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BUSINESS VALUATION ISSUES IN A DIVORCE SETTING
© 2002 National Legal Research Group, Inc.
There are many issues that have evolved over the past few years, and some even in the past few months, that play a major part in a business valuation for marital dissolution purposes. The major issues relate to the divisibility of goodwill in a marital estate and the tax issues relating to valuations of pass-through entities. Both of these issues can have major implications on the outcome of the division of the marital estate. This article will explain these major issues, how they arise, how they are dealt with, and what some of the courts have decided in regard to them.
I. GOODWILL
Goodwill in a marital dissolution situation can be separated into two types. One type is personal goodwill and the second type is entity goodwill. Personal goodwill is goodwill that attaches to the person involved with the business due to his/her personal efforts. Entity goodwill is goodwill that attaches to the business or entity due to characteristics such as location or reputation. In the context of divorce, one of the major issues that has burst onto the scene in the valuation arena during the past couple years is the issue of which type of goodwill, if any, should be included in a marital estate.
How goodwill is handled in a divorce setting depends on the jurisdiction. Some courts have ruled that goodwill should never be a divisible marital asset. For example, in Holbrook v. Holbrook, 309 N.W.2d 343 (Wis. Ct. App. 1981), the Court of Appeals of Wisconsin overturned a trial court's ruling that the professional goodwill of the husband's law partnership is a marital asset. The Appeals Court stated that the goodwill of the law partnership is already reflected in the substantial salary paid to the husband. In another case, Sorensen v. Sorensen, 839 P.2d 774 (Utah 1992), the Supreme Court of Utah ruled that the goodwill and/or reputation of the husband's dental practice should not be included as a divisible asset in the marital estate. See also Travis v. Travis, 795 P.2d 96 (Okla. 1990); Hickum v. Hickum, 463 S.E.2d 321 (S.C. Ct. App. 1995).
Other courts have always included goodwill as a divisible asset, regardless of the nature of the goodwill. For example, in Dugan v. Dugan, 457 A.2d 1 (N.J. 1983), the New Jersey Supreme Court held that the goodwill of a solo law practice was marital property. In that case, the court held that much of the economic value produced during an attorney's marriage will inhere in the goodwill of the law practice. The court further stated that it would be inequitable to ignore the contribution of the non-attorney spouse to the development of that economic resource.
To confuse things even further, some courts have ruled that only personal goodwill should be excluded from the marital estate and that entity goodwill is a marital asset. Thus, these courts have required a distinction between personal and entity goodwill. For example, in a very recent case in Indiana, Yoon v. Yoon, 711 N.E.2d 1265 (Ind. 1999), the Indiana Supreme Court ruled that to the extent goodwill is enterprise goodwill, it is divisible. The Supreme Court remanded the case back to the trial court for a determination of the value of Yoon's medical practice in excess of the value attributable to Yoon's personal goodwill. In another similar case, Hanson v. Hanson, 738 S.W.2d 429, 434 (Mo. 1987), the Supreme Court of Missouri held that goodwill in a professional setting is the value of the practice which exceeds its tangible assets and which is the result of the tendency of clients/patients to return to and recommend the practice irrespective of the reputation of the individual practitioner.
Yassir Karam, JD, CPA/ABV, is a Senior Manager for the Valuation and Forensic Services Team at Clifton Gunderson LLP in Indianapolis, Indiana. Mr. Karam is currently a member of the AICPA Business Valuation subcommittee and is a national instructor of the AICPA's courses on Fundamentals of Business Valuations.
Randie Dial, CPA/ABV, AM, is a Manager for the Valuation and Forensic Services Team at Clifton Gunderson LLP in Indianapolis, Indiana. Mr. Dial specializes in forensic/litigation services and the valuation of closely held businesses.
Mr. Karam and Mr. Dial practice with the Valuation and Forensic Services Group at Clifton Gunderson LLP, 9339 Priority Way West Drive, Suite 200, Indianapolis, IN, 46240; telephone (317) 569-6212; fax (317) 574-1275 .
As presented above, there are no set guidelines to follow on this issue. Courts across the country have viewed this issue in very different ways. This can create very different views and very different valuations in a divorce setting, as seen in the aforementioned cases. To avoid any confusion, the business valuation experts should discuss this issue up front with the attorneys who engage them. This is a very important step in a business valuation because, as presented above, most states have different interpretations of this issue.
