Last year I had the privilege of attending the BVR/Morningstar Summit on Best Practices in Business Valuation in Divorce, which will be held this month in Chicago. Unfortunately I have to miss it this year as I will be visiting my new niece in San Diego. They will be discussing the latest developments in business valuation and complex financial issues in divorce, including the following summary of a double-dipping decision from California, which I am posting verbatim from the BVWire blast email:
In re Marriage of Blazer, (August 25, 2009) (partially unpublished)
The California Court of Appeal considered two issues of first impression: whether an owner’s capital account in a small, closely held company should count toward his income for determining spousal support; and whether the ultimate support award, when combined with the disposition and division of the business as a going concern, constitutes an impermissible “double dip” into the income stream of the business and of the owner-spouse.
Profitable produce company. The husband owned a brokerage fruit company in California, focusing primarily on the strawberry market. The trial court valued the closely held business at $5.6 million. Although each party presented expert testimony, the record did not reveal their respective methodologies or the trial court’s determination, except to note that it used the “capitalization of excess earnings method.” It ultimately awarded the entire business to the husband and all remaining asserts to the wife, plus a $1.34 million equalization payment.
In determining the wife’s request for permanent support, the trial court also considered whether the husband’s contribution of roughly $1.4 million from his capital account to expand and integrate the company was a reasonable business expense. Due to changes in the produce industry, the “buyer-broker” entity was being phased out, the husband testified, and unless the company moved into the farming and distribution markets, it would “not exist, it will be gone.” The husband’s expert, a CPA, noted that the company was “very thinly capitalized,” and that the funds were the husband’s to invest and should not be credited as income for purposes of spousal support. The wife’s expert agreed that the business could be better capitalized, but declined to express any “legal” opinion regarding the nature of the husband’s contributions, conceding only that capital withdrawals were generally not taxable as income.
Based on this evidence, the trial court excluded the funds used to expand the business from its award of spousal support. “The need to maintain higher capitalization in the company and the need to diversify the company’s work are reasonable expenses that should not be charged against [the husband’s] income,” it said, “but rather should be taken out of the company before assessing what his reasonable income is for purposes of support.”
As a final matter, it awarded the wife $20,000 per month in permanent support—and both parties appealed. The wife claimed the trial court should have accounted for all of the husband’s income, including the funds in his capital account, before awarding maintenance, while the husband claimed the award unfairly permitted the wife to “double dip” into his business’s income stream. In other words, because the court awarded the wife half of the business’s goodwill value in the property division, which was measured by the excess earnings method, it should not have considered those same earnings in assessing his ability to pay her support.
Both arguments lack direct legal authority. The appellate court tackled the wife’s arguments first, finding nothing in California precedent directly on point. The wife offered two cases, one that permitted a trial court to consider future income from a husband’s bonuses in its award of spousal and child support; and a second case that permitted consideration of income from the future exercise of stock options. But as the husband pointed out, in those cases, the supporting spouse was an employee, not a business owner. Accordingly, the appellate court found them apposite to the current case. However, the record provided substantial support for the trial court’s factual findings regarding the nature of the business and its expenses, including testimony from the husband and his expert. Moreover, the applicable California statute requires courts to consider the “earned and unearned income and the assets of the supporting party,” the appellate court pointed out, with emphasis. Thus, the trial court acted well within its discretion by attributing the reinvested funds to the business instead of the husband, and the appellate court confirmed its alimony award.
In considering the issue of the double-dip, the court found no direct support in California case law. The husband offered cases from other jurisdictions, including New York, which prohibits courts from double-counting the income from professional licenses. “Once a court converts a specific income stream into an asset, that income may no longer be calculated into the maintenance formula and payout,” the court noted, citing Grunfeld v. Grunfeld 709 N.Y.S.2d 486 (Ct. App. 2000) (available at BVLaw™). At the same time, “there is no double counting to the extent that maintenance is based [on] spousal income which is not capitalized and then converted into and distributed as marital property,” the Grunfeld court held.
California courts have addressed the argument against double-dipping when dividing pension funds and determining support—but they have rejected its “superficial appeal,” this court observed. In one case, the award of spousal support extended only three years after the divorce, but in all cases, when “one spouse receives permanent . . . support from the other spouse, the source is from the separate property of the paying spouse, including . . . earnings or property which were once the community property of both spouses,” the court said (quoting a 1979 California Supreme Court opinion). Thus, it rejected the legal basis for the husband’s argument against double-dipping in divorce.
The appellate court also found no factual basis for it in the record. Unfortunately, the trial court’s orders did not explicitly identify the intangibles it valued when applying the capitalized excess earnings method to the business. Nor did it appear to have valued the business using a stream of future income belonging to the husband, the appellate court noted. Despite testimony from the husband’s expert that “the excess earnings method of valuing goodwill in a professional corporation . . . is not far removed from a prediction about future earnings,” the court rejected the notion that this valuation method “compels a determination that [the business’s] goodwill value is tied to the husband’s future efforts.”
First, testimony by the husband’s expert—even though it was uncontradicted, was not conclusive proof of such a finding. Second, and more importantly, “an entity’s future earnings do not always correspond with the owner’s contribution of labor,” the court found. The case law has long recognized that “goodwill may exist separate and apart from the services of the person who created it.” Although goodwill and earnings may arise from the personal talents, skills, and reputation of an individual employee, their value may attach to and continue with the business even after that employee departs.
Despite lapses in the record, it sufficiently showed that the trial court valued the husband’s business without including any of his potential or continuing income, the appellate court concluded. Further, nothing in the applicable statute precluded the trial court from recognizing the husband’s future earnings as income available for spousal support, even though such income was undoubtedly his separate property; the trial court also considered the wife’s future investment earnings from her award of marital assets to determine her reasonable needs. “To sum up, Calfornia authority offerns no basis for treating husband’s earnings from his ongoing business differently fvrom income generated by other assets divided at dissolution, for purposes of determining spousal support,” the court held, and declined to adopt any prohibition against the double-dip in divorce.
This summary suggests that California jurisprudence remains relatively unsophisticated on this important issue, which I might explain in the following way: a business valuation is a hypothetical sale of the business. If the business were sold in conjunction with the divorce, the business owner would receive a price equal to the fair market value yielded by the business valuation. That price is the marital asset that is divided in equitable distribution. The former owner of the business might then have to get a job, where he or she might earn a salary equal to the “reasonable compensation” element of the business valuation. Any future support obligation might be based on the reasonable compensation figure, but must not be based on excess salary and/or business profits that the owner might have received prior to the hypothetical sale, because the owner is no longer receiving such benefits after the “sale.” The divorce court must not consider the business owner’s actual compensation and profits when calculating post-divorce support obligations. On the other hand, any support obligations imposed prior to the divorce (i.e., prior to the hypothetical sale) may be based on the owner’s entire compensation and profits because the double dip does not occur until the business is “sold.” The court in Blazer seemed to miss this concept in its analysis.
One of my colleagues believes that there is a flaw in the double dipping argument when applied to business valuation because the business may continue to generate profits in the distant future. Mathematically, a business valuation is a net present value calculation, derived from the sum of the profits generated by the business year after year into infinity. Valuation is not based upon profits for a limited period of time; it is unlimited. By viewing the valuation as a hypothetical sale, this concept is easier to understand. A business owner will not receive profits at any future time period after selling the business.
Blazer demonstrates the importance of building a record at the trial court level and explaining valuation concepts in concrete terms. It is easy for a court to misconstrue esoteric terms like “goodwill,” but it seems unlikely that an expert could deny that fair market value implies a hypothetical sale, or that valuation is the net present value of an infinite series of annual profits.