The Supreme Judicial Court of Massachusetts ruled recently that agreements between spouses who plan to continue their marriage but wish to define their legal rights and obligations in the event of divorce are enforceable in that state. Some states (notably Ohio) do not permit spouses to execute agreements waiving their marital rights unless they are actually pursuing divorce, and the law of many states is unsettled. In its recent decision, the highest court of Massachusetts joined the ranks of states (including Pennsylvania) where such “post-nuptial” agreements are permissible.

Post-nuptial agreements may combine certain elements of prenuptial agreements with features of marital settlement agreements. Post-nuptial agreements may divide marital property between spouses, protect their separate property, and establish or restrict spousal support and alimony, like settlement agreements. Post-nuptial agreements can also protect family businesses, inheritance, and other separate property to be acquired in the future, just as prenuptial agreements do.

In Ansin v. Ansin-Cravin, 457 Mass. 283, 929 N.E.2d 955 (2010), the husband and wife entered into a post-nuptial agreement two years before their eventual divorce. The post-nuptial agreement in that case gave the parties a chance to attempt marital reconciliation while removing the financial risk of taking “one last chance”. The couple had been married for nineteen years at the time of their agreement. At that point, the husband separated from his wife and advised her that he would not return unless she would sign an agreement. She hired legal counsel, investigated the nature and value of their assets, and negotiated the terms of the agreement.

Having signed the agreement, the husband and wife reconciled for nearly two years. Ultimately the reconciliation did not last, but the parties were able to avoid the stress and expense of protracted divorce litigation by having an agreement in place (at least, they would have avoid those pitfalls if the wife had not challenged the validity of the agreement). The Massachusetts court applied the same standards to post-nuptial agreements as many states employ when judging the validity of prenuptial agreements and settlement agreements: (1) availability of independent legal counsel; (2) full and fair disclosure of financial resources; (3) absence of fraud or duress; and (4) reasonableness of the provisions for each spouse.

Pennsylvania has long recognized post-nuptial agreements, and for good reason. When entering into a post-nuptial agreement, full and fair disclosure is an essential element; and it may be important to engage legal counsel. While formbooks and software programs may contain “boilerplate” prenuptial agreements, post-nuptial agreements are very different and require the skill of an experienced family law attorney.

Texas has once again proven itself to be a haven for the affluent divorcee. In Mandell v. Mandell, 2010 WL 1006406 (March 18, 2010), the Texas Court of Appeals held that a professional spouse’s 25% interest in a medical corporation was limited under the terms of a buy-sell agreement to a nominal fixed price payable to shareholders upon divorce. The decision was summarized at BVLaw Blog as follows:

In a case of first impression, the Texas Court of Appeals considered a buy-sell agreement that purported to bind shareholders and their spouses in the event of divorce. As a further complication, the husband had signed an employment agreement with the private medical association—but neither he nor his wife had signed the shareholders’ agreement.  This unsigned agreement limited the value of a divorcing shareholder’s interest to the equity buy-in price (in this instance, a mere $11,000 for a 25% share in a business with an estimated $3 million to $5 million book value).

I share BVLaw Blog’s incredulity, but my analysis is somewhat different.

In the opinion, the Texas appeals court emphasized that the doctor, who signed the stock purchase agreement during the marriage three years before separation, tendered a check for his buy-in but never signed the shareholders agreement (which was referenced in the stock purchase agreement); and his shares were never issued. After separation, the corporation returned the shareholder’s fixed buy-in payment. At that point, the trial court  might have held that the shares were never acquired, and only the buy-in payment itself was community property.

Yet, during the pendency of the divorce litigation, the wife filed motions compelling her husband and the corporation to complete the transaction. The doctor returned the fixed sum to the corporation, and the corporation issued the shares. When the wife attempted to introduce expert testimony to prove the fair market value of the shares, she was met with a motion in limine, which was granted. The trial court held that the wife was bound by the terms of the agreements.

