Business Valuation Issues in Divorce

February 2014       Download PDF      Print

Divorce is a difficult process that becomes further complicated when a closely held business is involved. In such cases, a business valuation is typically required to determine the equitable distribution of marital assets. Often, the divorcing couple will disagree over the value of the company, requiring a business appraiser to provide his or her expert opinion to help the court come to a conclusion of value.

Knowing what to expect in the divorce process can help business owners and their spouses reach amicable agreements and reduce the cost, time, and stress involved in divorce proceedings. In the article below, we discuss some issues to consider when disputing the value of closely held business interests in divorce cases.

Standard of Value in Divorce Cases

Business valuation professionals must define a standard of value before proceeding with an appraisal. A standard of value is a set of hypothetical conditions under which the business will be valued. In business valuations for divorce cases, there are two generally accepted standards: fair market value and fair value.

Fair market value is "the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties [have] reasonable knowledge of the relevant facts."1 Under fair market value, many appraisers apply discounts, such as the discount for lack of control (DLOC) and discount for lack of marketability (DLOM), to obtain the value of minority interests.

The full meaning of fair value depends on the context of its use. While it is similar to fair market value in some ways, it typically does not involve the application of minority discounts. Fair value is dictated by the court with jurisdiction over the case.

The two standards mentioned above can result in significantly different value estimates. In marital disputes, business appraisers must select the correct standard of value or their expert opinions may be dismissed by the court. Ultimately, the correct standard to apply in divorce cases varies from state to state.

Jurisdiction

Attorneys and valuation experts must refer to a particular jurisdiction's statutes and case law to determine the applicable standard of value in divorce cases. Some jurisdictions use fair market value, while others reference the terms "fair value," or just "value" in divorce statutes. However, many states do not provide any further definition of these terms.

Attorneys and experts must refer to case law for guidance on the characteristics that comprise a particular standard of value. In reviewing past cases in a jurisdiction, an expert may discover that certain procedures, such as applying minority discounts, or determinations that comprise a particular standard of value are disallowed in martial disputes in that particular jurisdiction.

Double Dipping

When one spouse in a divorcing couple owns a business, the issue of "double dipping" often arises. Double dipping refers to the idea that a spouse may be awarded twice on income generated by the business—once in the equitable distribution of assets and again when calculating income available for support. The basis of the argument against double dipping partially lies in how a business is valued.

One of the most commonly used methods for valuing businesses in divorce cases is the income approach. Under this approach, the appraiser determines what the business is worth based on the present value of the income it is expected to generate in the future. The appraiser can accomplish this by either capitalizing the company's income over a single period using an expected rate of return or by estimating a company's income for each year over a forecasted period; the appraiser then applies a discount rate to determine the present value of the company's future earnings.

Many argue that using the future income stream of a company to determine its worth for property division purposes and then ordering the spouse to pay alimony or child support from the same future income stream is unfair and constitutes double dipping.

Attorneys should be aware of double dipping situations in which the amount of owner compensation used in calculating business value is different from the amount used to calculate spousal support. This problem arises when the business-owning spouse earns compensation that is above the market rate for his or her position, which is common in closely held businesses. During the valuation process, an appraiser makes normalizing adjustments to a company's income statement, such as adjusting owner compensation to reflect fair market value, and adds the difference back to the company's earnings. This results in a higher valuation, which is then divided between spouses. If the owner's actual salary is used to calculate spousal support rather than the adjusted rate used to value the company, then double dipping has occurred. Essentially, the difference between actual and adjusted compensation was already awarded during the equitable distribution of the business asset.

Jurisdiction should be considered in double dipping arguments. In business valuations relating to divorce, certain states treat goodwill differently than others, while others reject the concept of double dipping altogether. Most states generally recognize the difference between personal goodwill (associated with the individual/owner), and enterprise goodwill (associated with the entity itself). However, certain states disagree on what types of goodwill are considered marital property. In theory, excluding personal goodwill from marital property would prevent double-dipping from occurring. Attorneys should review case law to determine how courts in a particular jurisdiction have treated goodwill in similar cases.

Preventative Measures

While it may be unpleasant to think about divorce, the unfortunate truth is that the divorce rate is greater than 50%. When a couple jointly owns a family business, divorce can cause severe financial implications for each spouse and the company. The emotional and financial burden created by divorce can impact an owner's ability to manage the business and adversely affect productivity, profitability, and employee morale. To protect themselves and their futures, couples should take measures to minimize the stress and cost associated with divorce.

Most disagreements in marital disputes involving businesses occur due to a lack of clarity on how to divide the asset. A shareholder agreement can help a couple minimize the impact of the divorce on the company by defining certain guidelines to follow in the event of a divorce. Provisions in these agreements can establish mechanisms for valuing each spouse's interest in the company under certain circumstances, assign ownership in the event of a divorce, and include restrictions on the transfer of ownership. Prenuptial agreements can also help couples determine how the business asset should be divided.

Owners should consult with their attorneys to draft such agreements and to understand how such agreements are enforced by the court in divorce proceedings. While it is best to implement such agreements early in the life of a business partnership, they should be continually updated to reflect current business conditions. Being proactive before a divorce is imminent can help each spouse make better decisions.

Fraud & Forensics

A business-owning spouse may be so inclined to protect his or her own financial interests that he or she may commit fraud. A business owner going through a divorce may attempt to conceal or transfer assets, understate revenue, or overstate expenses. If you or a client suspects such behavior, you may also require the assistance of a forensic accountant. As we discussed in a previous article, these experts can help you develop a profile of the marital unit and interview each spouse then conduct a thorough investigation into the alleged fraud.

[1] IRS Revenue Ruling 59-60