Locked-Out Spouse Finds No Sympathy at IRS

The TaxProf Blog reported an interesting story about a husband who failed to report his share of passthrough income from the medical billing company that he and his estranged wife owned together. The Tax Court was not impressed with the husband’s explanation that his wife had locked him out of the home where the business was located, raided their business and personal bank accounts, and ran up more than $50,000 in credit card bills. In its decision, the Tax Court affirmed the deficiency assessed by the IRS.

More Personal Goodwill – Baker

In Baker v. Baker (2004), a predecessor to the Smith case reported previously in this blog, the Superior Court considered the intangible goodwill value of a veterinary practice located in rural Lycoming County. The husband, who was a sole practitioner, had purchased the practice of a deceased veterinarian for $250,000 (including real estate worth $90,000) approximately six months prior to the separation of husband and wife. Aside from $10,000 withdrawn by the husband from his marital retirement accounts, his purchase was entirely financed by loans.

In the Lycoming County divorce proceeding, the veterinarian’s wife offered the report and testimony of her valuation professional, David G. Bohlander of Analytics, Inc., regarding the value of the husband’s veterinary practice. Mr. Bohlander determined the value of the practice as of year-end 2002, two years after the date of separation. Husband offered no expert of his own.

The trial court accepted the opinion of wife’s expert that the equity in Husband’s veterinary practice, including enterprise goodwill, was $99,000. The briefs reveal that the wife’s expert used a discretionary cash flow method as well as a price-revenue multiple to determine the value of the practice. The discretionary cash flow multiple calculated by the wife’s expert was 2.84, which was multiplied by the discretionary cash flow of the previous owner, the deceased veterinarian. The indicated value under this method was $190,000.

Applying the price-revenue method, the wife’s expert multiplied a 0.63 ratio times the projected revenue of the practice in the hands of the new owner, the husband, to arrive at an indicated value of $115,000. Averaging the two methods, the expert expressed an opinion of value of $152,937 for the intangible value of the veterinary practice, which included its name recognition, customer lists and location.

On appeal, Husband argued that the trial court had erred in finding any value which might be attributable to enterprise goodwill. After all, unlike the Fexa case on which the wife’s expert had relied, husband’s professional practice did not employ multiple professionals or experience personnel changes over several decades. Dr. Baker’s veterinary practice was a sole practice more akin to the sole proprietorship in the Solomon case. Husband asked the Superior Court to interpret Solomon as holding that sole professional practices per se lacked any enterprise goodwill value.

Husband also argued that a substantial portion of the equity found by wife’s expert could be traced to the post-separation paydown of the loans by which the practice and real estate were acquired. Husband had paid down the loans by more than $20,000 from the date of separation to the date of the valuation.

The trial court’s decision was affirmed on appeal to the Superior Court.

Clearly, in ruling in favor of the wife, the Superior Court held that a business does not lack enterprise goodwill merely because it is a sole proprietorship. In this case, the fact that the husband had paid substantial consideration to purchase the practice was perhaps critical to the trial court’s decision.

Perhaps just as important, however, is the fact that the husband did not hire his own expert to quantify the personal and enterprise elements of goodwill. The Superior Court cited Litmans, in which the court had resigned itself to accepting uncontradicted evidence of value where no better evidence had been offered. The trial court in this case was faced with a troubling choice: to reject the opinion of wife’s expert and assign no value to the husband’s business, or to accept the report which merely proved the value of husband’s business fully two years after the date of separation. The latter, apparently, was the lesser of two evils.

The lesson: when representing a professional in a sole practice, do not neglect to hire a valuation expert while assuming that the trial court will not assign intangible value to the practice.

S Corporations: A Taxing Question (Part I)

A hot topic confronting the valuation community these days is whether to discount the earnings or cash flows of a Subchapter “S” corporation by subtracting the shareholder-level income taxes before capitalizing those earnings or cash flows in a business valuation. Intuitively, it stands to reason that an S corporation is not intrinsically more valuable than a C corporation that would generate the same net income or cash flow if it did not have to pay corporate-level income taxes. Perhaps this is why the valuation community has endorsed the practice of “tax-affecting” the earnings of S corporations – until recent court decisions have called into question that practice.

