Extensive work on this chapter was done by Noah J. Gordon, legal counsel for Shannon Pratt Valuations. Gordon is a regular contributor to valuation and legal publications.
While there are many reasons for which business valuations are performed, the various courts’ positions on how a valuation should be performed are the least settled in the area of marital dissolution. This is especially true in terms of different approaches from one state to another, but there are also inconsistencies within states. Even when there is general agreement on broad approaches, the courts still take contradictory positions on many issues. Courts have a very high degree of discretion, into which appellate courts are reluctant to intrude.
At the core of the differences among jurisdictions on how to value businesses or practices for marital dissolution is the appropriate standard of value. There can be many definitions (and interpretations of definitions) of value. Unfortunately, in most states, the definition of value for marital dissolution purposes is not clearly spelled out, leaving much room for interpretation. The lack of clear definitions and interpretations challenges appraisers and lawyers to work together to assist the courts in creating some sound precedential case law that will clear up much of the existing confusion.
Family law courts sometimes use a fair value standard of value that can be inferred from the language and rulings in the case. When this standard is used, it usually is not intended to be synonymous with “fair value” as used in dissenting stockholder actions, although some marital dissolution decisions have expressly referred to the fair value standard used in shareholder oppression and appraisal actions. Rather, it usually means something akin to fair market value with some (usually not well defined) modifications. Some traits characteristic of fair value cases are that distributions are made on a pro rata share of enterprise value with no discounts1; there are no “shareholder-level discounts” such as discounts for lack of marketability or lack of control; some element of goodwill is included, but discounts are disallowed.
Some states, such as Florida, Hawaii, Illinois, Missouri, Pennsylvania, South Carolina, Texas, and Wisconsin, adhere quite strictly to the standard of fair market value, the price at which the property would change hands between well-informed, willing buyers and sellers on an arm’s-length basis. Some states, such as Arkansas2 and Louisiana,3 mandate this standard by statute for the valuation of certain types of marital property. Those espousing the fair market value standard say that it is unfair to value the property that one spouse will receive at more than that spouse could actually realize in a sale. Other states adhere to the concept of value to the owner, reflecting whatever special circumstances may make the property more valuable to that owner than to someone else. Although the courts are not consistent in what they call this value, both business appraisers and real estate appraisers call it investment value.4 States that have used an investment value standard of value include Arizona, California, Colorado, Kentucky, Michigan, Montana, Nevada, New Mexico, North Carolina, and Washington (however, such use has not precluded the application of other standards in these states). Depending on the owner’s special circumstances, this value could be much higher than the value to other investors.5 The rationale for this position is that if a sale is not imminent, the question of how much the property would bring is irrelevant. States do not have totally consistent positions on this critical issue.
The court, the lawyer, and the appraiser should all be wary that there are many case decisions in family law that use the term “fair market value” but then actually take positions that are not consistent with fair market value as defined in Chapter 1 and in the tax court case law. Therefore, when seeking precedential case law guidance, it is necessary to read the entire opinion to see what valuation procedures were actually accepted.
Business appraisers who have been active in valuations for marital dissolution have debated the issue of the appropriate standard of value. Alan Zipp advocates that the value should be “current value to the marital community in the hands of the present owner.”6 David Bishop and Steven Schroeder counter as follows:
The relevant point to the court should be the amount the business assets could bring in cash or cash equivalent at the appropriate date. The point of whether or not the business or any other asset will actually be sold is beside the point. In fact, there is a sale of sorts which occurs within the dissolution. The net effect of the separation of marital assets is that each spouse purchases a (let’s assume) 50 percent interest in certain assets from their spouse and pays for the purchase by selling back their 50 percent interest in other assets. The transfers occur and the marital assets are separated. The end result is not substantially different than when both spouses agree jointly to each sell a marital asset and divide the funds received. The primary difference is they are the buyers and sellers: there are no outside parties involved, and the mode of payment is the exchange of interests in the marital assets.7
Bishop and Schroeder make the point that marketability discounts should be recognized, as in the tax court, because one spouse usually gets liquid assets while the other lacks the flexibility and safety of being able to “cash out” readily. They also make the point that “underlying principles are much more consistent and broadly accepted” under the fair market value standard than they are in marital dissolutions not using fair market value. This sentiment has been echoed by others.8
If the standard of value is fair market value, then goodwill should be a marital asset only to the extent that it is transferable. Furthermore, if the state does not allow proceeds from future activities of the spouse (or restrictions on future activities) to be a factor in property division, then goodwill should have to be transferable without requiring either an employment agreement or a noncompete agreement in order for it to be given value for marital asset purposes. Most state statutes contain language to this effect, but case decisions often ignore it.
Typical of language among states using the fair market value standard is the following:
When dividing and distributing the value of the property of the parties in a divorce case, the relevant value is, as a general rule, the fair market value (FMV) of the parties’ interest therein on the relevant date. We define the FMV as being the amount at which an item would change hands from a willing seller to a willing buyer, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.
We disagree with the position advanced by Wife, and In re Marriage of Fleege, 91 Wash. 2d 324, 588 P.2d 1136 (1979), that the relevant value of a sole professional business is its value to the professional who operates it. Other assets are, as a general rule, valued at their FMV. We know of no valid reason why sole professional businesses should not be valued at their FMVs.9
One of the states acclaiming fair market value as the standard of value in marital property distributions is Wisconsin.10 Nevertheless, at least one Wisconsin case included goodwill in the value of an accounting practice, even clearly recognizing that the spouse would have to execute a noncompete covenant to realize that goodwill in a sale.11 If the standard were strictly fair market value of the practice, the value of the noncompete covenant should be separate property and carved out of the total value.
A key issue regarding the premise of value is whether the business should be valued on a going-concern basis or on a liquidation basis. In Sommers v. Sommers,12 the wife’s expert valued the husband’s orthodontic practice on a going-concern basis, whereas the husband’s expert used a liquidation value. The trial court accepted the husband’s valuation, but, on appeal, the North Dakota Supreme Court reversed, finding no evidence that the husband intended to sell the practice. In Bausano v. Bausano,13 the husband’s expert claimed that liquidation value was the appropriate premise of value because the company had operated at a loss in recent years.
