WV Looks at Goodwill in Professional Practices

The Supreme Court of West Virginia recently considered the enterprise goodwill of a professional practice in divorce proceedings in Helfer v. Helfer, 221 W.Va. 625, 656 S.E.2d 70 (November 2007).

In Helfer, the business owner’s expert found that his chiropractic practice was worth $41,000, based on a capitalization of earnings. His wife’s expert found the practice to be worth $388,000 based on the excess earnings method. Neither of the experts made a distinction between enterprise goodwill and personal goodwill or placed values on those elements. The trial court adopted the opinion of the business owner’s expert, and the wife appealed, arguing that the trial court failed to consider the value of enterprise goodwill.

I have mentioned before in this blog that the real issue, in matrimonial actions, is whether goodwill is transferrable. Presumably, goodwill emanating from the skills and reputation of a professional is non-transferrable, while goodwill emanating from customer base, trade name recognition, unique goods or services, or other factors indistinguishable from the business itself can be transferred to new owners in a hypothetical or actual sale.

West Virginia, unlike Pennsylvania, has expressly described at least five acceptable methods of valuing a business, two of which are the capitalization of earnings method and the excess earnings method. (The other recognized methods are the Treasury method, the market value approach, and the buy/sell agreement method.) West Virginia precedent requires the court to determine the value of a professional practice and its goodwill if it is determined that distributable goodwill exists.

Since the business owner’s expert, whose opinion was adopted by the court, did not in this case identify the enterprise goodwill, the West Virginia court remanded the case for a determination of the value of enterprise goodwill. The Supreme Court directed the trial court on remand to assign a value of zero to the enterprise goodwill if it found that no enterprise goodwill existed.


I may have mentioned this before on this blog, but it is striking to me how many accountants and valuational professionals regard court decisions as monolithic. At NACVA chapter meetings, I have heard CPAs say that “you must do this” or “you can’t do that” because of some court decision or IRS position. But we must not forget that all court decisions are, to some extent, fact-sensitive and case-specific. The job of a lawyer as an advocate is to cite facts and cases that support one’s position and to distinguish/minimize facts and cases that do not. It is also important to realize that intermediate appellate decision carry less weight than supreme court decisions, and trial court decisions carry little or no precedential weight (except to the extent that their logic may be persuasive).

So I was pleased to read, in the latest BVWire blast email from BVResources.com, a report from the New York State Society of CPAs describing a lecture given at their 2008 Business Valuation Conference. BVWire reports:

IRS agents and auditors may tell you that the Internal Revenue Service does not have an official position on tax affecting Subchapter S corporations—but “don’t believe it,” Dan Van Vleet (Duff & Phelps) told the NYSSCPA gathering. The “official” IRS position “is to assess the reasonableness of the analysis and make a determination,” he said. The problem: The Service may presume that tax affecting is not reasonable—a position based in large part on prior Tax Court Memorandum decisions (Gross, Heck, Adams, Wall, Dallas – all are available to subscribers of BVLaw) in which neither the IRS nor the taxpayer’s expert presented a good model for tax affecting the subject interests. But only one of these—Gross, which concerned an “extreme” set of facts—has been affirmed by a federal court of appeals (6th Cir.). The rest are not binding. “The current reality is that the IRS has audited—and accepted—numerous reports involving substantial matters” that Van Vleet and his colleagues have prepared using his S Corporation Economic Adjustment Model (SEAM). “If you use a model that explains [tax affecting] reasonably,” he said, “they’ll accept it.”

“I’ve never been challenged,” agreed Chris Treharne (Gibraltar Business Appraisals, Inc.), who presented his S Corp model to attendees. “If you’ve got an S Corp that’s distributing enough to cover [shareholder] tax liability, then for heaven’s sake, tax affect. If you can explain it in your report with sound economic reasoning,” he said, “you will win.” The economic issues that lie at the heart of the valuation of any pass-through entity are “absurdly simple,” said Nancy Fannon, the third expert on the topic—but they have been wrapped in “deceptively complex” models. She reminded conference attendees that her article comparing the various models—including those used by the Tax Court and the Delaware Chancery Court—is available as a Free Download at BVResources (fifth on the current list) along with her book, Fannon’s Guide to the Valuation of Subchapter S Corporations).

