Basics of Pennsylvania Law: Double Dip, Part III

This is the third in a series of posts containing summaries of Pennsylvania case law on the issue of double dipping in divorce. “Double dipping” occurs when an income-producing asset (such as a pension or business) is counted as marital property subject to equitable distribution, as well as income subject to an alimony or child support obligation.

Miller v. Miller, 783 A.2d 832 (Pa. Super. 2001)

In Miller, the parties settled their division of property, and Wife subsequently sought a modification of child support based on the income that Husband derived from the sale of his share of marital assets. The Superior Court held that the proceeds from the sale of assets were not “income” within the statutory definition. The Superior Court affirmed the trial court’s refusal to modify child support when the payor received proceeds from the sale of marital assets after the divorce and division of property. The double dip in Miller was another reason for the Court’s decision.

Rohrer v. Rohrer, 715 A.2d 463, 465 (Pa. Super. 1998).

            Rohrer was the first published decision to prohibit double dipping in Pennsylvania. (Interestingly, the opinion was written by Judge Popovich, who had held in McFadden that double dipping was permitted.) In Rohrer, the husband was an owner of a business organized as a Subchapter “S” corporation. At an early stage of the proceedings, the pass-through earnings of the business were included in the husband’s income when calculating his support obligations. At equitable distribution, the husband asked the master to exclude retained earnings from the value of the business, in order to avoid double dipping. Husband’s request was granted by the master, but only to the extent that retained earnings from the date of the support order forward into the future were excluded. The retained earnings that accrued prior to the support order were counted as part of the value of the business.

            The trial court reversed the master’s decision and excluded all of the retained earnings. On appeal, the Superior Court reversed and adopted the master’s finding. The Superior Court held that “money included in an individual’s income for the purpose of calculating support payments may not also be labeled as a marital asset subject to equitable distribution.” Rohrer, at 465.


Recession Impact on Value: Known or Knowable?

The current economic recession has had a profound adverse impact on many businesses. So, in cases where we are asked to value businesses on a valuation date prior to the recession, how can we ignore what we know will happen? One of my favorite lecturers, Mel Abraham, answered this question in the BVResources newsletter this month by recalling an interaction he had with a California judge a few years ago. In that case, the business had lost its largest (60%) client six months after the valuation date, and Abraham had factored the risk of client loss into his discount rate and DCF calculations. When the judge argued that this was a subsequent event, Abraham agreed but countered, “The loss of the client was definitely a subsequent event, but the risk of losing the client was known and knowable as of the date of valuation.” Looking back to valuation dates, particularly in mid-2008, you cannot include loss of revenues or other damages that actually occurred as the result of this current economic downturn, he added. However, conditions known as of the valuation date (like heavy leverage, declining assets, or other high-risk indicators) could, should, and would have been known or knowable even prior to the stock market meltdown.

Discounts in Art: “Starving Artist” Prices?

The 9th Circuit Court of Appeals recently issued a decision (highlighted by Carsten Hoffman’s FMVOpinions) affirming a tiny fractional interest discount applied to a jointly-owned collection of paintings. In Stone vs. U.S. (2009), the district court rejected the opinion of the estate’s expert, who testified in favor of a 44% fractional interest discount, citing the expert’s “total lack of experience with the art market; the dissimilar motives driving purchasers to acquire art, on one hand, and real estate or limited partnership shares, on the other; and the unreasonably low appreciation rate and unreasonably high present-value discount rates Hoffmann used in his cost-of-partition analysis.” The district court refused, on the other hand, to apply no discount, as urged by the government. Instead, the district court settled upon a 5% fractional interest discount, the percentage that was conceded by the IRS. The 9th Circuit affirmed.

On appeal, the estate argued that the lack of data regarding real-world  sales of fractional interests in art justified its use of discounts derived from sales of fractional interests in real estate and limited partnerships. The estate also argued that the district court had erroneously assumed that the estate’s 50% interest in the art collection would be sold together with the other 50% interest. The appellate court dismissed both arguments under an abuse of discretion standard.

In his post-mortem analysis, Carsten Hoffman (who was the estate’s expert in Stone) speculated that fractional interest discounts in art should actually be higher than, not lower than, discounts in real estate and partnerships.