The court rejected this approach and found the valuation of the wife’s expert more credible because it used replacement value and valued the business as a going concern. The court found that the business had potential, especially since the husband had indicated that he was planning to focus his efforts on the business once the divorce was final. In Hoverson v. Hoverson,14 the court rejected liquidation value for valuing a farm that had losses of about $1 million, finding that the assets had value to the farm as long as it continued in business. The court indicated that the business had to be valued as a going concern despite its current financial condition.
Some states consider appreciation in a premarital asset as a marital asset, whereas others do not. Of the many states that do, some hold that whether the appreciation will be considered a marital asset depends on whether the increase will have resulted from the natural growth of the business (separate property) or from an individual’s management skills (marital property).15
In some, the appreciation is marital if it results from either spouse’s efforts.16 Sometimes it is not clear whether appreciation has resulted from “active” efforts or merely market forces; if the latter, the appreciation will be held not to be a marital asset.17 Also, courts have held that the party seeking to characterize appreciation as “active” must prove that marital efforts have resulted in the appreciation.18
There are many possible dates that can be used for the valuation date in marital dissolutions. Many courts use the date of trial as the valuation date.19 Some use a date as near as possible to the final divorce decree.20 The effective date in some cases is the date the complaint was filed.21 Some use the date of separation.22 Also, trial courts may exercise discretion in determining valuation dates,23 and when selecting a valuation date for marital dissolution purposes, the date can be different for different assets.24
Courts in some states have considerable discretion in choosing the valuation date. Where the valuation date is not set by law or not declared by the court, the valuation expert may need to be prepared to testify to a value as of two or more valuation dates.
The classic concept of goodwill is the propensity of customers to return. If this propensity is due to the practitioner, it is often called personal goodwill or professional goodwill. If it is due to other factors (such as location) not dependent on the individual practitioners, it is often called practice goodwill or enterprise goodwill. Some definitions of goodwill include all intangible value, not just the persistence of the customer base.
A key issue in marital dissolution cases involving goodwill valuation is whether it is necessary to distinguish between personal goodwill and enterprise goodwill, and if such a distinction is necessary, which type of goodwill is a marital or distributable asset. A number of courts, but not a majority, make no distinction between personal and enterprise goodwill. These jurisdictions have taken the position that both personal and enterprise goodwill in a professional practice constitute marital property. A minority of courts have taken the position that neither personal nor enterprise goodwill in a professional practice constitutes marital property.
The majority of states differentiate between enterprise goodwill and personal goodwill. Courts in these states take the position that personal goodwill is not marital property but that enterprise goodwill is marital property. In many states, professional goodwill is an element of marital property value even if it is not transferable. Some states have not issued a decision on whether types of goodwill must be distinguished. For a comprehensive state-by-state guide of the treatment of goodwill in marital dissolution cases, see “Goodwill Hunting in Divorce.”26
This section explores representative positions taken in various decisions on this issue. As you will see, the decisions sometimes seem to be inconsistent with the stated definition of value. It presents a challenge to the appraisers, lawyers, and courts to make the treatment of goodwill consistent with the espoused definition of value.
A case widely cited that details the factors to consider when calculating the value of professional goodwill in a divorce is the California case Lopez v. Lopez.27 These factors are the following:
1. The age and health of the professional
2. The professional’s demonstrated past earning power
3. The professional’s reputation in the community for judgment, skill, and knowledge
4. The professional’s comparative professional success
5. The nature and duration of the professional’s practice, either as a sole proprietor or as a contributing member of a partnership or professional corporation28
An excellent summary and analysis of the extremes of various states’ positions on goodwill in a professional practice as a marital asset is found in a decision by the supreme court of Missouri, sitting en banc and issuing the decision without dissent:
The husbands in the consolidated cases are the sole partners in an oral surgery partnership. In Hanson v. Hanson, the Circuit Court of Boone County valued the partnership at $324,862, including $233,727, an amount characterized as “goodwill” by the parties. In Graham v. Graham the Circuit Court of Cole County, hearing virtually identical evidence, valued the same partnership at $90,280. …
In addressing the question of the existence and value of goodwill in a professional context as marital property, the courts have not spoken with a uniform voice.
In Dugan v. Dugan, 92 NJ 423, 457 A.2d 1 (1983), the New Jersey Supreme Court found that goodwill in the law practice of a sole practitioner is property subject to distribution in a dissolution action. The court recognized that reputation is “at the core” of any consideration of professional goodwill (457 A.2d at 6). While acknowledging that future earning capacity is not per se goodwill, the New Jersey justices noted that when “future earning capacity has been enhanced because reputation leads to probable future patronage from existing and potential clients, goodwill may exist and have value.” Id. Dugan has been criticized, and properly so in our view, for its failure to distinguish between the reputation of the professional as an individual and the reputation of the professional practice as a business entity.
In the Matter of the Marriage of Fleege, 91 Wash. 2d 324, 588 P.2d 1136 (banc 1979), the Washington Supreme Court defined the critical question as “not whether the goodwill of the practice could be sold … but whether it [the goodwill] has value to [the practitioner]” (588 P.2d at 1138–39). In determining the value of such goodwill, Fleege outlined several factors for consideration: “The practitioner’s age, health, past earning power, reputation in the community for judgment, skill and knowledge, and his comparative professional success” (588 P.2d at 1138). Each of these factors is, in our view, directly attributable to the professional as a person. For this reason, we find that the Fleege analysis is mired in the same mixture of personal reputation and entity reputation as is found in Dugan.
Several courts have refused to acknowledge professional goodwill as property. A leading case is Holbrook v. Holbrook, 103 Wis. 2d 327, 309 NW2d 343 (App. 1981). There the court refused to follow “the twisted and illogical path that other jurisdictions have made in dealing with the concept of professional goodwill in the context of divorce.” The court continued, “If the concept of professional goodwill evanesces when one attempts to distinguish it from future earning capacity, … the goodwill or reputation of such a business accrues to the benefit of the owners only through increased salary,” 309 NW2d at 354. See also Powell v. Powell, 231 Kans. 456 646 P.2d 218, 223 (1982). (“We are not persuaded that a professional practice such as Dr. Powell’s has a goodwill value. The practice is personal to the practitioner. … It is totally dependent upon the professional.”) Nail v. Nail, 486 SW2d 761 (Tex. 1972), reaches a similar result.