They are right! Many valuation professionals believe that tax-affecting is appropriate and justifiable in certain situations, and if they express their views to the lawyers who are advocating their positions, they can as a team convince factfinders and influence the development of judicial precedent. Soon we will look at the recent
decision in Bernier, a marital dissolution decision arising from Massachusetts, which may not have as pervasive an influence as has been described in some reports.

Florida court declines to adopt "fair value" in Erp

A recent Florida divorce decision, Erp v. Erp, considered the valuation of an RV dealership acquired by the husband and wife during their marriage. The dealership was organized as a subchapter “S” corporation, of which the husband and wife each owned 40% of the stock. Husband’s son from a prior marriage and wife’s son from a prior marriage each owned 10% of the stock, so that no decisions could be made without the consent of husband and wife, or one of the spouses and both children.

In addition to the divorce action, the wife commenced a simultaneous court proceeding for dissolution of the corporation.

The husband’s expert found an enterprise value of $4.56 million, while the wife’s expert found $12.5 million. The differences in the experts’ opinions were primarily due to (1) tax-affecting “S” corporation income; (2) regression analysis; (3) working capital adjustment; (4) A/R accounting convention; and (5) marketability discount. After discounts, the husband’s expert found that wife’s 40% share was worth $720,000. The wife’s expert found that her 40% share was worth $5 million.

The trial court arrived at an enterprise value of $6.2 million. This figure was based upon the testimony of the husband’s expert, after restoring cash flow to its pre-tax basis, scaling back the working capital reduction of cash flow, applying a LIFO convention to accounts receivable, and applying a 10% marketability discount. The trial court valued the husband and wife’s 80% interest at $4.96 million, of which the wife’s share was worth $2.48 million.

On appeal, the wife attacked the trial court’s marketability discount, arguing that a marketability discount should never be applied in matrimonial actions. Wife pointed to the state statute that mandated a “fair value” standard in shareholder suits, and a statute that prohibited discounts in such cases.

Rather than adopting a standard of value, the Florida appeals court held that the trial courts have discretion to accept or reject the testimony of valuation experts. The Florida appeals court noted that the state statute that adopts a “fair value” standard applies only to oppressed shareholder cases, and not to matrimonial actions.

The Court wrote: “In this case, the Wife is not the victim of majority shareholder oppression. From her perspective, there has been no involuntary change in the fundamental nature of the corporation.”

The Florida court noted that marketability discounts were discretionary (not prohibited) in cases involving corporate dissolution. Perhaps it was significant that the trial court in Erp had reduced the marketability discount to 10%. Finding no abuse of discretion, the appellate court affirmed.

Power Point Presentations on BVSource

Just a reminder that I have posted two of my most recent PowerPoint presentations – Child Support, Spousal Support and Alimony Pendente Lite from PBI’s 2007 Family Law Update and Tax Traps for the Unwary! from the National Constitution Center’s 2007 webcast – at the bottom of this blog.

Family Law Update will be updated in October 2008, and Tax Traps will be updated as I have the opportunity.

To FMV or Not FMV?

Last week I attended the AICPA/AAML National Conference on Divorce, a summit of some of the brightest minds in business valuation and divorce. Many of the lectures were good, but the one that most captured my attention was Jay Fishman’s discussion of “standards of value.” He made the best argument I have heard why the divorce courts should not abandon the fair market value standard in favor of fair value.

Jay observed that fair value, which is sometimes defined as fair market value without discounts, is a creature of the judiciary and has different meanings in different jurisdictions and contexts. It arises from dissenting and oppressed shareholder cases, which is one reason why discounts are not applied. In dissenting shareholder cases, for instance, the entire company has been sold, and dissenting shareholders are unhappy with the price or terms. Lack of control and marketability are irrelevant when the entire company has already been sold.

The reason why some professionals advocate a “fair value” standard in divorce is that there is no actual sales transaction in a divorce, and the business owner is not divested of his or her interest in the business as a result of the transaction. Jay pointed out that there is an exchange of value, however, in that the non-owner spouse “pays” for the owner’s interest in the business with other marital or community assets. It is also worth noting that the divorce court has the power, in most jurisdictions, to compel the marital property to be sold for value.

More about the AAML topics – and some new cases – coming soon.