In Texas, the fair market value of a business is presumed to be zero if the shareholders are contractually obligated to sell back their shares upon retirement, death or divorce. A divorcing spouse may present evidence of book value or comparable sales to rebut the presumption, but in this case, the court held that the net asset value was the property of the corporation, not the shareholders.

It might be signficant that Texas is a community property jurisdiction. Since the marital community exists throughout the marriage in those jurisdictions, it could be said that the doctor’s wife was in privity with her contracting husband when he signed the stock purchase agreement. Furthermore, property in Texas apparently cannot be owned simultaneously by one legal entity (a corporation) and another legal entity (the marital community). These principles might not apply in common law (marital property) states, such as Pennsylvania, where it might be argued that the spouses were neither in privity nor intended third party beneficiaries of such contracts, and where marital property is merely a fictitious estate rather than a legal entity.

A former client recently asked me to prepare a cohabitation agreement. It was heartening to hear about her successful new relationship after a tough divorce. It had been a while since I had been asked for a cohab agreement, so I spent a couple of weeks polishing up my form. As I considered the provisions of the agreement in light of recent development in the law, I started to think: Who really needs a cohabitation agreement anyway? Four categories came to mind:

1. Committed unmarried couples. Divorce can be difficult, but when long-term unmarried couples split, the breakup can be brutal. The law provides rules, procedures, and remedies for married couples when they part ways, but those rules do not apply to unmarried couples. Lots of different laws can create legal nightmares for unmarried couples when they break up or one of the couple passes away. Tax laws do not authorize tax-free property transfers between unmarried couples; property laws do not specify who is responsible for paying a joint apartment lease when one of the couple moves out; unmarried couples cannot inherit from each other unless they have wills, and even then, death taxes may consume their inheritance. Property laws contain provisions for dividing joint property or allocating joint bank accounts, but those legal provisions do not adapt well to breakups. The procedures for partition of joint property or contribution to joint debts may be slow, inflexible and inequitable. A cohabitation agreement can spell out the consequences of a break up or the death of an unmarried partner, avoiding costly and protracted legal proceedings.

2. Couples who are married under common law. Common law marriage is a tricky subject, surrounded by myths and falsehoods. Pennsylvania no longer recognizes common law marriage for couples who formed their relationships after December 31, 2004. Perhaps the Commonwealth might recognize a common law marriage formed under the laws of another state, or a relationship formed here before 12/31/2004. But the outcome of such cases is very uncertain. A cohabitation agreement might help by memorializing the common law marriage and spelling out the consequences of divorce or death.

3. Unmarried same-sex couples. Pennsylvania does not solemnize same-sex marriages, so same-sex couples must create contractual relationships to protect their children and property. Cohabitation agreements, along with testamentary instruments, are essential to protecting their legal rights, not only upon breakup or death, but in many everyday situations such as hospital visitation, access to children’s school records, and authority to make financial transactions.

4. Married same-sex couples. This category might be surprising. Since some states permit same-sex couples to marry or enter into domestic partnerships, why should they need a cohabitation agreement? The reason is illustrated by a recent Texas appeals court case, in which there is a challenge to the Texas court’s power to divorce same-sex couples who were legally married in another state. If a same-sex couple has been married outside of Pennsylvania, there is no guarantee yet that Pennsylvania will have the legal authority to divorce them under its existing laws. A cohabitation agreement can provide a remedy.

An article published recently in USA Today reports that prenuptial agreements are more acceptable today to couples who are engaged than at any time in the past.

Nearly one-third of single adults say they would ask a significant other to sign a prenup, according to a February survey of 2,323 adults by Harris Interactive.

 Only 3% of folks with a spouse or fiancée have a prenuptial agreement, but that’s up significantly from the 1% reported when Harris conducted a similar study in April 2002.

Personal-finance expert Suze Orman encourages every engaged couple to get one to protect their current and future assets as well as to shield themselves in case a mate secretly runs up massive credit card debt (which could damage both partners’ credit scores).