To begin with, empirical data regarding discounts for lack of marketability as it relates to restricted stock, demonstrates that the magnitude of the discount is directly related to the degree of volatility. This is logical, as an investor would rather surrender liquidity for low volatility assets compared to high volatility assets. For example, the FMV Restricted Stock Study shows that the discount for lack of marketability is approximately 300 percent higher for stocks in the top 10 percent, measured by volatility, compared to those in the bottom 10 percent (approximately 45 percent vs. 11 percent). This is significant, as art has provided the least attractive risk and return potential of any asset class as reported by Merrill Lynch. The report also indicates that over a 5-year investment horizon, the risk of loss in art ownership is 70 percent higher than the risk of loss in the S&P 500 Index. Further, the standard deviation (a measure of volatility) for art is 44 percent higher, on average, than for the S&P 500.

Hoffman noted that data did not exist in 1982 when the courts first confronted the challenge of applying a fractional interest discount to real estate and partnership interests. The data that supports such discounts has been developed over the intervening years. Similarly, the scholars will have to compile data for the art market.

Another Big Decision: Personal Goodwill in Kentucky

Apparently the new frontier in divorce litigation is personal goodwill. Following closely on the heels of May (W.Va.2003) and other divorce decisions, the Supreme Court of Kentucky held recently that the non-transferrable goodwill of a professional practice was properly excluded from the marital estate.

The subject business in Gaskill v. Robbins (2/17/09) was an oral surgery practice, operated by the wife, without associate professionals. The wife’s expert presented an asset-based valuation, giving no value to goodwill because “Gaskill’s role in the business amounted to a ‘non-marketable controlling interest.'” The wife’s expert reasoned that no buyer would pay more than the fair market value of hard assets when the wife could set up shop down the hall and attract her patients away from the old practice.

The husband’s expert considered several approaches: capitalization of earnings, excess earnings, net asset value, and market comparables. He averaged these approaches to arrive at a valuation that included goodwill and a non-compete agreement. He also criticized the opinion of the wife’s expert who had doubled the compensation of the wife’s non-professional staff, thereby depressing earnings.

The trial court adopted the valuation of the husband’s expert, reasoning that the salary adjustment made by the wife’s expert was unreasonable, and noting that Kentucky law did not recognize a distinction between enterprise goodwill and personal goodwill.

The Kentucky Court of Appeals reversed, holding that not all businesses have goodwill; and the Supreme Court of Kentucky affirmed that reversal on other grounds.

In its Opinion, the highest court of Kentucky examined the fair market value standard and the meaning of “goodwill” in the context of business valuation. The Kentucky court noted that none of its prior decisions had specifically considered the difference between enterprise goodwill and personal goodwill but none had prohibited such an analysis. The Court recognized that the reputation and skill of this professional practice were closely associated with the wife and might not be transferrable to a buyer. The Court also noted that professional degrees are not regarded as marital property to be divided upon divorce under Kentucky law.

The Kentucky Supreme Court also considered the decision of the West Virginia Supreme Court in May v. May (2003), which contained a survey of cases dealing with goodwill nation-wide. May, in turn, relied heavily upon the Indiana Supreme Court’s decision in Yoon v. Yoon (1999), which distinguished between transferrable enterprise goodwill and non-transferrable personal goodwill. Ultimately, the Kentucky court aligned itself with these courts in reaching that distinction.

See also Helfer (W.Va.2007); Stewart (Idaho 2007); Hess (Maine 2007).

Gaskill joins a long list of cases that distinguish personal goodwill from enterprise goodwill in the context of professional practices. It will be interesting to see, in the future, whether these courts will extend this rationale to other types of businesses, where the reputation, skills and efforts of the business owner spouse are not so easily associated with the goodwill of the business.

Standard of Value dictates Use of Discounts in Divorce Case

The Alabama Court of Appeals recently issued an opinion in Grelier v. Grelier, holding that the parties’ agreement to employ the fair market value standard in a divorce case precluded wife from arguing on appeal that the trial court should not have applied marketability and minority discounts.

In Grelier, the parties appointed a neutral expert to determine the value of the husband’s business, a retail and commercial real estate development company. The husband owed a 25% interest; his father, brother and college roommate owned the other interests. The consent order appointing the expert specified that he would determine the fair market value of the business. Husband and Wife each hired independent experts to offer their opinions of value as well.

