Once again this fall, I am the course planner, author and lecturer for the child support portion of Family Law Update, an annual survey of the latest developments in Pennsylvania’s child support law and procedures. A copy of my PowerPoint presentation is available here. While there weren’t many new precedents published this year by the Pennsylvania courts, there have been some meaningful changes to the procedural rules and child support guidelines. Family Law Update will be presented in Pittsburgh on October 26, 2011; and on November 8, 2011, it will be presented again in Mechanicsburg and broadcast to dozens of satellite locations around Pennsylvania.
Double Dip and Goodwill Considered by Wisconsin Supreme Court
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.
10 Cash Flow Rules In Divorce (Part I)
In business, they say, cash flow rules. The same principle is true, I find, in divorce. I have been brainstorming a set of cash flow “rules” for divorcing spouses. Here is part one:
1. Never run out of cash. My #1 divorce rule is the as Inc Magazine‘s #1 business rule. In divorce, there is a period of time immediately following separation when a divorcing spouse’s cash flow may be particularly vulnerable. Spouses who are not working need to know that litigation might drag on for weeks before the support payments will begin. In order to meet routine financial obligations (bills, loans, credit cards), divorcing spouses should be sure to have a two months’ supply of cash before separating.
2. When it is impossible to increase income, reduce spending. Some divorcing spouses expect to preserve the standard of living they have always enjoyed, but it is just not possible. In fact, the law does not guarantee it. Our judges know that two households cannot be run as cheaply as one, so it is necessary to cut corners. Many families are living beyond their means or just scraping by. Divorce did not create the problem and cannot solve it. If your cash flow is not enough to pay the expenses, you must reduce expenses.
3. House-poor or pension-poor is just plain poor. Liquidity is a valuable resource. Some divorcing spouses insist on keeping a house or pension instead of assets that can be converted to cash more easily. Kids can’t eat a house. A pension won’t pay the light bill if you are 45 years old. Even though you may have worked your whole life to earn that pension or create a great home for your kids, you might be better off trading it away or selling it to generate cash that will pay the bills. You will sleep better at night.
4. Credit borrowing does not equal cash flow. Loans and credit cards are temporary – and very expensive – ways of dealing with inadequate cash flow. By borrowing, you may be digging a deeper financial hole for your future. Do not borrow unless you have a sure means of paying off the loan or credit card within a year or less.
5. Build earning capacity. We have all heard the story about the father who is refusing overtime at work so that he will not have to pay more child support or the mother who is waiting until the divorce is concluded before she returns to college. It might seem like an attractive strategy, but it always backfires. The sooner that you enhance your cash flow, the sooner you will restore your financial stability.
Kids and summer jobs: Some tax reminders
My friends at Crawford Ellenbogen LLC know a lot about taxes. One of their principals, Victor Dozzi CPA, recently sent me a great tip about kids who are earning income from summer jobs, and I asked him if I could share it with you. He agreed, so here it is:
Are your children working at summer jobs this year? If so, here are some tax reminders.
* If a child did not owe any income tax last year and doesn’t expect to owe any this year, the child can claim “exempt” when completing the federal withholding allowance form (Form W-4). This will eliminate having federal income tax withheld from his or her paychecks.
* For 2010, your child can earn as much as $5,700 without owing federal income tax. There will still be withholding from your child’s paycheck for a number of other taxes, including: social security, Medicare, PA, PA UC & perhaps local.
* As long as you provide more than half of your child’s support, you can still claim the child as an exemption on your 2010 tax return.
* Earnings from a summer job will qualify a child to contribute to an IRA – up to $5,000 or the child’s 2010 earnings, whichever is less. If your child would rather spend his earnings than save for retirement, you could gift all the cash, or agree to match what your child saves. As long as the amount put into the IRA doesn’t exceed the child’s wages (or the $5,000 limit), it doesn’t matter where the cash comes from.
The principals of Crawford Ellenbogen (Joan, Victor, and Barb) can provide great advice and personalized service – it’s just a phone call away.
Department of the Treasury Required Disclosure
In accordance with IRS’ Circular 230 we are required to advise you that any written advice we provide to you cannot be used for the purpose of avoiding penalties under the Internal Revenue Code.