 More than one-third of adults — 36% — said prenups make smart financial sense, according to the Harris survey. When Harris asked that same question in 2002, 28% said so.

“People are hopeful,” Orman says. “They want their relationship to last. … It’s just natural that they don’t think they’ll need a prenup. Never in a million years do they think (divorce) will happen.”

 In 2008, the divorce rate was about 50%. Among married Americans, the median duration of their wedded life in 2008 was 18 years, according to Pew Research Center’s analysis of government data.

Given those odds, “Hope is not a financial plan,” says Orman, who urges that every couple get a prenup. “The time to plan for a divorce is not when you’re in a state of hate,” she says.

Among the divorced, 15% say they regret not having a prenup in their most recent marriage, according to the Harris poll. Men are more likely than women to have this regret, at 19% vs. 12%. Nearly 40% of divorced Americans also say they would ask their significant other to sign a prenuptial agreement if they remarried.

Prenuptial agreements make sense for lots of reasons, especially for people who have family businesses, children from a prior relationship, or substantial personal savings or retirement savings. See my previous post:

 ”Once You Pop the Question, How do You Spring the Prenup?“

The Chicago Sun-Times, Huffington Post, and The Daily Beast are reporting that Elin Nordegren, the wife of golfing billionaire Tiger Woods, is demanding that Woods renegotiate the terms of their prenuptial agreement after learning of Woods’ multiple infidelities. Under their 2004 agreement, Woods allegedly agreed to pay Nordegren the sum of $20 million if they should separate after ten years of marriage. The recent news reports claim that Nordegren is now demanding $55 million to stay with Woods for another two years, seven years in total.

If the reports are true, why would Woods agree to such terms?  The obvious answer would be “to induce Nordegren to commit to marital reconciliation.” Yet, a less obvious, perhaps more cynical answer would be “to let the negative publicity abate before announcing that the couple is divorcing.” By letting the media firestorm subside, even temporarily until the couple can make a plausible announcement about having attempted to reconcile, Woods might be able to preserve his valuable sponsorships. Pure speculation on my part, sure, but if his sponsorship worth hundreds of millions of dollars per year were at stake, wouldn’t it make sense to throw a little money her way?

The Superior Court of Pennsylvania will be publishing my successful result in Mackay v. Mackay (2009), a case in which a parent attempted to enforce a casual conversation about college plans for their young children as a “verbal agreement” to pay college expenses. The Superior Court held that their conversation was merely an expression of plans or intentions, rather than an enforceable verbal contract.

The incident from which the dispute arose was a dinner conversation held between the parents when their children were pre-teens. The mother declared that she would like to retire after 30 years of service to her employer, and the father admonished her that both parents would have to continue working to pay for college expenses. Many years later, the parties divorced. In the divorce action, the mother testified about the dinner conversation but did not attempt to assert a contract claim in connection with the divorce. When the eldest child graduated from high school, the father pursued a reduction of his child support obligation, and the mother counter-claimed for enforcement of the alleged oral agreement.

The Superior Court examined the record exhaustively and concluded that a discussion of future plans for college did not constitute a verbal contract between the parents. The Court accepted my argument that the parents did not have an intention when they conversed to enter into a legally-binding agreement. This decision recognized and honored the difference between verbal contracts versus plans made by harmonious married couples, which are not understood or intended to have legal consequences after divorce.

192 WDA 2009

During the statewide broadcast of PBI’s Family Law Update today, my colleague David Ladov asked me to post the features that a marital settlement agreement would have to contain in order to qualify as a QDRO (qualified domestic relations order). A QDRO is one of two possible ways that someone may waive his or her right to receive a share of his or her ex-spouse’s retirement benefits (the other being a beneficiary designation form). According to the U.S. Supreme Court’s 2009 decision in Kennedy v. Dupont, a marital settlement agreement by itself was not good enough to waive an ex-wife’s interest in an employer-sponsored pension plan, in the absence of a QDRO or beneficiary designation form.

