that opinion, the disclosure statement may need to include an explanation of the difference.

Terms to protect the owner. There are several terms that a premarital agreement drafted on behalf of the business owner should generally include:

  • The interest in the business should be defined as the owner’s separate property, meaning he or she will have exclusive rights to it at death or divorce. The agreement may include some compensating provisions for the other spouse, discussed below.
  • The agreement should include explicit text that defines all appreciation, whether the result of active efforts of either spouse or passive market forces, as part of the owner’s separate property in the event of separation/divorce.
  • If a non-owner spouse will work for the owner, the owner should have a separate employment agreement with the spouse-employee.

Terms to provide for a weaker party. A business owner who wishes to include provisions in a premarital agreement for his or her spouse has a variety of options available, limited only by the creativity of the parties and their willingness to compromise. Parties may wish to consider terms that would take effect at divorce or after a death as well as obligations during the marriage, or a combination. Some options include:

  • An owner could agree to transfer an existing home into joint names, or to acquire a jointly titled home.
  • The business owner spouse may agree to make cash gifts to the other spouse upon marriage or over time during the marriage to allow him or her to create a nest egg.
  • The business owner may agree to pay all living expenses, educate the spouse’s children, or assume other obligations that may allow that party to save and invest his or her own resources. This could also include an obligation to maintain long-term care insurance for a spouse to provide for his/her future healthcare needs.
  • The owner may agree to a cash payment as a property settlement or the transfer of specified assets, such as real estate or securities, in the event of divorce. The amount can be tied to the length of the marriage.
  • The agreement can reserve the weaker party’s right to seek an alimony award, or can provide for a specified amount and duration of alimony at divorce.
  • The agreement can provide for a surviving spouse at death through a trust, life insurance, a cash bequest, survivor benefits under a retirement plan, or the right to certain assets that will be held in a survivorship form (such as a jointly owned home).

Confidentiality issues. A business owner may be particularly sensitive to disclosures made in connection with the execution of a premarital agreement being disseminated to others, such as family members of the spouse, as well as private information and documents becoming public in the event of a future dispute. As part of the process leading to execution, the owner must strike the right balance between providing sufficient data, and doing so in a way that can be readily provable in the event of a challenge, especially one that occurs after the client’s death, and the owner’s interest in keeping business information private. One option is for the owner to make a variety of documents available for review by the fiancé(e) and his/her lawyer, but not to allow these documents to be copied. The agreement should identify with specificity which documents were made available. There are a variety of other ways this process can be conducted, depending upon the particular circumstances.

The agreement can include a confidentiality provision that requires the parties to maintain the financial disclosures in confidence. This would preclude a party from giving copies of the other party’s disclosure to his or her adult children or friends, but would allow him or her to show it to his/her own lawyer, accountant, or financial advisor.

The confidentiality clause could also include terms governing future litigation, such as a requirement that business documents be submitted to a court under seal.

Another way to limit dissemination of sensitive business information in the future is through a form of alternative dispute resolution that keeps the parties out of court and their financial records out of the public record.

Dispute resolution. Even when there is no dispute about validity of a premarital agreement, parties may disagree about the meaning of some of the terms, or there may be matters deliberately left for future resolution, such as the specifics of a division of property at divorce. Parties may wish to provide for alternative dispute resolution to keep the dispute out of court and out of the public record.

  • The agreement could provide that a CPA or other trusted advisor would assist the parties to divide up any property that the agreement provides is to be shared at divorce, and to advise about the tax consequences of the division.
  • It is common for a premarital agreement to provide for appraisal of property subject to the agreement where the value is in dispute.
  • The agreement could provide for binding arbitration of any dispute about the meaning of the agreement or the parties’ rights and obligations under it. Such a provision can be very useful also to resolve a claim of breach or an issue deliberately left open, such as an alimony claim. However, an agreement should not provide for binding arbitration of a dispute about validity. Decisions of an arbitrator are virtually unappealable. A party who may be disadvantaged by a wrong decision on validity should retain the right to appeal that decision.