Between the opposing results reached in Dugan and Holbrook, several courts have attempted to chart a course which recognizes that goodwill is marital property, but only insofar as it exists independently of the individual professional’s reputation. Characteristic of these cases is Taylor v. Taylor, 222 Neb. 721, 386 NW2d 851 (1986). There the Nebraska Supreme Court concluded that “goodwill must be a business asset with value independent of the presence or reputation of a particular individual, an asset which may be sold, transferred, conveyed, or pledged. … If a party produces appropriate evidence establishing salability or marketability of goodwill as a business asset of a professional practice, professional goodwill may be considered in determining the value of property in a marital estate to be divided in a dissolution proceeding” (Taylor, 386 NW2d at 858–859). …
As we have said, goodwill is recognized as property in this state; that recognition is not dependent on a traditional mercantile setting. Goodwill may exist in both commercial and professional entities. Irrespective of the setting in which it is found, the meaning of goodwill does not change. It is property which attaches to and is dependent upon an existing business entity; the reputation and skill of an individual entrepreneur—be he a professional or a traditional businessman—is not a component of the intangible asset we identify generally as goodwill.
With the caveats which follow, we hold that goodwill in a professional practice acquired during a marriage is marital property subject to division in a dissolution of marriage proceeding. We define goodwill within a professional setting to mean 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.
Professional goodwill may not be confused with future earning capacity. We have not declared future earning capacity to be marital property.
Proof of the existence of goodwill is particularly troublesome in a professional context. This difficulty is a product of the fact that the reputation of the individual practitioner and the goodwill of his enterprise are often inextricably interwoven. Because of the difficulties inherent in separating the reputation of the professional from that of his enterprise, evidence that other professionals are willing to pay for goodwill when acquiring a practice is, in our view, the only acceptable evidence of the existence of goodwill. Thus, as a matter of proof, the existence of goodwill is shown only when there is evidence of a recent actual sale of a similarly situated professional practice, an offer to purchase such a practice, or expert testimony and testimony of members of the subject profession as to the existence of goodwill in a similar practice in the relevant geographic and professional market. Absent such evidence, one can only speculate as to the existence of goodwill. Divisions of marital property may not be based on speculation as to the very existence of the property being divided. …
The fair market value method is most likely to avoid the “disturbing inequity in compelling a professional practitioner to pay a judicially determined value that could not be realized by a sale or another method of liquidating value” (Holbrook, 309 NW2d at 355). We therefore reject the notion advanced by some courts that goodwill may exist and be subject to division in a dissolution proceeding even though it may not be sold.29
A case representative of the majority position is May v. May.30 In that case, the Virginia Supreme Court, ruling on an issue of first impression in that state, held that trial courts in marital dissolution cases must distinguish between personal and enterprise goodwill in a professional practice and that personal goodwill is not a marital asset but enterprise goodwill is. The court specifically noted that enterprise goodwill can exist in a professional practice that is operated as a sole proprietorship. The court also stated that this holding was consistent with its prior ruling that a professional degree or license is not marital property because it represents the future earning capacity of the professional spouse. Likewise, personal goodwill represents the future earning capacity of the professional spouse.
A case representative of the position that either personal goodwill or enterprise goodwill is a marital asset is Stewart v. Stewart,31 in which the Idaho Supreme Court held that “where a professional business is an independent entity, … goodwill is calculable and divisible in divorce just as goodwill in any other business.” In doing so, the court declined to enter the “morass” of trying to distinguish between the values attributable to a professional practice by virtue of the individual attributes of the professional and the value of the goodwill not attributable to those personal assets, valuing each separately and then dividing the latter but not the former. A strong dissent argued that because the majority had held that a professional’s personal attributes—including knowledge, skill, reputation, and so on—are not divisible community property, the court should have required the parties to distinguish whether the husband’s ability to earn above-average income was based on his personal attributes or “some other factor.”32
Once a court has determined whether to distinguish between personal and enterprise goodwill, the issue becomes how to do so. Indiana’s Yoon v. Yoon33 exemplifies a case in which a court attempted to distinguish personal and enterprise goodwill in a professional corporation. The court ruled that to determine if any goodwill should be included in a marital estate, there must be a determination as to what portion of it is attributable to the individual and the value of that portion must be excluded from the estate. In its decision, the court made the following statement to explain that enterprise goodwill is subject to equitable distribution, whereas personal goodwill can affect only the relative distribution of property:
Before including the goodwill of a self-employed business or professional practice in a marital estate, a court must determine that the goodwill is attributable to the business as opposed to the owner as an individual. If attributable to the individual, it is not a divisible asset and is properly considered only as future earning capacity that may affect the relative property division. In this respect, the future earning capacity of a self-employed person (or an owner of a business primarily dependent on the owner’s services) is to be treated the same as the future earning capability and reputation of an employee.
On the basis of Yoon, Bobrow v. Bobrow34 discussed the enterprise goodwill of the accounting firm Ernst & Young (E&Y). The husband, E&Y’s global CEO, had a partnership interest in a division of the accounting firm E&Y. Although there was a partnership agreement limiting the owner’s interest to the value of the capital account, thereby excluding goodwill, the husband conceded that the agreement applied only to a transaction of his partnership interest (resignation, retirement, or death). The court recognized that the assets of E&Y were not personal to the partner but, rather, belonged to the institution of which each partner had a share. These institutional assets included such intangible assets as E&Y’s trade name; the entity’s favorable business reputation and name recognition; methods and tools for conducting its business; and its relationships with suppliers. All these items were transferable to an outside purchaser.
This case, therefore, contrasted with Yoon, in which all these assets were associated with the doctor himself rather than the entity, and the court found that they could not be transferred to another individual. Ultimately, the court included the value of enterprise goodwill in valuing E&Y and awarded the wife a share of the value of the husband’s partnership interest in E&Y based on his pro rata share of the value of the enterprise.