Official PA Child Support Calculator
I have added a new page to my site with links to the official Pennsylvania child support calculator, published by the Pennsylvania Automated Child Support Enforcement System (PACSES). PACSES is the name of the statewide computer system used by the Pennsylvania courts to calculate child support.
The official PACSES child support calculator is labeled as an “estimator”, and for good reason. The PACSES calculator can perform a basic child support calculation for parents who have earned wages from employment and do not itemize their tax deductions, but it becomes less accurate if the parents have other forms of income or tax deductions. Use the PACSES calculator only as an estimate of the amount you might have to pay or receive. Only an experienced divorce lawyer can provide a more accurate calculation of child support.
Sneak Preview: 2009 PBI Family Law Update
Each year I am one of the broadcast presenters for Family Law Update, one of the most-watched legal education courses for the Pennsylvania Bar Institute. We make live presentations in Philadelphia and Pittsburgh, followed by a satellite broadcast to nearly two dozen counties around Pennsylvania. Traditionally, I have presented the most recent cases involving child support, spousal support and alimony pendente lite.
The Pittsburgh live presentation will be given tomorrow (October 23, 2009), with the satellite broadcast to be given on November 18, 2009. The book is available on PBI’s website, and I publish my Powerpoint slides here.
Update: I have added a page to this site with my Powerpoint slides.
More on Blazer: Retained Earnings Not Income for Alimony
The California Court of Appeal’s decision in Marriage of Blazer (2009) dealt not only with double dipping, but also with the exclusion of a company’s retained earnings when determining the owner’s income subject to an alimony obligation. After a 20 year marriage, Husband and Wife divorced, the husband retaining ownership of a berry distribution business. At trial, the husband’s expert testified that the berry company was thinly capitalized for its gross revenue. Wife’s expert agreed (if not grudgingly) that some earnings must be retained for capital reserves. The trial court excluded these retained earnings from the husband’s income for alimony purposes.
The husband’s expert also testified that retailers were seeking to eliminate middlemen, forcing the business to integrate vertically. The capital expenditures to purchase a growing farm and expand distribution were not added back to the company’s income, despite wife’s argument that husband “chose” to incur those expenses and would benefit from the enhancement in the company’s value. Again, the trial court adopted the position of the husband’s expert, over the opposition of wife’s expert.
On appeal, the California Court of Appeals affirmed the trial court’s decision under an “abuse of discretion” standard. The Court noted that there is no statutory definition of “income” for alimony cases in California, and it was unclear whether retained earnings could be properly categorized as “income” for alimony purposes. Case law held that the child support definition of “income” did not apply to alimony cases.
Blazer: California Considers Double-Dipping and Personal Goodwill
BVWire.com reported this week on a recent California case where the issue of double dipping was examined in the context of divorcing business owners:
The husband owned a produce company in California, valued at $5.6 million, ostensibly under the capitalization/excess earnings method. After a marriage of “long duration and substantial standard of living,” the trial court awarded the wife $20,000 per month in spousal support plus half ($2.8 million) of the business. The husband appealed, urging a blanket prohibition against double dipping—i.e., using the same stream of earnings to determine business value/property division and also support.
In Blazer v. Blazer (No. DR 38292, Aug. 25, 2009), the California Court of Appeals discusses the excess earnings method and, in particular, the myriad ways to distinguish personal from enterprise goodwill. It also considers the double-dipping precedent from other jurisdictions as well as its own cases concerning pension divisions. In the end, the court sidesteps the issue by finding insufficient proof that the husband’s expert in fact valued the business by capitalizing his future income stream. Moreover, “the earnings of an ongoing business…do not always derive solely from the personal efforts of its operator, nor is there evidence that such is the case here.” The court explicitly confirmed the equity of the spousal award in this case as well as the trial court’s implicit determination that there was no double counting of the husband’s income.
Thus, the question remains open in California and elsewhere—especially for cases concerning owners of a professional firm or solo practice whose interests are valued under the excess earnings method. Look for a full summary of Blazer and our continuing analysis of double dipping in the November Business Valuation Update™.
This weekend I am in Chicago to attend the BVR Divorce Conference. I will read the case and many others while I am there, so I will have much to report about when I return!