The court-appointed expert testified that marketability and minority discounts should not be applied to the husband’s interest in the real estate business, but the opinion does not reveal why. Wife’s expert testified that the court-appointed expert’s valuation was flawed because it relied on out-dated appraisals and verbal statements of value but agreed that discounts should not be applied. Husband’s expert testified that a minority interest discount was appropriate because the wife had not proven that the husband had a right to act independently from the majority stakeholders; and that a marketability discount was standard practice when determining the FMV of close corporations. Husband’s expert suggested a 25% minority discount and 25% marketability discount, but the trial court reduced the combined discounts to 40%.

On appeal, the wife argued that the trial court should have utilized the fair value standard instead of FMV; and that the minority interest and marketability discounts should not have been applied. The Alabama Court of Appeals held that the wife’s argument was waived for failure to raise it in the trial court, where she had consented to a FMV standard in the order appointed the expert. Moreover, the appellate court held that the trial court had not abused its discretion in applying the discounts to arrive at FMV.

Shadle – NAV Accepted by Divorce Court

In Shadle v. Shadle (108 PDDRR 102), a Bucks County divorce decision, the main issue was the valuation of an HVAC contracting business owned by the husband. The contracting business generated revenues from two primary sources: prepaid service contracts, and residential repair and replacement of HVAC systems. The company employed seven technicians, including the parties’ two adult sons. An ancillary issue was whether the husband had made an enforceable agreement with his sons to transfer the business to them upon his retirement.

On the latter issue, the trial court found no consideration for the promise made by husband to transfer the business to his sons. The trial court noted that each son had received adequate compensation for his services in the course of employment. The suggestion that the sons may have sacrificed other career opportunities in exchange for the promise was deemed speculative.

On the issue of valuation, there was a battle of experts. Wife’s expert considered three valuation approaches and concluded that the value of the business was $200,000. (The opinion does not reveal which approach(es) yielded this result.) The net asset approach, which is utilized when “liquidation is contemplated in the not-too-distant future,” as Wife’s expert explained, would yield a value of $130,000.

The testimony of Husband’s expert is not discussed at all in the opinion.

The trial court found that the fair market value of the HVAC business was equal to the NAV of $130,000, reasoning that “Husband will likely transfer the business to his sons rather than an independent buyer at some point in the future.” The trial court thus demonstrated a misunderstanding of valuation concepts, overlooking the fact that all parties contemplated an ongoing concern, not liquidation. It will be interesting to see whether the Superior Court of Pennsylvania reverses this erroneous decision, and whether, on remand, the issue of personal goodwill is raised.

Jelke and BIG Tax Liability

Chris Mercer’s Value Matters newsletter offered a succinct summary of the Eleventh Circuit’s recent decision in Jelke v. Com., an important decision dealing with built-in capital gains (BIG) tax liability of Subchapter C corporations. The subject company in the case was a C corporation established 80 years ago, whose principal asset was an investment portfolio managed for long-term capital growth. The company was valued for estate tax purposes, and the decedent’s expert discounted the net asset value by $51.6 million tax liability, assuming liquidation of the investment portfolio. The IRS took the position that liquidation was not imminent, and spread out the tax liability over 16.8 years (which was consistent with the slow rate of asset turnover). Discounting the future tax liability back to its net present value, the IRS estimated the tax liability at $21.0 million. The Tax Court adopted the IRS position, and the taxpayer appealed.

The Eleventh Circuit Court of Appeals employed the principal of substitution in its analysis, wondering why a hypothetical buyer would choose to purchase an interest in a corporation with BIG tax liabilities when the buyer could simply buy the underlying stocks in the market. The Eleventh Circuit court held that liquidation was the proper assumption when determining net asset value, and sided with the taxpayer by discounting the corporation’s value for the entire tax liability.

This decision might be persuasive in the divorce courts of Pennsylvania, where hypothetical tax consequences may be considered in determining the value of marital assets. Were the divorce court faced with the valuation of a C corporation having BIG tax liability, it might be appropriate to subtract the tax liability from the company’s net asset value. The market alternative for an interest in a corporation having BIG tax would be the underlying assets themselves without tax liability, according to Jelke.