A method developed by David Wood that has been accepted in some courts to calculate the enterprise and personal components of goodwill in the valuation of a professional practice is called the multiattribute utility model (MUM). This model involves several steps. First, the valuator sets forth an objective. Next, the valuator establishes “alternatives.” An alternative is a “range of percentages” that will define the choices “in which the method will result.” Each alternative is then assigned a “range.” After the objective and the alternatives are set, the valuator must then define the “attributes,” which are elements of goodwill to which the valuator must assign a value. Examples of attributes are personal reputation and business location.35
Another issue that may arise in valuing goodwill is the best method to do so. There are four major formulas that are used in valuing goodwill:
1. The straight capitalization accounting method
2. The capitalization of excess earnings method
3. The IRS variation of capitalized excess earnings method (based on Revenue Ruling 68-609The market value approach
4. The buy-sell agreement method36
Of these, the excess earnings method is the most commonly used; some courts find that the market value approach and buy-sell agreement methods are easily manipulated by the professional spouse. The capitalization of the excess earnings method focuses on the earning power of the business to determine what rate of return the predicted earnings will yield in light of the risks involved to attain them. Broadly put, the excess earnings approach is predicated on a comparison of the earnings of the spouse in question with that of a peer whose performance is average.
To make this comparison, courts may, among other things, determine the annual salary of a typical salaried employee who has had experience commensurate with the spouse who is the sole practitioner or sole owner-employee. Alternatively, courts may apply the similarly situated professional standard, under which reasonable compensation is based on the cost of hiring a nonowner outsider to perform the same average amount with which other people are normally compensated for performing similar services. Although not binding, compensation surveys may be used by experts and trial courts as guidelines for determining the reasonable compensation of a practitioner’s peers. To be relevant, however, the surveys must account for similarly situated professional practices and practitioners.37
Other cases have clarified that personal goodwill and enterprise goodwill can be a part of going-concern value but that going-concern value and goodwill cannot be the same because the latter is subsumed within the former. Going-concern value is the intangible value attached to the physical assets of the business, including the business’s fixtures, equipment, and its assemblage of personnel, as well as goodwill.38
Several courts, in attempting to determine what constitutes goodwill, have ruled that goodwill is indistinguishable from earning capacity, which is not a distributable asset.39 Other courts have ruled that goodwill is separate from earning capacity where the professional’s interest in a practice is transferable and separable from reputation.40 In such instances, it must be proved that goodwill is separate from earning capacity to avoid double-counting the same asset. Still, other courts view goodwill as supplementing earning capacity, rather than merging with it.41
A related issue is whether enhanced earning capacity, which is an individual’s ability to earn over and above what would be earned following a “normal” career path that results from enhancements, such as a degree, license, training, specialized knowledge, unique talent, and so on, should be considered goodwill that is a marital asset. Some states, such as New York42 and New Jersey43 recognize celebrity status or celebrity goodwill as marital property. This concept of goodwill is based on the enhanced earnings capacity of a celebrity. Only New York recognizes licenses or degrees as marital assets the value of which must be distributed.44
Another goodwill valuation issue is the degree to which goodwill inheres in a noncompete agreement. It is sometimes difficult to determine the value that should be assigned to a practice’s goodwill and the value that should be assigned to a noncompete agreement.45
Yet another issue, discussed at greater length in a section that follows, is that of double-counting, or double-dipping. This issue arises when a court in a matrimonial dispute considers excess earnings (or other factors that assume continued involvement by the operating spouse) in determining the value of a business as well as in setting alimony. This issue arises more frequently in those jurisdictions that hold that personal goodwill is a marital asset.
The California Business and Professions Code Section 14100 defines goodwill as “the expectation of continued public patronage.” However:
The philosophy of the community property system is that a community interest can be acquired only during the time of the marriage. It would then be inconsistent with that philosophy to assign to any community interest the value of the postmarital efforts of either spouse (In re Marriage of Fortier [1973] 34 Cal. App. 3d 384, 109 Cal. Rptr. 915). Since a community interest can only be acquired during the time of the marriage, the value of the goodwill must exist at the time of the dissolution, and that value must be established without dependence on the potential or continuing net income of the professional spouse (In re Marriage of Fortier, supra; In re Marriage of Foster (1974) 42 Cal. App. 3d 577 at 582, 117 Cal. Rptr. 49).46
A seemingly internal contradiction, which has also been referred to as the “market value of goodwill paradox”47 is prevalent in family law case decisions. Courts espouse the position that the valuation of a business or practice should not be dependent on future efforts (or restrictions on future efforts) of the operating spouse. Having said this, the same courts often go on to accept appraisal methodology that, in fact, reflects earnings that could be achieved only if the operating spouse continued in the business or practice.48
A buy-sell agreement is a contract between an owner and the company, or between two or more owners, describing the conditions under which one party may (or must) sell his or her interest to the other. The agreement normally incorporates a price, or a mechanism for determining the price, for such a sale. As such, the buy-sell agreement price is the price that the spouse could realize on withdrawal from the partnership or corporation.
From the company’s viewpoint, the agreement provides control over who will be involved in ownership. From the owner’s viewpoint, the agreement usually provides liquidity if he or she leaves the company, or for the owner’s estate in the event of death.
A frequent issue is whether a buy-sell agreement price is controlling for marital property valuation. Some courts hold that the price is controlling.49 Others, especially in states where professional (personal) goodwill is a marital asset, find that the buy-sell agreement price generally is not binding. A Washington case is typical of this position:
Professional goodwill has been recognized in Washington as intangible property subject to division in a marital dissolution (Hall, at 238–239, 692 P.2d 175). The important consideration is not whether the goodwill could be sold without the personal services of the professional, but whether it has value to him. In re Marriage of Fleege, 91 Wash. 2d 324, 327, 588 P.2d 1136 (1979) (goodwill of husband’s solo dental practice was a community asset).