I suggested during the broadcast that some divorce lawyers might wish to avoid this problem by crafting marital settlement agreements that would qualify as QDROs.  The requirements for QDROs under federal law are summarized on the website of the employee benefits administrator Hewitt Associates, as follows:

1. The instrument must be a court order, judgment or decree signed by a judge or other state-approved court official.
2. The instrument must relate to marital property rights or alimony, or the support of a child of the participant.
3. The instrument must contain a statement that it is issued pursuant to state domestic relations law.
4. The instrument must include the name, last known address, social security number and date of birth of the participant and alternate payee.
5. The instrument must describe the amount or percentage of benefits to be awarded to the alternate payee.
6. The instrument must indicate the manner of payment and when payments begin.

There are a couple of additional requirements (actually, three things the QDRO cannot do) that are described on Hewitt’s web site. In a case where a spouse is waiving his or her rights to an ex-spouse’s retirement benefits, these last few requirements might be irrelevant.

The first requirement listed above could be an obstacle in counties where settlement agreements are not routinely attached to the divorce decree or filed of record. Yet, a consent order incorporating a marital settlement agreement should be sufficient to satisfy this requirement. It is less clear that a consent order referring to an unattached settlement agreement might satisfy the requirement.

The Tennessee Court of Appeals recently held that a business owner’s spouse who signed a buy-sell agreement was bound by the value in a divorce action. In Inzer (2009), the husband and wife both signed a buy-sell agreement when they formed an LLC to purchase a Sonic Drive-In franchise. The buy-sell agreement granted other partners a right of first refusal to buy the interests of a withdrawing partner for the lesser of book value or the offer procured by the withdrawing partner. The owner’s expert presented evidence that the owner’s 24% interest in the franchise was worth $120,000 to $135,000 using capitalized cash flow or market methods, but only $16,000 net book value after discounts. Wife’s expert testified to a value of more than $500,000 after making adjustments to the owners’ compensation and ignoring discounts for lack of marketability, lack of control or the restrictive operating agreement.

The trial court valued the owner’s interest at $200,000 without much explanation. The Tennessee Court reversed, holding that the franchise was worth $33,000 book value without consideration of intangible value or discounts (as specified in the buy-sell agreement). The appellate court distinguished cases in which buy-sell agreements were not controlling, since the non-owner spouse in those cases did not sign the buy-sell.

Consider whether it was appropriate for Wife’s expert to perform  Type I adjustments in his normalization of the income statement, i.e., adjusting the owners’ compensation. Could a purchaser of a 24% interest compel the other owners to reduce their compensation? Even if the Court had not held the buy-sell to be controlling, it seems unlikely that Wife’s expert would have prevailed.

In divorce litigation where one of the spouses owns a professional practice, such as a medical practice, dental practice, law firm or accounting firm, the lawyers and their experts have to determine whether the business has value. Their determination depends upon whether the professional practice is believed to have enterprise goodwill.

Briefly, enterprise goodwill is the price that a buyer would pay for a professional practice over and above the value of its hard assets like equipment and supplies. In theoretical terms, enterprise goodwill is the reputation of the business that is not closely associated with a particular owner or professional. The opposite of enterprise goodwill is personal goodwill, which is the reputation and skill of the professional. Enterprise goodwill has value because it is transferrable but personal goodwill is not. Someone might be willing to pay for a name like Aspen Dental Systems, but what about Jane Doe, PC?

Increasingly, there is a market for professional practices that are not part of a regional or national chain. Dental practices, even those with a single location and single dentist, are bought and sold frequently. The same is true for specialty medical practics. Yet, primary care medical practices and legal practices are rarely bought or sold. So, how does a lawyer decide whether a professional practice should be evaluated by a business valuation specialist? Here are three signs that a professional practice might have value:

1. Actual transactions. If a professional or his/her partners have bought or sold their practices, it is more likely that there is transferrable enterprise goodwill. However, you must distinguish market transactions from succession planning. If the only transactions are between retiring partners and advancing associates, then there may not be much enterprise goodwill.

