Protecting the Family Business from Spousal Equalization Claims
When asked if they have a written marriage contract, clients often acknowledge that they gave the matter some thought but found it difficult or discomforting to discuss the issue with their future spouse. Apparently legal documents are not overly romantic. The benefits of these contracts, if properly drafted, can be invaluable to assist in an orderly, predictable and amicable resolution of a division of property following marriage breakdown. Despite their virtues, however, the fact is that most people who own or will in the future own a family business do not have a marriage contract. Issues arising from the division of property following a marriage breakdown are then determined in accordance with the provisions of the Family Law Act (the "Act"). One need merely attend Superior Court and examine the lengthy case hearing list on the Court's docket to discover that the Act itself is capable of divergent interpretations by family law practitioners and their clients.
So what is available to a business owner to unilaterally avoid the need for a domestic contract or Court Order to protect his or her interest in the business? So long as all family members are co-operative, the answer is a simple reorganization of the corporation which operates the business. Through a "net family property freeze" the shareholdings of a shareholder in a privately-held corporation, or the future shareholdings of his or her children, can be sheltered from inclusion in the calculation of “net family property” and thus excluded from a spousal equalization claim.
This technique is available to be used in two common scenarios: 1) The parents who are the sole shareholders of a family business wish to transfer the business to one or more of their children; and 2) a shareholder of a family-owned business wishes to stop or “freeze” the value of his shareholdings which are, or may in the future be, subject to equalization.
In the first situation, a standard freeze technique is used in which the common shares owned by the parents are converted into preference shares which have a fixed redemption value equal to the fair market value of the common shares. Since preference shares have a "preference" to shareholder equity, any common shares issued following this conversion will generally have no value at the date of issue but may acquire value over time if the business grows. Following the conversion of the shares, the corporation issues to the parents a number of common shares and a greater number of special shares, with no substantive rights other than the right to vote. The common shares are then gifted to their children by “deed of gift”. Gifted property is excluded under the Act from a spouse’s net family property calculation. Accordingly, there is no obligation under the Act to equalize on the value of these gifted shares. This technique is also beneficial to the parents as there are no tax consequences on the conversion of the common shares and voting control is retained. Further, the parents have the ability to redeem their shares over time and to decide the appropriate time to relinquish management control to their children.
The second scenario differs from the first in that it does not involve succession of the business. Rather, any shareholder with voting control of a private business can freeze the value of his shareholdings without obtaining the consent of his or her spouse (the only asset that is subject to nontitled spousal consent is the matrimonial home). Once the freeze is completed, the shareholder invites the co-operation of family members to subscribe for common shares who then immediately gift the shares to the original shareholder. Thereafter, because the common shares are “gifted property”, any growth in their value is exempt from an equalization claim. The value of the preference shares, however, will be included in the calculation of the shareholder’s net family property and subject to an equalization claim.
If one is hesitant to raise the subject of a marriage contract at the time of marriage or acquires an ownership interest in a business following marriage, it is essential that the business owner obtain proper advice on protecting this asset into the future, both for succession planning purposes and in the event of marriage breakdown.