Timing Counts When Classifying Property in Divorce
When a divorcing couple owns a private business interest, the court may decide to divvy up its value (or a portion thereof) between the spouses. How much is included in the couple’s marital estate may depend on a variety of factors, such as state law, the date the interest was acquired and the valuation date set by the court.
Minnesota’s Supreme Court addressed this issue in a recent case. But what makes Gill stand out from other divorce cases is that the business interest had been sold prior to settling the divorce, and the purchase agreement included so-called “earnout” payments that were contingent on the company’s future performance. (Francis Stephen Gill v. Gretchen Zwakman Gill, 919 N.W.2d 297, A16-1421, October 24, 2018).
Timing was a critical consideration in this case. The couple was married in 1993 and separated in 2013. In 2008, the husband and a business partner acquired a 50% interest in Talenti, a gelato and sorbet manufacturer, for roughly $1.5 million. The husband created a holding company for his interest and he transferred 20% of his interest to a trust for the couple’s children.
Unilever signed a letter of intent to buy Talenti in July 2014. The terms of the sale were unambiguous. The husband, along with the other owners, agreed to sell Talenti for 1) an upfront payment of $180 million, and 2) two future earnout payments, ranging from $0 to $170 million.
Under the agreement, earnout payments would be calculated using a formula that was based on the amount that annual sales exceeded $120 million. The excess amount would then be multiplied by 1.75 and certain variable costs would be subtracted. All owners were entitled to receive their respective share of the earnout payments regardless of whether they (or their individual owners) worked for Unilever after the sale.
Separate from the purchase agreement, the husband signed an employment agreement with Unilever. He agreed to continue working as Talenti’s CEO for $362,500 in 2015 and $375,625 in 2016.
The husband filed for divorce in August 2014, and the district court set a valuation date of September 5, 2014. The Talenti deal closed in December 2014. The couple’s divorced was finalized in January 2016.
Minnesota, like many states, classifies property as marital based largely on timing — that is, when the asset was acquired. If property is acquired during the marriage and before the court’s valuation date, then that property is presumed to be marital, and the court may value and divide that marital property equitably.
Nonmarital property may, for example, include certain gifts made by third parties, property acquired before or after the marriage, and property subject to a prenuptial agreement.
In this case, the sellers (including the husband) agreed to receive a portion of the purchase price in the form of earnout payments based on the company’s future performance. Initially, the district court concluded that earnout payments are nonmarital property. The court reasoned that the upfront payment compensated for work completed during the marriage, and the earnout payments compensated for future work.
However, the court of appeals reversed this interpretation. It decided that the marital estate should include all consideration received in the sale of the husband’s business interest, which occurred before the divorce was finalized. Consideration exchanged between buyers and sellers may include any amount paid at closing and the contractual right to receive future amounts, such as installment payments and earnouts.
Minnesota’s Supreme Court upheld the appellate court decision. Even though the husband continued to be employed by Talenti during the earnout period and after termination of the marriage, the court decided to include the earnout payments in the marital estate.
It ruled that, although the amount of the earnout payments was uncertain, the right to receive payments was acquired at closing, which was before the divorce was finalized. And that right was separate from the husband’s employment agreement with Unilever.
The court opinion states, “Moreover, the value of the future payments here does not depend on the compensation paid for an individual’s personal services but instead reflects the achievements of the company as a whole.” In other words, the value of Talenti wasn’t necessarily tied to the contributions of its individual owners or managers; its value was derived from the brand name, proprietary recipes and other business assets.
The case was remanded to the district court to determine the value of the earnout payments and equitably divide them between the husband and wife.
Earnout payments are increasingly common in mergers and acquisitions. Sellers use them to spread out their tax obligations from a sale over multiple tax years. And buyers use them to offset the risk that the business won’t achieve its financial projections after closing. But earnouts may complicate matters if the owners are in the process of getting divorced while negotiating a sale.
If you’re involved in a similar case, it’s important to review the terms of the purchase agreement to assess how they might be interpreted by the court. Your legal and financial experts can explain the key issues in Gill and how they relate to the treatment of marital vs. nonmarital property in your jurisdiction.
LOUIS J. CERCONE, JR., CPA, CFE, CFF, ABV, ASA, CVA
Lou is the Managing Director of Brisbane Consulting Group in charge of business valuations, forensic accounting, and litigation support services. He has extensive valuation experience and has served as a financial consultant and expert to attorneys in the economic aspects of matrimonial dissolution. He has been engaged in several forensic accounting cases and has served the judiciary as a court appointed expert and receiver for financially troubled companies. He has testified as an expert witness in State Supreme Court and Federal Court. Lou has also been engaged in the quantification of lost income in determining business interruption claims for insurance adjusters.