2.  Subordinates and equipment.  One reason why dental practices are increasingly transferrable is that dental procedures are performed by hygenists and associate dentists. If the owner of the practice is earning profit from other professionals and paraprofessionals, then a buyer might be willing to pay something to step into those shoes.

3.  Excess compensation. If a professional is earning substantially more than industry standards, then the professional’s practice might have enterprise goodwill. No buyer would pay to assume an existing practice if he or she could start a new practice for free – except if the existing practice were more profitable than a new practice would be. This criteria is based on the principle of substitution.

The U.S. Court of Appeals for the Seventh Circuit recently took up the case of Menard v. Commissioner, 560 F.3d 620 (2009), considering whether the CEO of a privately-held company was receiving a dividend disguised as salary from the business he controlled. The CEO whose salary was questioned was John Menard, founder and controlling shareholder of Menards, a chain of retail hardware and building supply stores. The Tax Court took the position that John Menard’s $20 million salary was really a disguised dividend because it was much greater than the salaries of the Home Depot and Lowe’s CEOs, who earned $2.8 million and $6.1 million respectively.

The appellate court’s opinion in this case is so well-researched that I cannot help but include large blocks of text, starting with its introduction to the subject:

The Internal Revenue Code allows a business to deduct from its taxable income a “reasonable allowance for salaries or other compensation for personal services actually rendered,”[or] “payments purely for services.” Occasionally the Internal Revenue Service challenges the deduction of a corporate salary on the ground that it’s really a dividend. A dividend, like salary, is taxable to the recipient, but unlike salary is not deductible from the corporation’s taxable income. So by treating a dividend as salary, a corporation can reduce its income tax liability without increasing the income tax of the recipient. . . As a result of a change in law in 2003, dividends are now taxed at a lower maximum rate than salaries—15 percent, versus 35 percent for salary. 26 U.S.C. § 1(h)(11). This makes the tradeoff more complex; although the corporation avoids tax by treating the dividend as a salary, which is deductible, the employee pays a higher tax. But depending on its tax bracket, the corporation may still save more in tax than the employee pays, and in that event, if the employee owns stock in the corporation, he may, depending on how much of the stock he owns, prefer dividends to be treated as salary. . . . Even before the change in the Internal Revenue Code, treating a dividend as salary was less likely to be attempted in a publicly held corporation, because if the CEO or other officers or employees receive dividends called salary beyond what they are entitled to by virtue of owning stock in the corporation, the other shareholders suffer. But in a closely held corporation, the owners might decide to take their dividends in the form of salary in order to beat the corporate income tax, and there would be no one to complain—except the Internal Revenue Service.

The usual case for forbidding the reclassification (for tax purposes) of dividends as salary is thus that “of a corporation having few shareholders, practically all of whom draw salaries,” Treas. Reg. § 1.162-7(b)(1), especially if the corporation does not pay dividends (as such) and some of the shareholders do no work for the corporation but merely cash a “salary” check. A difficult case—which is this case—is thus that of a corporation that pays a high salary to its CEO who works full time but is also the controlling shareholder. The Treasury regulation defines a “reasonable” salary as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances,” § 1.162-7(b)(3), but that is not an operational standard. No two enterprises are alike and no two chief executive officers are alike, and anyway the comparison should be between the total compensation package of the CEOs being compared, and that requires consideration of deferred compensation, including severance packages, the amount of risk in the executives’ compensation, and perks.

Courts have attempted to operationalize the Treasury’s standard by considering multiple factors that relate to optimal compensation. [Citations omitted.] We reviewed a number of these attempts in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.1999), and concluded that they were too vague, and too difficult to operationalize, to be of much utility. Multifactor tests with no weight assigned to any factor are bad enough from the standpoint of providing an objective basis for a judicial decision [citations omitted]; multifactor tests when none of the factors is concrete are worse, and that is the character of most of the multifactor tests of excessive compensation. . . . All businesses are different, all CEOs are different, and all compensation packages for CEOs are different.

