PLR Clarifies Taxes on Stock Options in Divorce

An IRS Private Letter Ruling (No. 200646003) clarifies the law with respect to the tax treatment of stock options that are distributed by constructive trust in divorce to the non-employee spouse. This PLR confirms that the non-employee spouse who directs the exercise of options in-the-money is responsible for the federal income tax and should receive a credit for the income tax withheld by the employer.

The important part of this ruling, however, concerns FICA taxes. In this PLR, it was decided that the employee spouse would be held responsible for FICA taxes resulting from the exercise, and the non-employee spouse would not be given credit for the FICA taxes withheld from the proceeds.

As a colleague from the East reminded me, there is an opportunity for settlement by recognizing that the non-employee spouse may be in a lower income tax bracket than the employee spouse, thereby maximizing the value of stock options distributed to the non-employee. On the other hand, there is no ability to shift FICA taxes from the employee spouse (unless he/she has already exceeded the FICA wage base at the time when options are exercised).

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Lawyer Beware!

Short week: happy Thanksgiving! FamilyLaw Prof Blog reports on a New York State case in which a divorce lawyer was held liable for the client’s loss resulting from a delay in transferring retirement funds. An important reminder to us all!

Celebrity Update

A fun and entertaining discussion of the premarital agreement signed by Britney Spears and Kevin Federline (not to mention their “faux wedding”) is posted here.

A Taxing Question (Part II): More Summertime Precedents to Make a Divorce Lawyer Blue

The courts continue to march away from the practice, widely-accepted in the valuation community, of tax-affecting passthrough earnings in business valuation. Following in the footsteps of the Tax Courts in Dallas, Gross, Heck, and Adams, the Supreme Court of Rhode Island recently rejected the valuation of an expert who capitalized the earnings of a Subchapter S corporation after deducting the shareholder-level income taxes (i.e., “tax-affecting”) in a business valuation for divorce purposes.

In Vicario (2006), the husband was a 50% owner of an accounting practice grossing about $700,000 per year, a related actuarial consulting business grossing $1 million annually, and a limited liability company that owned the real estate where both companies were headquartered. The husband testified that he received no salary or distributions from the actuarial business other than annual distributions to pay his income taxes on the company’s passthrough income.

The wife’s business valuation expert used a capitalization of net cash flow approach to render his opinion of value, dividing the “weighted adjusted net cash flows” of $167,000 per year by a capitalization rate of 21 percent. Next, applying a 25% discount for lack of marketability (DLOM) and a 10% minority discount, the wife’s expert arrived at a value of $268,000 for Husband’s interest in the actuarial business. The wife’s expert explained to the trial court that he did not tax-affect passthrough income because Subchapter S corporations does not pay taxes at the corporate level.

The husband’s expert also applied a capitalization approach, but in his report, he “tax-affected” the earnings of the corporation. The husband’s expert also deducted non-recurring earnings, the value of a covenant not to compete, and the personal goodwill of the husband’s business partner. The husband’s expert testified that the wife’s expert did not calculate earnings correctly because records of accounts receivable may not have been made available to the wife’s expert. The husband’s expert also admitted that the income to be capitalized would have been greater if he had normalized repair and maintenance expenses reported in the company’s income statement.

The trial court, to its credit, did not split the difference, but rejected the opinion of the husband’s expert in favor of the wife’s expert.

In its opinion, the Rhode Island Supreme Court cited the Sixth Circuit’s decision in Gross, 272 F.3d 333 (2001), which affirmed the Tax Court’s holding that it is improper to tax-affect passthrough income when determining the value of a Subchapter S corporation for estate and gift tax purposes.

The Rhode Island Supreme Court’s analysis was cursory, holding merely that the trial court did not abuse its discretion. No consideration was given to the myriad of factors that were presented to the Delaware court in Delaware Open MRI Radiology Assoc. v. Kessler, a case hailed by business valuation experts to bolster the industry-standard practice of tax-affecting.

Delaware Open MRI is such a long decision (86 pages) that it could benefit from a table of contents. The portion dealing with tax-affecting starts at page 53. Tax-affecting is based on the principle of substitution: that a buyer would not pay more for an asset than it would cost to acquire some other asset that would provide equal or greater economic utility to the buyer. Applying the substitution principle, a buyer would not pay more for an S corporation than he would for a C corporation that provides the same economic benefit.

The advocates of tax-affecting in Delaware Open MRI also argued that it is possible for an S corporation to lose its tax-favored status under certain circumstances. In order to maintain Subchapter S status, the corporation must have no greater than 100 shareholders, all of whom generally must be individuals, not corporations or other legal entities. The corporation generally must have no more than one class of stock. Subchapter S businesses that are acquired by venture capital firms or publicly-traded companies, therefore, could be expected to lose their status. Moreover, C corporations cannot be expected to pay a premium for S corporations if they cannot benefit from the Subchapter S status. Yet, in the context of business valuations prepared for divorces and estate and gift tax returns, no actual sale is contemplated, so the loss of Subchapter S status is not likely.

On the other hand, those who rejected tax-affecting correctly point out that Subchapter S shareholders actually pay no income taxes at the corporate level. They are not “double taxed” on distributions, so perhaps there is greater value in Subchapter S status. The physicians who owned interests in this MRI operation certainly appreciated the benefit of a tax savings. The Delaware court also noted the substantial difference between the applicable personal income tax rates and the corporate tax rates that would apply if the company were a C corporation.

In order to reach a compromise between these extremes, the Vice Chancellor in Delaware Open MRI developed an effective tax rate than was less than the 40% corporate tax rate used by the dissenting shareholders’ expert and more than the 0% tax rate used by the controlling shareholders’ expert.