Depending on what statutes regarding goodwill apply, a business valuation in a divorce setting can be easy to perform or become a very complex task. For example, if it is determined that all goodwill should not be included in the marital estate, then the business valuation should simply be a valuation of the net assets of the business excluding any goodwill. However, if it is determined that the goodwill needs to be divided into personal and entity components, the valuation of the business can become quite complex and requires several additional steps and procedures to arrive at a value.
A majority of our work is performed on businesses located in the State of Indiana, which treats only enterprise goodwill as part of the marital estate. Thus, we are often required to differentiate between personal and entity goodwill in the business valuations we perform. There are different techniques and document requests that can be performed to determine the appropriate value of the goodwill components. The section provides a brief overview of how this issue can be approached.
Distinguishing Between Personal and Enterprise Goodwill
The first major issue to consider is how much of the business would be lost if any of the key individuals were to leave the business. In many instances, business valuation experts only consider the personal effects that the individual getting divorced would have on the business. However, some of the other individuals within the business may hold personal goodwill as well. If those individuals are not considered, their personal goodwill will be included in the entity goodwill determined. An example of this scenario would be a medical practice that contains three physicians in which one physician is getting a divorce. In this case, the business valuation expert would be asked to value the physician's interest in the practice excluding personal goodwill. To do this, the business valuation expert would need to exclude all personal goodwill of the practice and not just the personal goodwill of the physician getting divorced. This is a common mistake made in divorce valuations involving this issue.
To determine how much of the business would be lost if any of the key individuals were to leave, there are a few techniques that can be used. One technique is to simply send affidavits to the major clients asking them what their intentions would be if any of the key individuals were to leave the business. If any of the major clients would respond by stating that they would take their business elsewhere if one of the key individuals were to leave the business, then that client is obviously there due to the individual efforts of a key individual, which equates into personal goodwill. This strategy can be effective for smaller businesses or those businesses with a few major clients representing a large portion of the business.
Another technique that can be performed is to request documentation regarding referral patterns and the tracking of new business. Many companies usually keep track of how their customers learned of their business. This information can be vital to the business valuation professional. For example, if it can be determined that a majority of the clients simply use the business because they are centrally located or were referred to the company based on its reputation, then it might indicate that a lot of the goodwill is entity goodwill.
Another document that can play a significant role in the determination of goodwill is a covenant not to compete. This is a document that is executed by key individuals restricting them from competing with the business for a certain amount of time if they were to leave. Some business valuation professionals believe that the execution of a covenant not to compete indicates that the key individuals have transferred their personal goodwill to the entity, thus resulting in entity goodwill. However, others disagree with that argument, reasoning that even if the key individual executed a covenant not to compete and were to leave, the clients who were there due to that key individual may not stay. In other words, the clients' personal goodwill would not become entity goodwill as the clients might leave as well. Others simply argue that if all of the key individuals execute covenants not to compete, then all of the goodwill is personal or they otherwise would not have had to execute the covenants.
A fairly recent court case dealing with covenants not to compete was Norwalk, TCM 1998-279. In that case, the tax court ruled that had there been a covenant not to compete in the taxpayers' accounting practice, the accountants would not have been able to take the corporate clients with them. The court went on to state that if there would have been a covenant not to compete, goodwill might have been found because the business would have been better able to retain its client lists and the ability to continue its business. Thus, the tax court in Norwalk believed that a covenant not to compete would have transferred the personal goodwill into some entity goodwill.
Other Issues to ConsiderOther Issues to Consider
Another important consideration that arises is the type of business that is being valued. Goodwill is a major factor in the valuation of professional practices such as medical practices and law practices. In these types of businesses, goodwill may comprise a large portion of the total assets and usually requires the practitioner to hold a license or certification that is personal to the practitioner. The practitioner's reputation also is an important aspect of the practice. Most court cases on the subject of personal goodwill deal with valuations of professional practices.
However, goodwill also arises in commercial businesses. There are several factors that can help to show that goodwill, whether personal or entity, exists. One example would be the depth of management of the business. A strong management team may indicate that some entity goodwill exists as it can help to ease the potential loss if a key individual were to leave. Another example would be the extent to which individuals are involved with customers. As we discussed earlier, if a key individual is involved with major clients and then decides to leave, the clients may leave as well. A final example would be the source of new customers. If new customers are the result of relationships developed and maintained by an individual, then the potential loss from the individual leaving may be greater. Differentiating personal and entity goodwill in a valuation of a commercial business can be very difficult.
