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Tracing Nonmarital Property

by bvertz on Dec 12, 2011 • Comments Closed • , , , ,

A recent Superior Court decision, Childress v. Bogosian, 2011 WL 61616 (2011), illustrates the challenge of tracing nonmarital property in divorce. Under Pennsylvania law, the property owned by a spouse prior to marriage, or acquired by gift or inheritance during the marriage, or acquired after separation, is generally nonmarital property if it has not been converted into marital property by re-titling it in joint names. Still, the law creates a presumption that property acquired during the marriage is marital property, so if a spouse wants to overcome that presumption, he or she bears the burden of producing sufficient credible evidence.

Married people frequently re-invest their nonmarital property in other assets during the marriage. Funds might be withdrawn from a bank account and deposited in a different account. A certificate of deposit or bond might mature, and the proceeds might be reinvested in other assets. Premarital money or inheritance might be used to purchase real estate or other tangible assets. Generally, the property that is acquired in exchange for nonmarital property is still nonmarital if it has not been retitled in joint names.

“Tracing” is the process of proving that property acquired during the marriage was derived from a nomarital source, such as premarital property, gifts or inheritance. Tracing requires a chain of evidence from the original nonmarital property to the new property that was acquired in exchange for the original property. Sometimes there are gaps in that chain of evidence.

In Childress, the spouses lived in a residence that was previously owned by husband’s mother. When she died, husband inherited the home. Husband’s real estate appraiser provided an opinion of what the home was worth when he inherited it, which was more than listed in the deceased mother’s estate; and wife’s appraiser testified to what it was worth at the time of separation and subsequent trial. The court did not accept husband’s appraisal for the trial date, because his appraiser “artificially” limited her search for comparables to a maximum price range. The Superior Court affirmed.

Husband also owned a vacation home, which was purchased during the marriage using the proceeds of husband’s premarital home. In measuring the increase in value from marriage to separation, the trial court started with the value of the proceeds that husband received when he sold his premarital home during the marriage. Note that the premarital home might have increased from the date of marriage to date of sale, but this was not the subject of this appeal.

Husband objected that the trial court did not consider his investment in home improvements, which enhanced the value of the vacation home. In its opinion, the Superior Court held that husband did not adequately prove that he used nonmarital funds to make those improvements. [Note that if he had done so, the court also might have questioned whether to give a dollar-for-dollar credit for those investments, since $1 of repairs or improvements might not result in $1 increase in the home's value.] While husband did produce cancelled checks and other evidence of what he spent, he did not prove that those expenses were paid with his nonmarital funds.

The Superior Court did not consider husband’s further argument that he should have been given credit for paying down the principal balance of the mortgage loan after separation. Husband argued that the trial court should have taken judicial notice of an amortization table that he attached to a brief for the equitable distribution master and trial court. Since the issue was not specifically raised in the appeal or addressed by the trial court’s opinion, the Superior Court declined the opportunity to weigh in. Normally, the marital component of nonmarital property is measured from the date of marriage or date of acquisition (whichever is later) to the date of separation or date of trial (whichever results in the smaller value).

Personal Injury Award is Marital Property, Says Pa. Supreme Court

by bvertz on Dec 5, 2011 • Comments Closed •

Stare decisis is a central principal of jurisprudence. That’s why it’s big news when a court explicitly overrules a long-standing precedent. The Pennsylvania Supreme Court did just that last month in Focht v. Focht, a 6-1 decision issued on November 23, 2011.

In Focht, the husband suffered a personal injury at an automotive race track about 2-1/2 years before they separated. The personal injury suit was settled a few months after divorce proceedings were commenced, with Husband receiving a six-figure settlement and Wife receiving a smaller sum for loss of consortium.

The extant precedent of the Supreme Court, Drake v. Drake, dealt with a case where the injury and resulting settlement both occurred prior to separation. Drake involved the settlement of a workers compensation/disability claim for lost wages, so the Court was called upon to decide whether the settlement could be excluded from marital property to the extent that it represented future wages. The Court affirmed the trial court’s decision holding that none of the exceptions under Section 3501(a) applied to overcome the presumption of marital property.

The newest family law precedent, Focht, held that Drake was conclusive on the issue presented, where the injury occurred prior to separation but the settlement of the claim and payment of the settlement proceeds occurred after separation. In its opinion, the majority explicitly overruled Pudlish v. Pudlish, a 2002 decision of the Superior Court of Pennsylvania.

What’s newsworthy about the Supreme Court overruling a decision of the Superior Court? Well, Focht shows that the Superior Court must not have correctly understood Drake when it decided Pudlish, which was published two years after Drake. The crucial issue in all of these cases is when a litigation claim is “accrued.” Keep in mind that the Divorce Code establishes a presumption that all property acquired during the marriage, including litigation claims, are marital property unless excluded by statute. Section 3501(a)(8) excludes any “cause of action or claim which accrued prior to the marriage or after the date of final separation” from marital property.

In Pudlish, the Superior Court held that a litigation claim does not “accrue” until the date of the verdict or settlement. By that standard, it was possible for a personal injury settlement to be separate property of the injured spouse if the case was not settled or litigated to judgment prior to the date of separation. The Supreme Court in Focht disagreed, explicitly overruling Pudlish in its decision. Instead, the Supreme Court held that a cause of action “accrues” when the plaintiff has a right to file suit.

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.

Divorce and Guns – Can They Backfire?

by bvertz on Jan 28, 2011 • Comments Closed • , , , , , ,

A recent decision by the Superior Court of Pennsylvania, Smith v. Yusavage (unpublished), got me thinking about the problems surrounding gun ownership for spouses facing marital separation or divorce.

In Smith, one of the unmarried partners filed a Petition for Protection from Abuse (PFA) seeking a restraining order and eviction from their shared residence. Most of the allegations of abuse sound like the kind of shouting matches that might occur from time to time in many relationships. One striking feature of the testimony, however, was that one of the partners applied for a concealed weapons permit, and the other partner would not support the application because of safety concerns. This evidence, in my mind, seemed to convince the judge to issue the restraining order. The Superior Court affirmed.

(In an interesting side note, the Superior Court refused to consider the arguments made in pages 71-122 of the defendant’s brief because they exceeded the 70 page limit imposed by appellate procedural rules.)

I have seen cases where firearms mysteriously disappear after a marital separation, probably because they have been disposed by a spouse who is fearful. More than once I have heard of valuable guns being thrown into the trunk of a car without proper care and handling, diminishing their value. And Smith demonstrates that judges might be cautious about guns and their owners in the context of heated marital disputes.

My advice: if you are facing marital separation or divorce, consider whether to store the guns in a locker at a sporting club or a gun dealer, away from the marital residence. At the very least, if you keep them in your home, be sure they are properly stored under lock and key, away from children, where they do not present a threat to anyone. Your guns can be used against you, even if they are never fired. If the guns are registered in your name, and your spouse disposes of them improperly, could you be connected with their misuse in someone else’s hands? Will improper gun storage have an impact on your custody request? Can you satisfy a judge that there is no chance that your guns could be used to harm anyone? These questions are worth considering.

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.

10 Cash Flow Rules In Divorce (Part I)

by bvertz on Sep 28, 2010 • Comments Closed • , , , , , , , , ,

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.

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.