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For the past three years, I have published family law news and analysis on my legal blog. My blog was named BV Source because of my initials and my blog’s emphasis on business valuation (BV) issues in divorce. As the scope of my blog has expanded, the time has arrived to rename the site and move it to a new URL. From now on, BV Source will be known as Family Law Source. The new URL is www.familylawyerspittsburgh.com. Please update your bookmarks.

Additional changes will be coming over the next few weeks. Soom we will implementing an all-new design, with home page areas dedicated to the latest news in divorce, child support, divorce court decisions and divorce valuation. Of course, all the best features will remain, including the child support calculator, substantive information about Pennsylvania family law, and latest court decisions. Please keep checking back!

While you are at it, you might want to check out my law firm’s new web site (well, less than a year old): www.pollockbegg.com.

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Recently in one of my cases (several, actually), I have encountered complex issues involving military retirement benefits for retired servicemembers. Fortunately, there is a lot of information out there, from the Department of Defense website to MOAA to Military.com. One of the best (read: most understandable) resources is a book published in 2006 by the American Bar Association, entitled “The Military Divorce Handbook.” For years it has sat on my credenza behind my desk as a handy reference.

I recently had the pleasure of meeting the author, Attorney Mark E. Sullivan, during the annual meeting of the American Academy of Matrimonial Lawyers in Chicago. Not only is Mark the expert on military divorce, but he can clarify the issues and present the alternatives without confusion or doubletalk. This post is a shout-out to Mark, who recently explained to me the nuances of the SBP.  His book is just as clear as his personal explanations; I can highly recommend it.

The typical “war of experts” was presented in Bussa v. Bussa, 2008 WL 2117138 (Mich.App.), a 2008 unpublished decision of the Michigan Court of Appeals. In this case, the business owner’s expert gave an opinion of value based upon the asset approach. The subject company (actually, companies) was a petroleum sub-jobber comprised of a gas station operator, a real estate holding company owning the gas stations, and a trucking company delivering fuel to the gas stations. The business owner’s expert relied on an net asset value approach and excluded the income approach because the company was involved in a highly volatile industry.

The wife’s expert considered all three approaches, including discounted cash flow, market comparables, and net asset value. In valuing the operating company, she relied primarily upon the market approach. For the trucking company, she considered all three approaches; and for the real estate holding company, the net asset approach was deemed most reliable.

The trial court rejected the opinion of the husband’s expert and slightly modified the value suggested by the wife’s expert, applying a 5% discount for lack of control (the business owner’s brother owned half of the stock) and a 10% key man discount. The opinion of the husband’s expert was rejected because of significant computational errors, an inability to cite data to support his views, and an impression of advocacy for his client.

On appeal, the Michigan court affirmed, finding that it was mostly an issue of credibility, which is best left to the trial courts to decide. It is perhaps notable that the business owner on appeal seemed to contradict his own expert, arguing that his businesses should be valued at their liquidation value (contrary to his expert’s testimony) and criticizing the discounts that were applied to the value rendered by wife’s expert (which were the discounts to which husband’s own expert testified).

An intriguing article, published recently by BVR on its BVWire blast email, reminds us that executive compensation is one of the most important components of a business valuation. The article summarizes a lecture given by Brian Brinig at the California CPA 2008 BV Conference, in which he challenged the term “reasonable compensation adjustment” as well as the methods that are commonly used to arrive at this normalization adjustment to the income statement.

Mr. Brinig would prefer the term “fair-value-of-the-owners’-services adjustment,” which is a mouthful but comes closer to describing the real objective: determining what it would cost to replace the owner with an equally qualified and competent manager. Brinig also indicates that by phrasing the question in this way, valuation professionals can avoid the mistake of valuing non-transferrable goodwill. The question is not whether a neurosurgeon is unreasonably compensated but whether another professional could be hired to replace the neurosurgeon, and at what price.

BVWire also considered whether valuation professionals, who are not generally trained or experienced in executive compensation matters, can qualify to give expert opinions in litigation on this subject. The verdict? If judges are unwilling to disqualify business appraisers from giving testimony on the subject, it must be okay to do so.

Last month the U.S. Tax Court released its memorandum opinion in Astleford v. Com. (TC Memo 2008-128), a case dealing with the minority and marketability discounts applicable to family limited partnerships. In Astleford, the widow of a Minnesota real estate tycoon contributed her interests in real estate (which included real estate partnerships and trusts) to a family limited partnership (FLP) for the benefit of the parties’ children.