II. VALUATION OF FLOW-THROUGH ENTITIES
This issue has taken on a whole new light since the July 1999 case of Gross v. Commissioner of Internal Revenue, T.C. Memo. 1999-254, 78 TCM 201. In this particular case, the Tax Court ruled that it was improper to tax-affect an "S" Corporation based on a fair market value standard. Although this article will not discuss the details of the case, it is a very interesting case to read. Another case just released in February of 2002 also dealt with this issue. In Heck v. Commissioner of Internal Revenue, T.C. Memo. 2002-34, neither business valuation expert tax-affected the earnings from the "S" Corporation. This issue has major implications on the value of a business in a divorce setting. Many business valuation professionals have been left to wonder what should be done in regard to tax-affecting "S" Corporations, LLCs, and partnerships when doing a business valuation since these are all flow-through entities.
Historically, the issue as to whether or not to tax-affect flow-through entities has not been a significant factor in regard to business valuations. It has been consistently held in the valuation community that flow-through entities make distributions to shareholders to cover the individual tax liabilities on the flow-through earnings. However, it has also been consistently held that "C" Corporations must make tax payments to the IRS on their earnings. Thus, whether distributions are made by the "S" Corporation to satisfy shareholder tax liability or a "C" Corporation makes direct payments of tax to the IRS, the decrease in cash represents a known payment which reduces the availability of cash which could otherwise be used to maintain or expand existing operations. However, in the Gross case mentioned above, the Tax Court did not agree with this theory and was not persuaded otherwise by the business valuation expert in the case.
As mentioned, this issue can have a major impact on the outcome of the marital estate. If the earnings of a corporation are tax-affected, the value, assuming all other things constant, would be significantly lower than if the earnings are not tax-affected. Thus, it is imperative for the business valuation professional to discuss this issue with the client and attorney at the beginning of an engagement to make sure all parties understand the issues and implications they may have. It is important to remember that there is no right or wrong answer to this issue. Some experts believe strongly that earnings should be tax-affected no matter what and are prepared to defend their opinions if necessary. Others believe in the opposite and are ready to defend their opinions as well. So it is very important that a competent, well-respected business valuation professional is engaged to ensure that he/she can testify to their opinion with convincing accuracy.
There are some beliefs in the valuation community that whether or not to tax-affect a flow-through entity depends a large part on the type of interest being valued. Some experts believe that if a controlling interest in a corporation is being valued that a decision to not tax-affect the earnings can be made since a controlling interest has control over the distributions to shareholders. Based on this theory, a controlling owner can make sure he/she gets enough in distributions to cover his/her share of the taxes on the flow-through earnings.
However, the issue becomes a little more complex when valuing a minority interest. A minority shareholder has no say in regard to how much money is distributed and is never assured of getting enough distributions to cover taxes on the flow-through earnings. Thus, some business valuation experts are of the opinion that if the earnings are not tax-affected, the discount rate, and, more specifically, the specific risk factor should be increased. This increase of the specific risk factor takes into account the additional risk of the minority shareholder not receiving tax distributions. However, what if the minority shareholders of the corporation have always received their share of distributions? What if the shareholder agreement forces the company to make tax distributions? In those cases, can the discount rate be increased? These are some of the questions and issues that we run into as business valuation professionals when valuing flow-through entities.
The only guidance that we have as business valuation professionals on the issue of tax-affecting the earnings of flow-through corporations is from the courts. There are no set guidelines as to whether it is right or wrong to tax-affect the earnings of flow-through corporations. This lack of guidance is more than likely going to begin causing some major differences in the valuations prepared by opposing sides of a divorce. The valuation professional hired by the owner-spouse may decide to tax-affect the earnings while the valuation professional hired by the non-owner spouse may decide not to tax-affect the earnings. Thus, a large difference in values may result. For this reason, it is very important for the business valuation professional to discuss these issues with the client prior to beginning work on the engagement.
As discussed in this article, the issues of goodwill and flow-through entities are the main issues today in terms of business valuation engagements for divorce purposes. It is imperative that the business valuation professional makes it clear before beginning an engagement what his/her opinions are in regard to these issues. Making these opinions clear at the beginning of the engagement will prevent a lot of problems down the road.
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