Executive Compensation: Excessive Salary or Disguised Dividend?
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.
Basics of Pennsylvania Law: Double Dip, Part V
This is the last in a series of posts containing summaries of Pennsylvania case law on the issue of double dipping in divorce. “Double dipping” occurs when an income-producing asset (such as a pension or business) is counted as marital property subject to equitable distribution, as well as income subject to an alimony or child support obligation.
Steneken v. Steneken, 873 A.2d 501 (N.J. 2005).
Although it is not a Pennsylvania decision, no discussion of double dipping would be complete without Steneken, a 2005 decision of the New Jersey Supreme Court. In this case, the husband was the sole owner of a business which was marital property subject to equitable distribution. The valuation expert performed a normalization of the owner’s compensation in his report, reducing the company’s salary expense and thereby increasing the value of the company. In determining an alimony award, the husband argued that the court should consider his lower, normalized compensation instead of his actual salary (since the excess compensation had been capitalized as part of the business valuation and divided as marital property). The trial court accepted the husband’s argument and used his normalized salary instead of his actual salary.
An appeal ensued, and the case was remanded to the trial court because the intermediate appellate court held that the record was not fully developed. On remand, the trial court reversed its earlier position and used the husband’s actual salary to determine the proper amount of alimony.
The intermediate appellate court, reviewing New Jersey’s divorce statute, held that the prohibition on “double dipping” extended only to pensions and affirmed the trial court’s decision. The husband appealed to the New Jersey Supreme Court to extend the principle to double dipping arising from the capitalization of earnings in the context of a business valuation. Since an income capitalization approach had been used by the valuation expert endorsed by the trial court, and was not challenged, the husband argued that he should not have to pay alimony from the excess compensation that had been capitalized and distributed as part of the value of the business.
The New Jersey Supreme Court disagreed, affirming the trial court’s decision to permit double dipping. Rather than adopting the intermediate court’s rationale, the New Jersey high court attacked the husband’s reasoning.
The logical flaw in defendant’s argument lies at its core. Defendant mistakenly equates the statutory and decisional methodology applied ni the calculation of alimony with a valuation methodology applied for equitable distribution purposes that requires that revenues and expenses, including salaries, be normalized so as to present a fair valuation of a going concern. Simply said, defendant’s charged mischaracterization of the issue here as one of “double counting” both misstakes the issue and ignores the fundamental principles that undergird related yet nonetheless severable alimony and equitable distribution awards. As our statutory framework and decisional precedent make clear, the proper issue is whether, under the circumstances, the alimony awarded and the equitable distribution made are, both singly and together, fair and consistent with the statutory design. . . . Because we embrace the premise that alimony and equitable distribution calculations, albeit interrelated, are separate, distinct, and not entirely compatible financial exercises, and because asset valuation methodologies applied in the equitable distribution context are not congruent with the factors relevant to alimony considerations, we conclude that the circumstances here present a fair and proper method of both awarding alimony and determining equitable distribution.
The New Jersey court’s opinion is not convincing; other reasons might have been more forceful. For instance, the court might have started with the observation that a business valuation expert ordinarily has no expertise in executive compensation. To identify part of the owner’s salary as excessive is tantamount to saying that the business could hire someone to do the job for less, or conversely, the owner would earn less if he or she sought employment elsewhere. Such determinations are beyond the expertise of most valuation experts, and should not be relied upon to determine the owner’s earning capacity for alimony and support purposes. Yet, if those normalization adjustments are not suitable to determine the owner’s earning capacity, why should we rely on them for the business valuation?
The New Jersey court noted that if a different valuation methodology had been applied, there might be no normalization adjustment to the owner’s salary. That is true, in the case of an asset approach. However, an asset approach assumes liquidation of the company, not ongoing concern value. The owner’s excess compensation does not get capitalized under the asset approach, so there is no possibility of double dipping. In the market approach, normalization of the income statement or cash flow is performed before applying a multiplier. Therefore, the potential inconsistency perceived by the Court is illusory.
In a vigorous and well-reasoned dissent, three of the seven Justices enunciated a compromise position: that the trial court need not use normalized compensation when computing the owner’s alimony obligation but should have discretion to adjust the value of the business or the alimony award to alleviate the double dip.