In Exacto, in an effort to bring a modicum of objectivity to the determination of whether a corporate owner/employee’s compensation is “reasonable,” we created the presumption that “when . . . the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner/employee’s] salary is presumptively reasonable.” But we added that the presumption could be rebutted by evidence that the company’s success was the result of extraneous factors, such as an unexpected discovery of oil under the company’s land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. 196 F.3d at 839.

The strongest ground for rebuttal, which brings us back to the basic purpose of disallowing “unreasonable” compensation, is that the employee does no work for the corporation; he is merely a shareholder. [Citations omitted.] Comparison with the compensation of executives of other companies can be helpful if—but it is a big if—the comparison takes into account the details of the compensation package of each of the compared executives, and not just the bottom-line salary. This qualification will turn out to be critical in this case.

Having explained the context of this case, the Circuit Court next explained why the Tax Court’s analysis was wrong, especially its comparison of John Menard’s salary to the salaries earned by the Home Depot and Lowe’s CEOs in that year. The appellate court first rejected the notion that the taxpayer’s $17 million bonus, which was equal to 5% of the company’s net income before taxes, was more likely to be a dividend than salary because it was paid at year’s end; was approved by a board that the CEO controlled without outside directors; must be returned if the IRS should disallow the company’s tax deduction as salary; and exceeded the salaries earned by the CEOs of publicly-traded competitors (Home Depot and Lowe’s). The appellate court noted that the managers of privately-held companies often face greater risk than public companies, warranting greater reward for success:

Of particular importance to this case is the amount of risk in the compensation structure. Risk in corporate compensation is significant in two respects. First, most people are risk averse, and the scholarly literature on corporate compensation suggests that risk aversion is actually an obstacle to efficient corporate management because managers tend to be more risk averse than shareholders. Shareholders can diversify the risk of a particular company by owning a diversified portfolio, but a manager tends to have most of his financial, reputational, and “specific human” capital tied up in his job. [Citations omitted.] So the riskier the compensation structure, other things being equal, the higher the executive’s salary must be to compensate him for bearing the additional risk.

That is not a critical consideration in this case because, as we said, management and ownership in Menards are not divorced. But a second significance of risk in a compensation structure is fully applicable to this case. A risky compensation structure implies that the executive’s salary is likely to vary substantially from year to year—high when the company has a good year, low when it has a bad one. Mr. Menard’s average annual income may thus have been considerably less than $20 million—a possibility the Tax Court ignored. Had the corporation lost money in 1998, Menard’s total compensation would have been only $157,500—less than the salary of a federal judge—even if the loss had not been his fault. The 5 percent bonus plan was in effect for a quarter of a century before the IRS pounced; was it just waiting for Menard to have such a great year that the IRS would
have a great-looking case?

The appellate court also noted that the Tax Court had not considered the total compensation packages of the CEOs from the public companies, such as equity compensation, severance packages, retirement plans, and perks. The appellate court noted that the CEO of Home Depot, whose salary was used as a benchmark, actually earned $124 million over six years, and a $210 million severance package when he was forced out. The Court of Appeals also noted that the Tax Court had not considered the salaries of other senior managers, both of Menards and of the benchmark public companies, which may have indicated that this CEO was more productive and delegated less than average. The Court observed that John Menard worked 14 to 16 hours per day, six to seven days per week.

The Seventh Circuit adopted a skeptical, even sarcastic, tone toward the Tax Court’s remark that the owner of a business has no need for incentive compensation because ownership is incentive enough. The Court of Appeals held that owners should not be treated differently from other managers.

Having concluded that John Menard’s $20 million salary was not excessive, the Court of Appeals reversed.