The recent decision in Vicario does not resolve, or even advance, the question of tax-affecting in divorce valuations. One can only hope that when this issue is addressed by the Pennsylvania courts, all the right arguments will be made.

AAML Article & What’s Really Wrong with the Excess Earnings Method?

The recent edition of the Journal of the American Academy of Matrimonial Lawyers contains an interesting article describing various approaches to personal and enterprise goodwill. There is a handy list of which states consider goodwill (both types) to be separate property, which states consider goodwill to be marital property, and which states distinguish between the two types of goodwill.

The third section of the article describes five different valuation approaches and how goodwill might be computed in each of those approaches.

In describing the valuation methods, the author praises the excess earnings method and its cousin, the Treasury method, as superior to the other methods “invented by biased experts for the purposes of . . . giving larger values to businesses.” This phrase was quoted from a leading divorce treatise by Brett R. Turner, entitled Equitable Distribution of Property.

It is a terrific book, and I keep a copy in my law firm’s library, but on this topic, I think it is wrong. The excess earnings approach and Treasury approach are generally regarded by the valuation community as theoretically weak and flawed. These were among the first methods developed by valuation experts in the 1920’s, but were left behind long ago. Unfortunately, these seem to be the most prevalent methods in divorce litigation.

In the article, the author cites one court’s criticism of the excess earnings method, in which a Maryland court complained of “double counting.” The Maryland court claimed that the excess earnings method was flawed because it regarded the owner’s future compensation both as income and as part of the value of the business. Turner, in his book, correctly noted that this criticism is unjustified. There is no double dip because the owner’s compensation is excluded from the excess earnings which are capitalized in the business valuation. To avoid the double dip in alimony and child support determinations, the court should exclude any business income that exceeds the owners’ compensation as used in the business valuation.

There is a double dip in the excess earnings method, however. The value which is calculated in most divorce cases is a going concern value, which assumes that the business will continue to operate and generate profits in perpetuity. The tangible assets of a business – its receivables, inventories, equipment, supplies – all will be consumed and replaced, over and over, in the production of an earnings stream over an infinite period of time. Nothing lasts forever. There is no residual value.

But the excess earnings approach carves out a separate value for the hard assets and adds that value to the capitalized earnings stream of a going concern business. That is a double dip.

Another problem with the excess earnings approach is the capitalization rate. The most common method of an appropriate capitalization rate, which measures the risk of certain investments
compared to other investments, is called the Ibbotson build-up method. The risk-free rate, which is generally equal to the yield on long-term government bonds, is added to an equity risk premium, a size premium, an industry risk premium, and a specific company premium. All but one of those elements is published annually in a statistical study by Ibbotson Associates.

The result of an Ibbotson build-up calculation is called an after-tax net cash flow discount rate, which is easily converted to an after-tax net cash flow capitalization rate. Several more steps are required to convert this rate into an after-tax intangible capitalization rate, which is used in the excess earnings method. The conversion from a net cash flow capitalization rate to an intangible capitalization rate involves additional levels of subjectivity, so the excess earnings approach is actually more subjective than other methods of valuation (not less subjective, as suggested by Turner).

In his discussion of the Treasury method, Turner exaggerates the level of acceptance this method enjoys outside of divorce cases. I doubt that the excess earnings method is prevalent in IRS valuations. That was once true, in the days of Prohibition when it was the only recognized method, but it is not true today. NACVA teaches that the excess earnings approach should not be used outside of divorce cases, and in those cases, only because it is widely accepted by the courts.

Perhaps it is time for us to present better valuation methods to the divorce courts and point out the flaws of the excess earnings method. I chafe when I hear divorce lawyers accuse valuation experts of tailoring their opinions to their clients’ expectations (see note 41 of the AAML article). Why should we believe they are less ethical than we?

Cases Mentioned on PBI "Family Law Update" Broadcast

On the PBI “Family Law Update” satellite broadcast yesterday, I said that I would post the citations to the cases that were not included in the written materials. Here they are:

  • Koehler, 2005 WL 4312126 (Northamp.2005)
  • Johnson, 2006 WL 2589787 (9/11/2006)
  • Johanson v. Commissioner, T.C. Memo 2006-115
  • Kean v. Commissioner, 407 F.3d 186 (3d Cir.2005)
  • Salesky v. Commissioner, T.C. Memo 2006-162

I appreciate all of the good feedback that we have received from all over the state! We had a lot of fun during the broadcast. Just before we went on-air, the director invited us to play a game. He gave us an unusual word, to see if each of us could work it into our lectures. All but one of us did! See if you can guess the “secret word” we were given…..

Cases from the trial courts may be available in the Pennsylvania Divorce and Domestic Relations Reporter (PDDRR), published by LRP Pulications. Many law library carry this publication. If you can’t find a court decision there, send me an email and I will fax it to you.

Should Tax Code Reflect Marriage (and Divorce) Realities?

From the TaxProf Blog:

Shari Motro (Richmond) has published A New “I Do”: Towards a Marriage-Neutral Income Tax, 91 Iowa L. Rev. 1509 (2006).

Here is the abstract:

The federal income tax system treats married couples as if each spouse earned approximately one-half of the couple’s combined income through a mechanism called “income splitting.” For many one-earner and unequal-earner couples, income splitting produces a significant advantage, a “marriage bonus,” by shifting income from higher to lower rate brackets. Marriage-based income splitting relies on a presumption that marriage is a good indicator of economic unity between two taxpayers. It is not. Marriage does not require spousal sharing and many unmarried couples share everything they earn. As a result, the current system extends the benefit of income splitting to some taxpayers who do not deserve it while withholding it from others who do. Because marriage is a poor proxy for economic unity, this Article proposes a new eligibility criterion for income-splitting: only couples legally committed to sharing their income, regardless of marital status, would be permitted to file jointly.