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Gallagher: Tax Court Reviews Business Valuation Principles

by bvertz on Jan 23, 2012 • No Comments •

The opinions of the U.S. Tax Court in estate valuation cases can be instructive guidance on legal and valuation principles that are equally relevant to divorce cases. A recent decision of the Tax Court in an estate taxation case contains an excellent summary of those principles, as well as the latest thinking on a variety of hot valuation topics, including normalization of financial statement, tax-affecting of Subchapter “S” corporations, and valuation discounts.

In Estate of Gallagher v. Commissioner, T.C.Memo 2011-148, the IRS disputed the business valuation used by a decdent’s estate in an IRS Form 706 estate tax return. Rather than the $35 million dollar value claimed by the taxpayer, the IRS asserted a value of $49.5 million for the decedent’s 15% interest in a newspaper publishing conglomerate. The taxpayer and IRS each obtained new appraisals for trial, which narrowed the gap somewhat, with the Tax Court eventually finding the value to be $32 million.

Initially, the Tax Court noted that the taxpayer’s “admission” of the company’s value ($35 million reported on the tax return) was merely rebuttable evidence of the value, which could be overcome by a preponderance of evidence at trial. This ruling allowed the taxpayer to offer its appraisal of $28 million during the trial, rather than being bound by the taxpayer’s assertion on its tax return.

The Court also found that recent arm’s-length transactions in the company’s stock may be the most reliable method of valuing the company. Yet, in the absence of such transactions, expert opinions are probative evidence of value, and the Court may mix-and-match the findings of competing experts in arriving at its conclusion.

One of the hot topics addressed by the Court in Gallagher is the consideration of data or events that are subsequent to the date of valuation. The Tax Court held that it was proper to consider quarterly financial statements that were issued shortly after the death of the taxpayer because they were more accurate than those issued just before the valuation date. Hindsight was admissible in this case because the data in the subsequent financial statements was knowable on the valuation date; it just hadn’t been fully compiled or analyzed at the time of death. It did not matter to the Court that the subsequent financial statements would not have been available to a buyer on the valuation date (and in a transaction of this magnitude, a buyer probably would not rely on internal financial statements without performing due diligence anyway).

Another hot topic was the IRS expert’s use of market-based methods in his valuation report. Perhaps it demonstrates the proficiency of the Tax Court that the Court was willing in Gallagher to reject the IRS expert’s reliance on the guideline public company method rather than deferring to the expert’s professional judgment. The Court found that the IRS expert did not sufficiently prove the similiarity of the subject company to comparable public companies. If a company the size of this company is not sufficiently similar to public companies, it is hard to imagine how a more modestly-sized company could be valued under this method.

The Gallagher opinion also analyzed the experts’ use of the discounted cash flow (DCF) method. The DCF method is hardly ever used in divorce cases, partly because it is difficult to get reliable earnings projections from owners who are embroiled in matrimonial litigation. For this reason, the Court’s DCF analysis will not be reviewed in this article. A good summary of the Gallagher decision (in chart form) is available here.

The Gallagher court declined to tax-affect the earnings of the subject company, which was organized as a Subchapter “S” corporation until it was converted to an LLC prior to the valuation date. Simply put, the Court found no compelling reason to apply a hypothetical shareholder-level tax liability against earnings in order to place the company’s valuation on equal footing with a Subchapter “C” corporation. The Court cited Gross v. Commissioner as legal authority for its position, without further explanation. Later in the opinion, the Court also rejected a bottom-line adjustment made by the taxpayer’s expert to account for the benefits realized by “S” corporation shareholders.

The next section of the Gallagher opinion is a concise, learned discussion of capitalization rates and valuation discounts. The Court held that minority discounts may be applied only if the expert’s method yields the value of a controlling interest, and should not be applied if the expert has calculated value on a minority basis. Since the Court adopted the opinion of the expert who calculated enterprise value, the minority discount was applied. However, the Court adjusted the minority discount, finding that the expert underestimated the control premium. The experts’ calculations of marketability discounts were nearly identical.

