Valuing a business or a business interest in a divorce has become one of the most common reasons for obtaining a business valuation. It has also generated more than its share of court decisions. In part, this is due to the myriad of laws and case law in various states or jurisdictions of the United States.
Making sense of this patchwork quilt is difficult at best. Here are some issues that should be considered in developing a valuation for a marital dissolution.
Equity Trumps Bright-line Rules
In some ways, divorce valuation is still the Wild West of valuation services. Because divorce cases are not heard in federal courts, they're subject to the rules, law, and case law of particular states or jurisdictions.
It should also be noted that family law courts are courts of equity. The judge might determine a value for a business interest based on the needs of splitting the entire marital estate and not specifically on the value determined by one or the other of the experts.
The rules are complex and depend not just on state law, but on whether the business is a sole proprietorship, partnership, S corporation, C corporation or LLC.
A Little Forethought Offers Big Payback
So it is important for the attorney and the valuation expert to agree on some concepts up front so they know which direction to go:
What is the appropriate standard of value for the jurisdiction in which the case is being tried?
How is personal goodwill handled in the jurisdiction?
What type of report is best for the case at hand?
What other unique issues regarding how a business is to be valued exist in the jurisdiction?
Valuing a business for divorce purposes varies significantly depending on the case's venue. Here are some examples:
Florida has an "active participation" rule, which requires the owner of the business to actively participate in it in order to have the full value included in the marital estate.
Some jurisdictions do not allow the inclusion of inherited property in the marital estate. (Note: A judge may be able to use the "court of equity" concept to "back door" the value of inherited property).
About half of the state specifically exclude personal goodwill from the value of a professional practice (but still include enterprise goodwill) if the business owner's earnings are used to determine maintenance payments. Other types of businesses -- such as retailers and manufacturers -- may also possess elements of personal goodwill, depending on the facts and circumstances of the case.
Some states make the assumption that the value is determined as if the business is NOT being sold. Instead, the value is determined under a "value-to-the-holder" (or "investment value") premise. This considers the value of a business or business interest in the hands of its owner, regardless of whether he or she intends to sell the business. It further assumes that the titled spouse will continue to enjoy the benefits generated by a business that was created or appreciated during the marriage.
Some states do not allow "tax affecting" for pass-through entities. Tax affecting involves a business valuator making adjustments to future earnings on the basis of assumed future tax bills. It generally comes into play when the value of an S corporation is discounted to take into account the tax rate applicable to C corporations.
Comprehensive Reports Help Judges Understand Valuation Issues
Comprehensive written appraisal reports can be especially important in divorce cases, because they provide relevant information for judges to use when divvying up the marital estate. That information assists the judge in determining the rationale for the expert's conclusion of value. It also provides a clear record for appeal.
For example, let's say a business that has two primary segments: one devoted to a single large multi-year government contract and the other to serving small businesses with similar products. If the appraiser knows that the government contract is ending and will not be renewed, he or she will obviously take that into account in developing the future business income to be valued. Without additional explanation in the report, the trier of fact might miss the circumstances of the government contract ending and wonder why the appraiser has developed a lower value for the business than the opposing expert.
Defining the Standard of Value
The standard of value is also important in a divorce case. Many states claim to have a fair market value standard in divorce cases. According to IRS Revenue Ruling 59-60, fair market value is: "The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller. Both parties must be acting at arm's-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."
But be careful not to be fooled by other standards of value disguised as fair market value. Often, the statutory definition of the standard of value would more aptly be referred to as "fair market value except." For example, a particular state or jurisdiction might exclude transferrable personal goodwill, might not allow tax affecting in determining the income approach value, and might require that a hypothetical sale of the business not be taken into account.
Divorce cases are even more contentious and complicated when they include an interest in a privately held business. It's important for the attorney and the valuation expert to be knowledgeable about the important issues in the jurisdiction where the matter is being heard. Together, the team can help divorcing spouses achieve an equitable division of the marital estate.
LOUIS J. CERCONE, JR., CPA, CFE, CFF, ABV, ASA, CVA
Managing Director, Brisbane Consulting Group, LLC
Lou is the Managing Director of Brisbane Consulting Group in charge of business valuations, forensic accounting, and litigation support services. He has extensive valuation experience and has served as a financial consultant and expert to attorneys in the economic aspects of matrimonial dissolution. He has been engaged in several forensic accounting cases and has served the judiciary as a court appointed expert and receiver for financially troubled companies. He has testified as an expert witness in State Supreme Court and Federal Court. Lou has also been engaged in the quantification of lost income in determining business interruption claims for insurance adjusters.