Both parties cite cases from other jurisdictions as authority. Some cases hold the nonshareholder spouse should be bound by the buy-sell agreement or that the buy-sell agreement should at least be considered. Hertz v. Hertz, 99 N.M. 320, 657 P.2d 1169, 1174 (1983) (a nonshareholder spouse was bound by the goodwill valuation clause in corporate bylaws for purposes of establishing the valuation of corporate goodwill in a dissolution action. This ensured that the nonshareholder spouse did not receive a greater value than the shareholder.). See also In re Marriage of Ondrasek, 126 Wis. 2d 469, 377 NW2d 190, 192 (Ct. App. 1985) (in a dissolution, value of a partner’s interest in a professional partnership is determined by the monetary consequences of that partner withdrawing from the business); Holbrook v. Holbrook, 103 Wis. 2d 327, 309 NW 2d 343, 355 (Ct. App. 1981) (capital account was the only value that should be assigned to a lawyer’s partnership as an asset where lawyer was entitled to receive only his capital account value on withdrawal and any goodwill is reflected in his salary which can be considered in setting the family support award); and Hanson v. Hanson, 738 SW2d 429, 436 (Mo. 1987) (value of goodwill of professional practice, subject to division in dissolution proceeding, is determined by the price the practice would bring if sold on open, relevant market to qualified professional; under certain circumstances value may be established by buy-sell agreement).
Other courts have held that the nonshareholder spouse is not bound by the terms of the withdrawal agreement and in some cases, even where the nonshareholder spouse cosigned the withdrawal agreement. In re Marriage of Slater, 100 Cal. App. 3d 241, 160 Cal. Rptr. 686 (1979) (on theory withdrawal agreement was not signed for dissolution purposes); Mitchell v. Mitchell, 152 Ariz. 317, 732 P.2d 208, 210 (1987) (partnership agreement provided that no value was to be placed on goodwill of the firm; however, it did contain provisions for payments to a partner upon retirement or death which were not limited to the firm’s tangible assets and accounts receivable, but included a share of net profits for a limited period. A buy-sell agreement had been considered in establishing the valuation of goodwill, but was not dispositive. At best it created a presumptive value which either spouse could rebut); Stern v. Stern, 66 N.J. 340, 331 A.2d 257, 260, 74 L.R.3d 613 (1975) (of the four payment plans found in the partnership agreement applicable to a partner who withdraws from a firm, becomes disabled, dies or retires, the formula applicable on a partner’s death is presumptively the value to be used in dissolution; here, the partner was entitled to the value of his capital account plus a fixed sum appended to the partnership agreement which was revised quarterly). But cf. Rogers v. Rogers, 296 NW2d 849, 852–53 (Minn. 1980) (it was reversible error not to consider the terms of the buy-sell agreement which create contingencies that affect the value, such as the possibility the shareholder might die or be disabled before he realizes the full value of his interest).
Our state has not considered whether a buy-sell agreement not made in close proximity to a divorce is binding on the nonshareholder spouse in a dissolution action. Hall did not reach this issue but held that, at least in some circumstances, buy-sell agreements are not binding in a dissolution action. In light of Hall and Fleege (that it makes no difference whether the goodwill can be sold) we hold the court did not err in valuing goodwill even though it was assigned no value in the Brooks & Larson, P.S. corporation bylaws.50
In the above case, the spouse had practiced law for 4 years before the marriage and 13 years since. The court decided that the interest in the practice that the husband had bought (and that was subject to the buy-sell agreement) was separate property and that his goodwill (valued at $93,115 by the excess earnings method) was community property.
Sometimes a buy-sell price may be a factor to be considered but not as a completely controlling factor.51 In one case the husband purchased stock, subject to a buy-sell agreement, for $65,567 from funds he borrowed from his mother. In three years, the stock paid $251,000 in dividends, and the buy-sell formula price increased to $82,000. In rejecting the trial court’s valuation at the buy-sell price, the court of appeals explained:
It is unreasonable to assume the value of the stock to Darrell was only what he could sell it to the company for, in light of the fact it was producing such generous dividends. It stretches the bounds of reasonableness to value a goose for slaughter price when it lays golden eggs.52
The appellate court declined to value the stock at $1.6 million, as claimed by the wife’s expert based on capitalization of earnings, but it did award the wife an additional $40,000 representing her interest during the marriage.
One case that rejected a buy-sell agreement price as controlling the value of a minority interest noted the following:
• There was evidence that another family member had been bought out at a price that exceeded the value set by the buy-sell agreement.
• The buy-sell agreement was taken into consideration to some extent by the expert’s reduction of 35 percent in value for minority interest and lack of marketability.53
Similarly, in another case where the stock was subject to a buy-sell agreement at book value, the court “decreased the unrestricted fair market value substantially more than it increased the book value to arrive at a valuation for purposes of the marriage dissolution.”54
Another case summarized the most typical position:
A majority of courts which have considered a buy-sell agreement in a closely held corporation setting the stock value for equitable distribution purposes has determined that such agreement should not be considered as binding, but rather should be weighed along with other factors in making a determination as to the value of such stock. E.g., In re Marriage of Melnick, 127 Ill. App. 3d 102, 82 Ill. Dec. 228, 468 N.E.2d 490 (1984); In re Marriage of Moffatt, 279 N.W.2d 15 (Iowa 1979); Rogers v. Rogers, 296 N.W.2d 849 (Minn. 1980); Bowen v. Bowen, 96 N.J. 36, 473 A.2d 73 (1984); Amodio v. Amodio, 70 N.Y.2d 5, 516 N.Y.S. 2d 923, 509 N.E.2d 936 (1987); In the Matter of the Marriage of Belt, 65 Ore. App. 606, 672 P.2d 1205 (1983); Bosserman v. Bosserman, 9 Va. App. 1, 384 S.E.2d 104 (1989); Arneson v. Arneson, 120 Wis. 2d 236, 355 N.W.2d 16 (Wis. Ct. App. 1984). It is apparent that buy-sell agreements in a closely held corporation can be manipulated by the shareholders to reflect an artificially low value. This is why caution should be exercised in accepting their value for equitable distribution purposes.55
In a Washington case involving a minority interest in an insurance agency, the court did find the buy-sell agreement price controlling. The court noted that the minority status was not likely to change, there was no evidence that the company was likely to be sold, and it was reasonable to conclude that if the husband were to sell his stock, he would do so subject to the buy-sell agreement formula.56
Buy-sell agreements involving key persons often are funded with life insurance benefits payable to the designated purchaser under the agreement, providing liquidity to exercise the buy-sell agreement in the case of the death of the owner of the interest. The amount of the “key man” insurance is sometimes presented as evidence of the partners’ idea of the value of the interest. Such evidence could be supportive of an appraised value, at best, but it is certainly no substitute for an appraisal.