Double Dip and Goodwill Considered by Wisconsin Supreme Court

by bvertz on Aug 15, 2011 • Comments Closed •

Last month the Wisconsin Supreme Court weighed in on two issues that are important to family lawyers and their clients who operate professional practices like physicians, lawyers, dentists and accountants. In Marriage of McReath, the Wisconsin Supreme Court ruled that “saleable” goodwill would be considered marital property, in a case where a dentist argued that “personal” goodwill should not be counted as part of the marital estate. The Court also held that it was not double dipping to include the dentist’s business earnings as part of his income for post-divorce alimony, after dividing the fair market value of the business based on capitalized earnings.

Lawyers, judges and valuation professionals use many different terms – often imprecisely – to describe goodwill, the intangible value of a business that exceeds the value of hard assets like inventory, equipment and receivables. Some courts distinguish between “enterprise” goodwill and “personal” goodwill; other refer to “professioinal” goodwill. As lawyers and judges have advanced along the learning curve, their usage of these terms has improved. Still, the historical record remains a fertile source of confusion.

Wisconsin’s highest court, and the advocate who must have guided the Court’s analysis, Richard J. Auerbach, Esq., of Madison, admirably honed in on the most important aspect of goodwill: whether it is transferable to a buyer. In this case, the husband had purchased two dental offices for a purchase price of more than $900,000. Thirteen years later, Wife’s expert opined that the practice was worth just under $1.1 million and testified that much of the value would be associated with a noncompete clause. While recognizing that some of the saleable goodwill might be fairly characterized as “personal” goodwill, the Supreme Court refused to assume that personal goodwill is necessarily nontransferable. The fact that Husband purchased his practice from another dentist, in a transaction where most of the purchase price was allocated to goodwill, was proof enough that personal goodwill may be transferable.

Unfortunately, the Wisconsin court’s analysis of double dipping was not especially well-reasoned. The Court made little effort to rebut Husband’s argument that it should not include earnings from the dental practice in his income when determining post-divorce alimony, after having divided up the fair market value of the business based on capitalized earnings. The Court cited its own precedent where it cautioned about an inflexible application of the prohibition against double dipping, given the “infinite range of factual situations facing circuit courts in dividing property.” The Supreme Court found that a business is more like an income-producing investment than a pension.

Actually, that analogy does not hold up upon close scrutiny. The value of an investment is equal to the account balance on a particular date, and any interest income generated after that date would be counted as income to the owner of the investment because it can be consumed without decreasing the principal of the investment. If the interest or dividends generated by an investment are counted as income, there is no double dip. On the other hand, a pension is valued by taking the net present value of the future annuity payments. Theoretically, the value of the pension is diminished as payments are received. Therefore, pension payments cannot be counted as income if the pension has been divided as property.

Generally, a business is valued in the same manner as a pension. The value of the business is equal to the net present value of the cash flow or profits that the business generates. A business valuation is a hypothetical sale of the businessin which  the owner sells the business to a hypothetical buyer, who might retain the owner as a employee (paying “reasonable market compensation”) or simply hire a new employee to do the owner’s job. If the business is sold, the owner is not entitled to receive profits, so counting those earnings as income for alimony purposes is clearly double dipping. The Wisconsin court got it wrong.

To get even more sophisticated, the courts might have examined what a dentist like this gentleman was capable of earning as an employee of someone else’s dental practice. Alimony based on earning capacity would not be a double dip. It may be reasonable to believe that a professional could sell his practice and go to work for someone else. The salary that the professional could earn elsewhere might be equal to the “reasonable compensation” that a hypothetical buyer would pay to a replacement employee, or it might be more or less (depending upon the hours, duties and skills that the owner would bring to his new job).

Furthermore, the court might consider the investment return that the owner, having sold his business for cash, would earn on the sales proceeds. That argument might have gotten more traction ten years ago than today (when CD’s pay less than 1%) but it is still worth considering.

5 Settlement Documents that Divorcing Business Owners Must Have

by bvertz on Jun 8, 2011 • Comments Closed • , , , , , , , , , , , ,

When business owners get divorced, their settlement may have profound consequences for the business and other owners. Often, one spouse “sells” or gives up a share of the business to the other spouse. Since most small business owners do not have enough cash to pay a lump sum for that share, they might have to make installment payments over months or years. It is critical to structure the divorce settlement properly with documents that will minimize tax consequences, quantify and secure the payments to be made to the spouse who is leaving the business, and preserve the company’s ability to operate and obtain financing. These are the top five documents that a business owner should have when finalizing a divorce where a spouse is “selling” his or her share of the business to the other spouse:

1. Marital Settlement Agreement. Divorce courts rarely issue orders containing sufficient detail to adequately protect business owners who are divorcing. Settlement provides the best opportunity to resolve important financial and tax issues that a divorce court might overlook. A settlement agreement should contain a clear description of the stock, partnership or LLC membership units, and other business interests being sold or waived, how much is being paid, when it is being paid, and what happens if the payments are not made in full and on time. Unincorporated associations are tricky because their assets and liabilities are often intertwined with the owners’ personal assets and liabilities, so be as clear as possible. When setting the price, the business owner must consider whether the price is consistent with the value reported to tax authorities for estate planning purposes. The spouse who is making payments might be required to maintain enough life insurance, retirement assets, or investments to pay off the obligation in full upon death or default. The other documents related to the sale of the business (installment note, security agreement, etc.) can be attached to the marital settlement agreement and signed at the same time.

2. Installment Note. The installment note states the price that a business owner must pay for a spouse’s share of the business, the timing and amount of each installment payment, and the consequences for late payments or default. If the payments will be made over a period of years, the note might include interest (particularly for late payments). An acceleration clause might make the entire balance due immediately upon sale of the business, death, bankruptcy, or other major events. In some jurisdictions, a confession of judgment clause might avoid the delay and expense of a collection lawsuit if there is a default. The majority owner might be required to provide a personal guarantee. The note can also be secured by a mortgage against real estate or lien on business assets, such as equipment and receivables.

3. Mortgage/Security Agreement. An installment note can be secured by a mortgage against real estate or lien on business assets, such as equipment and receivables. The lien against business assets can be recorded publicly by filing a UCC-1. In some cases, the business might want to subordinate the mortgage or security agreement so that trade creditors and lenders who demand higher priority will not withdraw their credit.

4. Pledge of Stock. A pledge agreement creates a lien on the stock of the business. The pledge agreement might contain representations and warranties about the financial condition of the business or give the selling spouse a right to vote the pledged stock or inspect the books until paid off. If dividends or distributions are paid, the pledge agreement might direct the proceeds to be paid toward the loan. The pledge can also restrict the sale, gifting or dilution of the stock.

5. Consent and Waiver. If the business owners have previously signed a buy-sell agreement or right of first refusal, giving the company or other owners a right to buy their shares, then they should probably obtain the consent of those other owners before transferring stock between themselves. A consent and waiver confirms that the company and other owners will not exercise their rights when divorcing spouses transfer their stock.

Iowa Rejects Rule of Thumb Business Valuation in Divorce

by bvertz on Feb 11, 2011 • Comments Closed • , , , , , , ,

A recent decision of the Iowa Court of Appeals illustrates the perils of reliance upon industry rules of thumb to value a business in matrimonial litigation. In Marriage of Hagar (11/24/2010), husband and wife purchased a dry cleaning business from a trust established by husband’s parents as part of a business succession plan. Husband and wife agreed to a $300,000 purchase price that was determined by the companies’ accountant. The trust took a promissory note for the purchase price. The opinion does not describe the technique by which the accountant estimated the company’s value, but there were adjustments to normalize the excess rent and excess interest paid by the dry cleaning business to the real estate company (which the parents’ trust continued to own).

Over the years, the dry cleaning business struggled. The payment terms were modified to maximize the seller/parents’ tax benefit and to accommodate the buyers’ inability to pay the notes. For instance, the dry cleaning business began to make quarterly distributions to pay the notes in lieu of salaries for husband and wife. When husband and wife separated, the distributions ceased entirely. The promissory note from husband and wife to the trust was reduced from $300,000 to $160,000 over the course of the marriage.

In the equitable distribution trial, the company’s accountant estimated the current value of the operating company based on industry rules of thumb. He testified that the range of values was between $71,000 and (-$120,000). He further testified that his range of values was not based upon his professional judgment, but simply an application of industry rules of thumb.

The trial court misconstrued the accountant’s testimony, finding that the business was worth the mid-point between $120,000 and $71,000. On appeal, the Court of Appeals held that a better measure of value was the equity created by the buyers’ paydown of the note: $140,000. The appellate court held that rules of thumb are too unreliable in cases where insider/family transactions might skew the data used in the calculation. An actual transaction, such as the husband and wife’s purchase of the business less than ten years prior to the trial, was deemed more reliable.