In several recent decisions, “tax-affecting” S corp earnings has been disapproved by the Tax Court. Most recently, in Dallas v. Commissioner, the Tax Court rejected several arguments frequently cited by valuation experts as reasons for “tax-affecting” S corps:

(1) The Tax Court rejected the argument that the company (a family-owned chemical-processing business) might lose its Subchapter “S” status. There was no evidence of record to suggest that the stock transfers which prompted the experts to value the business for estate and gift tax purposes would result in a loss of Subchapter “S” status.

(2) The Tax Court rejected the argument that “tax-affecting” S corp earnings is the standard method among NACVA-certified experts and is taught in NACVA courses for valuation professionals. The expert who had advocated “tax-affecting” in this case testified about an informal poll he took at a cocktail party during a NACVA convention. Not surprisingly, the judge did not regard his poll as scientifically valid. Similarly, the Court dismissed testimony that most bankers and business brokers usually tax-affect S corporation earnings.

(3) The Tax Court rejected the rationale set forth by the Delaware Court of Chancery in its opinion published in Delaware Open MRI Radiology Assoc. v. Kessler. The Tax Court held that the “fair value” standard employed in shareholder dissent cases like Kessler is not necessarily the same as “fair market value” in estate and gift tax cases.

Some of the leading commentators in the business valuation field have been following these cases closely. Those commentators seem to agree that whether “tax-affecting” is appropriate is fact-dependent. In Part Two of this post, I will describe some of the theories that these commentators have developed and how they might apply in a divorce context.

Quantifying Personal Goodwill – Smith v. Smith

In Smith v. Smith, the Pennsylvania Superior Court ventured into the murky waters of goodwill, an intangible element of business value. Goodwill may be derived from the positive reputation of a business, its location, and its unique products and services. This type of goodwill is generally known as “enterprise goodwill” in divorce parlance. On the other hand, goodwill also may be derived from the personal skills of a business owner or employee – such as a surgeon or accountant. This type of goodwill is generally called “personal goodwill.”

For many years, the divorce courts of Pennsylvania have held that business goodwill constitutes marital property only if it is transferable to a hypothetical buyer. Goodwill which is not transferable – in other words, personal goodwill – is not marital property. Yet, in more than twenty-five years since the Pennsylvania Domestic Relations Code was enacted in 1980, the courts of Pennsylvania have not attempted to isolate and quantify the mixed elements of personal and enterprise goodwill in a single business – until now.

In Smith, the business owner (who was the husband) operated a trucking business based in Blairsville, Pennsylvania. The husband’s business valuation expert chose the net asset value (NAV) method of valuing the trucking business. Wife’s expert, on the other hand, considered the excess earnings method, the discretionary cash flow method, and the capitalized earnings method. In contrast to the nominal value calculated by husband’s expert, wife’s expert found substantial value (which included intangible value in excess of net asset value). The trial court rejected husband’s valuation and accepted wife’s valuation in its equitable distribution decree.

On appeal, husband’s counsel argued that wife’s valuation included personal goodwill, which was not marital property subject to equitable distribution. Judge Orie Melvin for the Superior Court, while opining that “we suspect that much, if not all, of the goodwill was that of the enterprise,” nevertheless remanded to the trial court to quantify the personal and enterprise elements of business goodwill. Seemingly, this decision establishes a precedent that would require valuation experts in divorce cases to isolate and quantify personal and enterprise goodwill in a business where both might be present.

Welcome!

Welcome to BVSource, a blog about business valuation and divorce. In the coming weeks, I hope to begin a dialogue about current and recurring issues that are of interest to business owners who are experiencing or contemplating divorce, their lawyers and valuation experts, and others who may be interested.