In almost any situation where a buy-sell agreement is taken into consideration, the extent to which the agreement was entered into on an arm’s-length basis should also be considered.
A covenant not to compete or noncompete agreement is a contract preventing an individual (or group of individuals) from competing with a given entity or person. In some cases, some partnerships or corporations require entering into a covenant not to compete as a condition of ownership. The covenant usually enhances the value of the entity by reducing the risk of certain individuals taking away business.
Treatment of an actual or prospective covenant not to compete is controversial. Most courts take the position that such a covenant restricts the postmarital activities of the spouse, and therefore is separate rather than marital property.57 Others find that such covenants are marital property.58 Still others hold that adjustments for hypothetical noncompete agreements are impermissible, even though comparable transactions include such agreements of similar duration, where the appraiser does not present evidence on the nature of such agreements or their impact on value.59
A covenant not to compete, by definition, restricts the postmarital efforts of the spouse. In most jurisdictions, this would be considered a nonmarital asset. If the analyst uses the market approach to value the business or practice and the comparable sales include covenants not to compete, it could be argued that the value of the covenants should be deducted from the comparable company or practice sales before they are used for comparison. However, most family law courts seem to ignore this factor.60
A minority interest usually is worth significantly less than a pro rata share of the value of the entity as a whole. This is because a control owner can make many decisions that a minority owner can’t—decisions that can affect both the value of the company as a whole and also the relative values of the controlling versus the minority interests.
Therefore, if the valuation methodology produces a controlling interest value, and the interest being valued is minority, a minority interest discount, also known as a discount for lack of control (DLOC), usually would be applied. Also, since minority interests usually are harder to sell than controlling interests, the minority interest discount might be compounded by also subtracting a discount for lack of marketability (DLOM).
A frequent issue is whether a minority discount should be applied (and if so, how much) if the interest owned is less than controlling.
In one case, an expert for the husband testified that a 15 percent minority discount was appropriate for a 50 percent interest. An expert for the wife testified that no minority discount was appropriate in a divorce settlement context because generally there is no change of ownership. The court rejected the wife’s expert’s opinion, with several references to decisions in other states:
We reject [wife’s expert’s] view as a matter of law. The concept of value is keyed to the price that a prospective buyer would pay. Moffitt v. Moffitt, 813 P.2d 674 (Alaska 1991). Sherwin’s testimony runs counter to this concept. We also note that courts in many jurisdictions have recognized that a minority discount is frequently appropriate in divorce proceedings. See Arneson v. Arneson, 120 Wis. 2d 236, 355 N.W.2d 16, 22 (App. 1984) (not clearly erroneous for trial court to apply minority discount); In re Marriage of Jorgensen, 180 Mont. 294, 590 P.2d 606, 610 (1979) (not an abuse of discretion to apply minority discount); In re Marriage of Belt, 65 Ore. App. 606, 672 P.2d 1205, 1207–08 (1983) (trial court’s valuation modified to include minority discount where the only credible evidence produced at trial favored discount); In re Marriage of Reiling, 66 Ore. App. 284, 673 P.2d 1360, 1364, 1365 (1983) (same); In re Marriage of Hoak, 364 N.W.2d 185, 192–93 (Iowa 1985) (no error to apply minority discount, but discount allowed by the trial court was too large and must be reduced); Bowen v. Bowen, 96 N.J. 36, 473 A.2d 73, 76–77, 81 (1984) (trial court should appoint independent expert to advise it in deciding whether to apply minority discount).61
In one case the minority interest discount was eliminated because the minority owner had a purchase right that would enable him to obtain control of the corporation sometime within the next 7 to 10 years.62 There have been many marital dissolution cases that have accepted discounts for lack of control63 and many that have not.64
As with discounts for lack of control, many courts in marital dissolution cases have accepted discounts for lack of marketability,65 whereas many have not.66 In one case, the court ruled that discounts for lack of marketability are not precluded as a matter of law in marital dissolution cases.67
In many cases the marital estate owns property that is worth more than its cost basis. In this case, if the marital estate (or one of the spouses) were to sell the property, it would be subject to paying federal capital gains taxes. This is a liability called trapped-in capital gains.
Whether to consider tax liabilities that would be triggered by the sale of assets is one of the most common issues in marital property divisions. For the most part, family law courts have been unwilling to make any allowance for trapped-in capital gains on appreciated property unless a sale of the property is imminent.69 Since family law courts often take tax court positions into consideration, perhaps the tax court’s sharp turnaround on this issue in 1998, directing reflection of trapped-in capital gains taxes in valuation will lead family law courts to give some consideration to this issue.
A Washington case is typical. The trial court adjusted the gross value of the parties’ interest in a real estate partnership from $119,049 to $101,000 to reflect the capital gains tax that would be paid if it were sold. The court of appeals reversed. The court noted, “There is no Washington case specifically addressing whether capital gains tax consequences should be a factor in determining the value of marital assets.” Thus the court looked to other states for precedent, citing cases in seven other states. The court then concluded:
Courts have generally found that consideration of tax consequences is either required or at least appropriate where the consequences are immediate and specific and/or arise directly from the court’s decree, but find they are not an appropriate consideration where speculation as to a party’s future dealings with property awarded to him or her would be required. … We agree with the rule adopted by most jurisdictions. … Mr. Hay testified at trial that he had no plans to sell his partnership interest. … We remand to enable the trial court to consider the property division without regard to the capital gains tax consequences of a hypothetical sale of H&L Investments.70
The practice of reviewing decisions from other states is very common. Typical of a decision reached after doing this is that the court should consider potential tax consequences in valuing marital assets only if the following is true:
1. The recognition of a tax liability is required by dissolution or will occur within a short time.
2. The party’s future dealings with the assets are definite enough that the court need not speculate.
3. The future consequences are definite enough that the court need not speculate, and the tax liability can be reasonably predicted.71
The courts usually factor in the tax consequences when it is clear that they will be triggered as part of the divorce action. However, a trial court ordered the husband to pay a mortgage, a car loan, and a cash judgment to the wife from the sale of at least one of two laundromats owned. The trial court reduced the marital estate by a $53,200 tax liability to be incurred on the sale of the laundromats. The trial court explained that although it did not specifically order the sale of the laundromats, sale was the only way that the husband could comply with the orders of the court. Nevertheless, the appellate court found that the sale of both laundromats was not an immediate consequence of the property disposition and that the trial court erred in reducing the marital estate by the amount of the tax liability.72
In an extreme denial of consideration of tax consequences, the property division mandated by the trial court had the effect of requiring the husband to liquidate his closely held business and turn the proceeds over to the wife to satisfy a cash award. Nevertheless, the court rejected the husband’s argument that the stock should have been valued at its liquidation value rather than its going-concern value because of the tax consequences, reasoning that to follow this argument would universally prevent a court from valuing property at more than cost because of tax consequences.73
There are, however, cases in which the tax consequences on sale have been deducted in valuing the marital estate, even when no immediate sale was contemplated. For example, in one case it was concluded that it was proper to deduct the amount of capital gains tax that the husband would have to pay on the anticipated sale of limited partnership interests. The wife objected to reducing the value by the impounded taxes, claiming that they were “hypothetical, speculative, imaginary, unfair, and arbitrary.” Evidence was introduced to show that the partnership was a tax shelter that would have lost its desirability in five to seven years and would probably be sold. The court concluded that the date of sale was not imaginary or hypothetical.
The court then offered an interesting broader statement that “partnerships ought to be reduced by future capital gains taxes” where the partnerships were investments that “were only valuable as long as other investments were not more desirable” and the husband “was more likely to sell his interest in the partnerships than die owning them” and would, therefore, incur a capital gains tax from the sale of the partnerships (emphasis added).74 From the viewpoint of a financial analyst, it is reasonable to think that this reasoning should apply to any investment asset.
Another interesting decision upholding subtraction of capital gains tax involved a commercial building. The appellate court held that the trial court did not abuse its discretion in subtracting the capital gains tax that would be incurred on sale, even though there was no evidence that the property was going to be sold. The court found that experts for both parties attested to the property’s fair market value and that the concept of fair market value assumes the sale of the property to an interested buyer. Thus, the court was reluctant to find any error by the trial court in presuming a sale of the real estate with its attendant tax consequences in order to value that marital asset.75 In another case, where the husband would effectively have been forced to purchase the wife’s shares in a company, the court permitted a credit for capital gains taxes.76
Some courts hold that tax consequences may be considered if the court determines that the property division award will force a party to sell the business to generate the cash needed to pay the court-imposed obligations.77
The holdings in these and similar cases suggest that if the sale of the assets is so remote a possibility as to eliminate consideration of the capital gains tax liability, the asset approach should not be the only primary valuation approach used. However, these holdings also suggest that perhaps an income approach would be more appropriate, or maybe an income approach blended with an asset-based approach.78
Trial courts have wide discretion in deciding factual matters, such as value, but appellate courts expect trial courts to have an adequate evidentiary basis for reaching their conclusions of fact.79 There is a considerable incidence of “expert” evidence at the trial court level being so inadequate that the appellate court has remanded the cases for new hearings and evidence on the value of a business or practice.80
This has usually meant that all the money and time spent on “experts” and the related lawyer fees have been wasted. This can be avoided if competent business valuation experts are retained to begin with, and the lawyer and expert work together to make a good record at trial—especially since courts tend to give significantly greater weight to the valuations of qualified, independent, business appraisers.81 This also means that the attorney must obtain the full cooperation of, and disclosure from, the client.82
It is common for an operating spouse to resist access to the records necessary for the nonoperating spouse’s expert to do a thorough valuation. Since the nonoperating spouse has a financial interest in the property, the lawyer can almost always get a court order compelling production of the information needed by the expert to do a thorough valuation. In a case that went all the way to the supreme court of Connecticut, a radiologist filed a motion to exclude the wife’s expert’s report and testimony because the report had not been produced prior to trial. The expert testified that the delay in preparing his report was attributable to a lack of cooperation on the part of the husband in failing to make the pertinent financial records available. In denying the motion, the court declared the following:
If anybody is playing cat and mouse, it’s the [husband]. … It is virtually frivolous for the husband to suggest that the court abused its broad discretion by failing to impose the sanction of excluding testimony because of delay in furnishing the report of an expert witness, after concluding that the delay was largely attributable to the husband’s failure to comply with the order for disclosure of his financial records.83
One of the most prevalent problems in family law cases involving a business or professional practice valuation is “double-dipping.” By double-dipping we mean computing a value based, at least in part, on the spouse’s future earnings for property division and then using the future earnings capacity as a basis for determining spousal support or alimony payments.
The potential for this problem arises when an income approach, an excess earnings method, or a market approach is used for the valuation. If these methods reflect an implication that the operating spouse will continue to operate, the value of that spouse’s future efforts is impounded, at least to some extent, in the distributive value. If payments are then ordered out of the earnings from that spouse’s efforts, double-counting is the potential result.
This problem is exacerbated in those jurisdictions that consider personal goodwill to be a marital asset. Personal goodwill is a function of future earning power resulting from persistence of patronage of the individual. If this value is fully reflected in the distributive asset, then this earning power is being used twice if it is the basis for future payments to the nonoperating spouse.
This problem can be avoided if the valuation methodology truly follows the philosophy of not being dependent on future efforts (or restrictions on efforts) of the operating spouse. However, as noted earlier, many court decisions espouse this philosophy, but they then accept a valuation methodology that actually incorporates an assumption of the operating spouse’s continuing efforts, or restrictions on those efforts.
In Steneken v. Steneken,84 the trial court determined that the husband’s annual compensation was excessive, and the court normalized the compensation in determining the value of his company using the excess earnings method. The court then determined alimony using the husband’s actual annual compensation—which was $50,000 more. The husband argued that distributing his excess earnings as the goodwill portion of the value of his business, and also considering it for alimony purposes, was impermissible double-counting.