Entrepreneurs at Greater Risk of Divorce?

by bvertz on Jan 3, 2011 • Comments Closed •

The holidays have given me some time to catch up on my overdue reading list. One article I recently caught was Inc. Magazine’s November 2010 article on entrepreneurs who divorce. Business owners may be at greater risk of divorce, the article suggests, because of the time and emotional investment that a fledgling business requires, the independent attitudes that entrepreneurs may develop, and the financial sacrifices that may be necessary.

Conversely, divorce may adversely affect a business, the article notes:

Just as company building can lead to divorce, divorce can destabilize a company, and even sap brand equity if the company trades on a family image. Chris Blanchard grows 20 acres of vegetables at Rock Spring Farm in Iowa, a stone’s throw from the Minnesota border. In his original marketing materials (which he is slowly replacing), he and his now-ex-wife, Kim, were the literal face of the farm.  …  He hasn’t lied about the end of his marriage, but he hasn’t broadcast it, either. “Look, my customers want a good story with their vegetables,” he said. “They want a narrative. This divorce just doesn’t belong in a Smith & Hawken catalog. And I have a business to run.”

Financially, divorce can affect companies by imposing new financial obligations (child support, alimony, business buyouts) upon owners, divesting collateral for loans, or depriving the owners of an independent source of income to pay personal expenses. Those risks must be considered and thoughtfully resolved in any divorce involving business owners. Like children, businesses can become unwitting victims of divorces that are not properly handled.

What’s the Hullabaloo about Balicki?

by bvertz on Dec 12, 2010 • Comments Closed •

In Balicki v. Balicki, 2010 Pa.Super.134 (2010), the Superior Court affirmed the trial court’s decision to discount the value of an insurance business, based on the hypothetical income taxes that would be incurred by its owner upon sale of the business. The trial court’s decision was itself a reversal of the master’s report, in which the master found that the tax discount was inappropriate because the owner would not likely sell the business (which had been in the family for more than two generations).

The decision is based on the 2005 amendments to the Pennsylvania Divorce Code (specifically, § 3502(a)(10.1) and (10.2)), which require the divorce court to consider tax consequences and costs of sale associated with marital assets, even if those taxes and costs are not imminent or certain. Balicki is also the result of an “abuse of discretion” standard of appellate review in Pennsylvania divorce cases, which affirms the trial court’s decision unless it is manifestly unreasonable.

In the September/October 2010 edition of The Value Examiner, the magazine of the National Association of Certified Valuation Analysts (NACVA), authors Meg Holland and Maureen Thomas proclaim that Balicki will affect divorce cases across the United States. In their article, the authors draw a parallel that may be difficult for some (even me, an experienced divorce lawyer and accredited valuation analyst) to follow.  Balicki, they say, is the antithesis of Bernier, a 2007 Massachusetts Supreme Court decision that established “fair value” (as opposed to fair market value) as the value standard in Massachusetts divorces.

Balicki is no Bernier, however. First, Balicki is an intermediate appellate court decision, the opinion of three out of the fifteen Superior Court judges, not a Supreme Court decision. Second, Balicki does not change the value standard in Pennsylvania (not that Holland and Thomas are saying that; they aren’t). Sure, Balicki has been interpreted in some outposts as the death knell for the argument that tax discounts may be ignored in cases where the owners never intend to sell. Yet, many of us read Balicki as a decision that stands on its own factual and evidentiary record. The panel in Balicki specifically found insufficient evidence to prove that the owner of the insurance business would never sell. In spite of Balicki, I still maintain that tax and sales cost discounts are not mandatory in every business valuation case.

I would also venture to guess that the wife’s camp did not argue strongly enough that the taxes and expenses were already considered as part of the marketability discount in the business valuation. Had that argument been made cogently at the master’s level, it is possible that the master and trial court would have adopted that position, and the Superior Court under an abuse of discretion would have affirmed.

The Holland and Thomas article leads to some interesting topics for reflection, such as: how do you calculate the hypothetical taxes that a seller would incur when selling an equipment-intensive business whose equipment was fully or greatly depreciated? The depreciation recapture analysis would seem to require a good equipment appraisal.