In valuing the interests gifted to the children for the donor’s IRS Form 709s, the taxpayer’s valuation expert took a 41.3% absorption discount against the value of the real estate. The taxpayer’s expert opined that the parcel of farmland was so much larger than the average comparable sales that it would flood the market, warranting a discount. The IRS, predictably, rejected the absorption discount.

On appeal, the Tax Court reduced the absorption discount considerably, to approximately 20%. In doing so, the Tax Court examined the specific data on which the taxpayer’s expert relied and reached its own conclusion from that data by excluding certain datapoints and determining its own weighting.

The taxpayer’s expert also discounted the value of the partnership donated to the FLP and the FLP interests conveyed to her children for lack of control and lack of marketability, relying on market data from sales of registered real estate limited partnerships (RELPs). Deriving a range of 22% to 46%, the donor’s expert settled on a 40% combined discount against the value of the partnership. The IRS did not discount at the partnership level, arguing the discounts should be applied only at the FLP level.

The taxpayer’s expert applied “tiered discounts” by discounting the partnership interests that were donated to the FLP and the FLP interests that were transferred to children. In other words, the value was discounted once at the partnership level and again at the FLP level. The Tax Court noted that tiered discounts were disallowed where minority interests comprised most of the assets of the FLP entity being valued, but since the partnerships were just 16% of the FLP’s value, the tiered discounts would be allowed. The TAx Court arrived at a 30% combined discount at the partnership level.

The IRS in calculating discounts at the FLP level applied data from REIT sales, which the Tax Court deemed more reliable than RELP data. Because of the data source, the IRS expert had to adjust his minority interest discount to account for the unusual liquidity of REITs. By eliminating the liquidity premium from the observed discount, the IRS arrived at a minority interest discount of 7-8%, which the Tax Court deemed too low. The Tax Court instead calculated a minority interest discount of 16-17%.

The Tax Court accepted the IRS’s marketability discount of 22% (which was slightly higher than the marketability component of the taxpayer’s combined discount).

The Supreme Court of West Virginia recently considered the enterprise goodwill of a professional practice in divorce proceedings in Helfer v. Helfer, 221 W.Va. 625, 656 S.E.2d 70 (November 2007).

In Helfer, the business owner’s expert found that his chiropractic practice was worth $41,000, based on a capitalization of earnings. His wife’s expert found the practice to be worth $388,000 based on the excess earnings method. Neither of the experts made a distinction between enterprise goodwill and personal goodwill or placed values on those elements. The trial court adopted the opinion of the business owner’s expert, and the wife appealed, arguing that the trial court failed to consider the value of enterprise goodwill.

I have mentioned before in this blog that the real issue, in matrimonial actions, is whether goodwill is transferrable. Presumably, goodwill emanating from the skills and reputation of a professional is non-transferrable, while goodwill emanating from customer base, trade name recognition, unique goods or services, or other factors indistinguishable from the business itself can be transferred to new owners in a hypothetical or actual sale.

West Virginia, unlike Pennsylvania, has expressly described at least five acceptable methods of valuing a business, two of which are the capitalization of earnings method and the excess earnings method. (The other recognized methods are the Treasury method, the market value approach, and the buy/sell agreement method.) West Virginia precedent requires the court to determine the value of a professional practice and its goodwill if it is determined that distributable goodwill exists.

Since the business owner’s expert, whose opinion was adopted by the court, did not in this case identify the enterprise goodwill, the West Virginia court remanded the case for a determination of the value of enterprise goodwill. The Supreme Court directed the trial court on remand to assign a value of zero to the enterprise goodwill if it found that no enterprise goodwill existed.

I may have mentioned this before on this blog, but it is striking to me how many accountants and valuational professionals regard court decisions as monolithic. At NACVA chapter meetings, I have heard CPAs say that “you must do this” or “you can’t do that” because of some court decision or IRS position. But we must not forget that all court decisions are, to some extent, fact-sensitive and case-specific. The job of a lawyer as an advocate is to cite facts and cases that support one’s position and to distinguish/minimize facts and cases that do not. It is also important to realize that intermediate appellate decision carry less weight than supreme court decisions, and trial court decisions carry little or no precedential weight (except to the extent that their logic may be persuasive).