The New Jersey intermediate appellate court ruled that the value of the business was as of the date of dissolution and was based on past excess earnings, whereas the alimony determination was based on future income. The court also noted that even if this was double-counting, it was not banned by New Jersey law, which bans only the double-counting of pensions.
The New Jersey Supreme Court expressly rejected the premise that because alimony and equitable distribution are interrelated, a credit on one side of the ledger mandates a debit on the other side. Instead, the court focused on the “bedrock proposition” that all alimony awards and equitable distribution determinations must satisfy basic concepts of fairness and that, although clearly interrelated, the structural purposes of alimony and equitable distribution are different.
Accordingly, the court rejected the husband’s assertions of double-counting, saying that the husband “mistakenly equates the statutory and decisional methodology applied in the calculation of alimony with a valuation methodology applied for equitable distribution purposes that requires that revenues and expenses, including salaries, be normalized so as to present a fair valuation of a going concern.” The court concluded that it is not inequitable to use a valuation method that normalizes salary in an ongoing closely held corporation for equitable distribution purposes, and to use actual salary received in calculating alimony—the valuation methodology chosen for equitable distribution purposes should not alter the alimony award. According to the court, the “interplay of those two calculations does not constitute ‘double counting.’” The ultimate judicial inquiry must be whether the ultimate result, both in toto as well as in its constituent parts, is fair under the circumstances and congruent with the standards set forth in the alimony and equitable distribution statutes. The court also rejected the distinction made by the appellate court between the fact that “valuation of the corporate asset was based on [the husband’s] past earnings, not his future earnings,” whereas “[the husband’s] actual current and future compensation may be treated as income for alimony purposes.”
Justice Long, in a dissenting opinion, agreed with the husband that the majority’s holding would allow the impermissible double-counting of income (albeit not dollar for dollar). Justice Long’s position was that the majority converted a certain amount of the husband’s projected future income stream into an asset and then calculated the amount of alimony based on that asset. According to Justice Long, this was improper because “[o]nce a court converts a specific stream of income into an asset, that income may no longer be calculated into the maintenance formula and payout.” Instead, Justice Long’s solution would have used the appellate court’s approach, which neither allows the unfettered dual use of a single income stream nor requires the use of the same figure for both calculations. “Rather, judges should be able to use the ‘real’ income for alimony and the ‘normalized’ income for the corporate valuation so long as the ultimate outcome recognizes that a single income source (the difference between the real and normalized income) played a part in both.”
It is arguable that, to the extent the court used excess compensation as the basis for alimony, the court used that money twice: once to value the distributed value of the business and again to determine the amount of alimony—a classic case of double-dipping.
In Sampson v. Sampson85 the value of the wife’s insurance agency was offset in the husband’s property distribution and then was counted as credit toward his alimony support obligations. The wife argued that this was double-counting. Because there were inconsistencies in the experts’ reports concerning owner salary, the court was unable to determine whether double-counting had occurred, and it remanded the case for further factual determinations on this issue.
The court in Champion v. Champion,86 noting that there is a split among jurisdictions on the issues of what constitutes double-dipping and whether it ought to be prohibited as a matter of law, rejected a claim of double-dipping and found the business to be both a marital asset and a source of income.
In Keane v. Keane,87 New York’s highest court held that the prohibition against double-counting applies only to intangible assets, such as professional licenses or goodwill, or the value of a service business, not income-producing tangible assets such as rental property.
In Sander v. Sander,88 the court ruled that it is not double-counting to assign a value to a business, as well as to attribute gross income from that business to the spouse, without adjusting either. Where the trial court, in its discretion, valued the company at a value it would have to a buyer who would pay a manager’s salary, the court’s decision was upheld as both logical and supported by the record.
Bateman, Tracy A. 2000. Divorce and Separation: Consideration of Tax Consequences in Distribution of Marital Property. 9 A.L.R. 5th. Lawyers Cooperative Publishing, p. 568. Contains an exhaustive listing and discussion of cases involving consideration or lack of consideration of tax consequences in marital property settlements.
Business Valuation Resources (BVR), www.BVLibrary.com. Contains the complete text of all major state appellate decisions involving business valuation decisions, searchable by case name, keyword, and state. Also contains full texts of relevant laws and regulations and unpublished conference presentations.
Business Valuation Resources. 2007. BVR’s Guide to Fair Value in Shareholder Dissent, Oppression, and Marital Dissolution. Portland, OR: Business Valuation Resources.
Business Valuation Resources. 2008. BVR’s Guide to Personal v. Enterprise Goodwill. Portland, OR: Business Valuation Resources.
Feder, Robert D., ed. 1997. Valuation Strategies in Divorce, 4th ed. New York: Aspen Law & Business.
Fishman, Jay, et al. 2008. “Valuations for Divorce Engagements.” In PPC’s Guide to Business Valuations. Fort Worth, TX: Practitioners Publishing, pp. 12-1 to 12-49.
Goldberg, Barth, and Barry A. Schatz. 1984 plus 1999 supplement. Valuation of Divorce Assets. RM New York West Law, pp. 335–552 of the 1999 supplement and pages 443–485 of the 1984 volume are case summaries on the valuation of closely held corporations and partnerships; pages 176–217 of the 1999 supplement and 198–227 of the 1984 volume are on valuation of professional entities, goodwill, and license agreements.
Gold-Biken, Lynne Z., Steven A. Kolodny, Adam R. Koritzinsky, and Barbara A. Stark. 1994. Divorce Practice Handbook. Charlottesville, VA: Michie.
Kleeman, Robert E., Jr., James R. Alerding, and Benjamin D. Miller. 1999. The Handbook for Divorce Valuations. New York: Wiley.
Oldham, L. Thomas. 1999 edition. “The Closely Held Business.” In Divorce, Separation and the Distribution of Property. pp. 10–1 to 10–5.
Pratt, Shannon. 2003. “Marital Dissolutions.” In Business Valuation Body of Knowledge, 2nd ed. New York: Wiley, pp. 235–328.
Pratt, Shanon, and Alina V. Niculita, 2007. “Valuation for Marital Dissolution Purposes” and “Marital Dissolution Court Cases” (ch. 37 and 38). In Valuing a Business, 5th ed. New York: McGraw-Hill.