The Valuation Examiner article also contains an outright mistake: the authors state incorrectly that § 3502(a)(10.1) and (10.2)  were enacted in 1988, prior to the Pennsylania Supreme Court’s decision in Hovis (1988), which held that tax consequences could not be considered unless imminent and certain. (Actually, those statutes were enacted in 2005. The 1988 recodification of the Divorce Code was silent on the tax issue.)  The authors go on to say that three subsequent divorce decisions, including two out-of-state Supreme Court decisions, were incorrectly decided in reliance on Hovis, which the authors mistakenly regard as bad law.

Of course, Hovis was the law of Pennsylvania until the Pennsylvania Legislature enacted § 3502(a)(10.1) and (10.2) in 2005. During our discussion at the 14th Annual Family Law Update (November 2010), it was the consensus of four leading divorce lawyers that Balicki was an unremarkable decision.  It just means that the next lawyer who wants to argue that tax discounts should not be applied must work that much harder. Still, let’s see what happens in January 2011, when the PBA Family Law Section devotes an entire 90 minute seminar to this case.

Judges are Deciders, not Investigators, in Divorce Litigation

by bvertz on Sep 16, 2010 • Comments Closed • , , ,

A recent post on BVLaw (culled from the materials for the BVR Summit on Business Valuation in Divorce, going on now in Chicago) reminds us that pre-trial discovery and preparation are essential tasks in divorce litigation which must be conducted by the parties, with the assistances of their lawyers and experts, not the court:

Speaking at this morning’s BVR Divorce Summit, Judge Thomas Zampino gave some excellent advice for matrimonial lawyers.  ”I’m not going to go out and find all the assets that are hidden under the bed.   And, I’m not going to determine what they’re worth.   You don’t want me doing that.  But, my job is to narrow the field of answers, and then divide the assets as best I can.”

Judge Zampino’s comments are his opinion, of course, but many judges feel the same way. The court has no power, authority or resources to perform the investigation and valuation functions that are necessary to an equitable result. Lawyers, experts and their clients must do this work before it is time to settle or litigate the case. Judge Zampino also made the interesting observation that he can feel more confident about making a decision on how to divide property if there is not a wide gap between the opposing experts’ opinions. In some cases, we allow the experts to confer with each other in advance to identify the similarities and differences between their opinions. This often leads to a stipulation, or agreement, on the value of a business. Even if it does not, the experts may be better prepared to show the judge why their opinions differ and convince the judge to adopt the “right” answer.

Blazer: Double Dip Still Moribund in California

by bvertz on Sep 8, 2010 • Comments Closed • , , , , ,

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.

Fair Value Standard Rejected by Colorado Supreme Court

by bvertz on Jun 5, 2010 • Comments Closed • , , , , , ,

The Colorado Supreme Court, in Marriage of Thornhill (June 1, 2010), held that it would not mandate the “fair value” standard for valuation of business in divorce proceedings. The husband in Thornhill operated an oil and gas service company that was valued at $1.625 million after applying a 33% marketability discount as part of an FMV valuation for divorce purposes. The wife argued on appeal that the marketability discount should not be applied, citing a Colorado precedent in which marketability discounts were prohibited in minority shareholder oppression cases. The Supreme Court affirmed the trial court’s refusal to prohibit marketability discounts in divorce cases. The Supreme Court noted that the “fair value” standard was required under the state’s shareholder oppression statute but not under the state’s divorce statute.

This decision contains a good explanation of the reasons why “fair value” is not necessarily appropriate to divorce cases. The wife argued that divorce cases are similar to shareholder oppression cases because a divorce involves an involuntary divestiture of a party’s interest in the business. The Colorado Supreme Court explained that valuation discounts are prohibited in shareholder oppression cases to discourage majority shareholders from engaging in oppressive behavior. In other words, the prohibition of marketability discounts in shareholder oppression cases forces the majority shareholders to pay more than fair market value as a penalty for their conduct. Imposing the fair value standard in divorce cases would not serve the same purpose.

The Colorado Supreme Court did not go as far as prohibiting the fair value standard in divorce cases. Instead, the court held that marketability discounts must be considered on a case-by-case basis. It is conceivable, under certain circumstances, that marketability discounts might not be applied in divorce cases. It would not be appropriate, however, to impose the fair value standard in every divorce.

Buy-Sell Controls Value of Medical Practice in Texas Divorce

by bvertz on May 5, 2010 • Comments Closed • , , , , , , , , , , , , , ,

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.