So I was pleased to read, in the latest BVWire blast email from BVResources.com, a report from the New York State Society of CPAs describing a lecture given at their 2008 Business Valuation Conference. BVWire reports:

IRS agents and auditors may tell you that the Internal Revenue Service does not have an official position on tax affecting Subchapter S corporations—but “don’t believe it,” Dan Van Vleet (Duff & Phelps) told the NYSSCPA gathering. The “official” IRS position “is to assess the reasonableness of the analysis and make a determination,” he said. The problem: The Service may presume that tax affecting is not reasonable—a position based in large part on prior Tax Court Memorandum decisions (Gross, Heck, Adams, Wall, Dallas – all are available to subscribers of BVLaw) in which neither the IRS nor the taxpayer’s expert presented a good model for tax affecting the subject interests. But only one of these—Gross, which concerned an “extreme” set of facts—has been affirmed by a federal court of appeals (6th Cir.). The rest are not binding. “The current reality is that the IRS has audited—and accepted—numerous reports involving substantial matters” that Van Vleet and his colleagues have prepared using his S Corporation Economic Adjustment Model (SEAM). “If you use a model that explains [tax affecting] reasonably,” he said, “they’ll accept it.”

“I’ve never been challenged,” agreed Chris Treharne (Gibraltar Business Appraisals, Inc.), who presented his S Corp model to attendees. “If you’ve got an S Corp that’s distributing enough to cover [shareholder] tax liability, then for heaven’s sake, tax affect. If you can explain it in your report with sound economic reasoning,” he said, “you will win.” The economic issues that lie at the heart of the valuation of any pass-through entity are “absurdly simple,” said Nancy Fannon, the third expert on the topic—but they have been wrapped in “deceptively complex” models. She reminded conference attendees that her article comparing the various models—including those used by the Tax Court and the Delaware Chancery Court—is available as a Free Download at BVResources (fifth on the current list) along with her book, Fannon’s Guide to the Valuation of Subchapter S Corporations).

They are right! Many valuation professionals believe that tax-affecting is appropriate and justifiable in certain situations, and if they express their views to the lawyers who are advocating their positions, they can as a team convince factfinders and influence the development of judicial precedent. Soon we will look at the recent
decision in Bernier, a marital dissolution decision arising from Massachusetts, which may not have as pervasive an influence as has been described in some reports.

A recent Florida divorce decision, Erp v. Erp, considered the valuation of an RV dealership acquired by the husband and wife during their marriage. The dealership was organized as a subchapter “S” corporation, of which the husband and wife each owned 40% of the stock. Husband’s son from a prior marriage and wife’s son from a prior marriage each owned 10% of the stock, so that no decisions could be made without the consent of husband and wife, or one of the spouses and both children.

In addition to the divorce action, the wife commenced a simultaneous court proceeding for dissolution of the corporation.

The husband’s expert found an enterprise value of $4.56 million, while the wife’s expert found $12.5 million. The differences in the experts’ opinions were primarily due to (1) tax-affecting “S” corporation income; (2) regression analysis; (3) working capital adjustment; (4) A/R accounting convention; and (5) marketability discount. After discounts, the husband’s expert found that wife’s 40% share was worth $720,000. The wife’s expert found that her 40% share was worth $5 million.

The trial court arrived at an enterprise value of $6.2 million. This figure was based upon the testimony of the husband’s expert, after restoring cash flow to its pre-tax basis, scaling back the working capital reduction of cash flow, applying a LIFO convention to accounts receivable, and applying a 10% marketability discount. The trial court valued the husband and wife’s 80% interest at $4.96 million, of which the wife’s share was worth $2.48 million.

On appeal, the wife attacked the trial court’s marketability discount, arguing that a marketability discount should never be applied in matrimonial actions. Wife pointed to the state statute that mandated a “fair value” standard in shareholder suits, and a statute that prohibited discounts in such cases.

Rather than adopting a standard of value, the Florida appeals court held that the trial courts have discretion to accept or reject the testimony of valuation experts. The Florida appeals court noted that the state statute that adopts a “fair value” standard applies only to oppressed shareholder cases, and not to matrimonial actions.

The Court wrote: “In this case, the Wife is not the victim of majority shareholder oppression. From her perspective, there has been no involuntary change in the fundamental nature of the corporation.”

The Florida court noted that marketability discounts were discretionary (not prohibited) in cases involving corporate dissolution. Perhaps it was significant that the trial court in Erp had reduced the marketability discount to 10%. Finding no abuse of discretion, the appellate court affirmed.