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.

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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.

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.

Are Capital Gains Considered "Income" under the Child Support Guidelines?

The statutory and rules definitions of “income,” as provided by 23 Pa.C.S. § 4302 and Pa.R.C.P. 1910.16-2(a) include “gains derived from dealings in property” (§ 4302) or “net income from business or dealings in property” (Pa.R.C.P. 1910.16-2). Neither the statute nor the rules specifically mention “capital gains.”

Under the Internal Revenue Code, a “capital gain” is the gain realized upon the sale or exchange of a species of property known as a “capital asset.” Capital assets are all property other than the sales inventory of a business, notes or accounts receivable, depreciable business assets, business supplies, real property used in a trade or business, intellectual property, or derivative commodities. See IRC § 1221. Generally, capital gains realized on the sale of property held more than one year are long-term capital gains.

Frequently, taxpayers who maintain securities or funds in investment portfolios must recognize capital gains when securities or funds that have appreciated in value are exchanged for other securities or funds, even if the profits are not actually distributed to the taxpayer. The main reason why gains must be recognized and taxed immediately, even though the owner of the account receives no distribution of income at the time of sale, is to simplify the determination of tax basis. If stocks or funds were sold and reinvested over many years without recognizing the gains, the owner of the account would have to trace back the tax basis to stocks or funds that he had not owned in many years. This would greatly complicate the determination of taxable gains when the stock or funds were eventually liquidated.

Instead of tracing back stocks and funds, the tax code provides for the recognition of gains and the assignment of a stepped-up basis for the stocks and funds that are purchased from the sale proceeds of other stocks and funds.

The Pennsylvania Domestic Relations Code and rules contemplate the inclusion of all sources of income that are readily available to an obligor to meet his or her support obligations. Still, it is well-settled that in the context of a support action, a party’s taxable income is not necessarily the same as his income for support purposes. See Com. ex rel Hagerty v. Eyster, 429 Pa.Super. 665 (Pa.Super.1981). Furthermore, the appreciation in value of a party’s assets are not included in the definition of “income” for support purposes. It would not be proper to consider the increase in value of a party’s residence, art, jewelry, antiques, valuable, or business when setting a support obligation.

To illustrate this point, the Superior Court held that the pass-through income which is reported on the tax return of a shareholder in a subchapter “S” corporation was not “income” for support purposes unless actually received. Fennell v. Fennell, 753 A.2d 866 (Pa.Super.2000). In other words, retained earnings (which probably represent an increase in the value of a business) are not income for support purposes.

Capital gains are very similar to pass-through income in that they are recognized and reported on the shareholder’s tax return even if they are not actually distributed and received. The Superior Court in Fennell held:

Our jurisprudence is clear, therefore, that the owner of a closely-held corporation cannot avoid a support obligation by sheltering income that should be available for support by manipulating salary, perquisites, corporate expenditures, and/or corporate distribution amounts. By the same token, however, we cannot attribute as income funds not actually available to or received by the party.

In Fennell, a crucial consideration was the historical practice of the business and the legitimate reasons for retaining earnings in the business. The trial court in Fennell had found that the obligor had not cause the business to retain its earnings in an effort to shield income from the obligor’s support obligation. Similarly, where a portfolio has been historically managed to achieve growth and gains have not been historically distributed to the owner, the court should not find that undistributed capital gains are “income.”

Perhaps surprisingly, the appellate courts of this jursdiction have rarely addressed the issue of capital gains in the context of a support action. In Riley v. Foley, 783 A.2d 807 (Pa.Super. 2001), the Superior Court held that the trial court had correctly considered the father’s liquidation of stock options in its determination of his earning capacity. It is important to note that the stock options were actually liquidated and the sales proceeds were received by the father in that case. He did not reinvest the stock proceeds in other stocks or investments.

Similarly, in Coffey v. Coffey, 575 A.2d 5887 (Pa.Super.1990), the Superior Court held that the proceeds from the liquidation of limited partnership interests was “income.” Again, the Coffey case is distinguishable on the grounds that the property in that case was liquidated, not reinvested. It is also questionable whether Coffey is still good law, as the Superior Court in that case rejected the appellant’s argument that the proceeds from the sale of property were marital property subject to equitable distribution. In light of the Superior Court’s subsequent decisions in Rohrer and Miller, infra, such double dipping would not be permissible.

In Miller v. Miller, 783 A.2d 832 (Pa.Super.2001), the husband realized a profit on the sale of timber rights that were awarded to him in equitable distribution. The trial court held that the gain was not “income” for support purposes. The Superior Court agreed, holding that such double dipping was not permissible, and income would result only if the asset awarded in equitable distribution were sold for more than its assigned value in equitable distribution.

These cases lead to the same conclusion: that “income” for support purposes may be recognized only when an asset is liquidated. If a taxpayer is required to report a capital gain or pass-through income on his or her income tax return but does not actually receive a distribution of gain or profit, there is no “income” for support purposes.

PBI Family Law Update 2007 – Support

For those of you who asked for a copy of my PointPoint slides, I am posting them below at the bottom of this page. They are embedded through SlideShare.net, where you can also find my presentations from 2006 Family Law Update (PBI) and 2007 Tax Issues that Family Lawyers Care About (National Constitution Center).

Valuation of Sports Franchises

According to the Pittsburgh Business Times:

The Dallas Cowboys are the NFL’s most valuable franchise, according to Forbes magazine’s annual ranking of NFL teams.

Forbes values the Cowboys at $1.5 billion, a 28 percent increase from the previous year. The Washington Redskins, who held the top spot for the past seven years, fell to No. 2, with only a 3 percent increase in value to $1.47 billion.

The Cowboys overtook the Redskins thanks in part to the construction of a $1 billion stadium, expected to be ready for the 2009 season.

The Steelers ranked 16th with a team value of $929 million, up 6 percent from last season’s $880 million.

Forbes’ $782 million valuation for the Minnesota Vikings ranked the team as the least valuable of the NFL’s 32 franchises.

The valuation of sports franchises is an intriguing subject. To what degree does the value of a sports franchise depend upon the net income generated? Apparently, not all the value depends upon a positive cash flow. Anecdotal evidence suggests that the market for sports franchises is not economically rational. Even money-losing franchises sell for high prices. (I’m not specifically thinking of the Pirates or Penguins….)

So why would a buyer open the wallet for a business that bears a high purchase price, breaks even or loses money, and cannot be easily restructured or traded, due to heavy restrictions (franchise agreement, collective bargaining, municpal ownership of arenas, league oversight, etc.)??

Well, one reason is the prestige of being a team owner. As some have learned, being a team owner can bring publicity that is favorable (Mark Cuban) or unfavorable (Marge Schott, George Steinbrenner, Mark Cuban). But whether one is lionized or villanized by the public and press, there is an undeniable prestige in being a team owner.

Another reason might be access to celebrities. Being a team owner places one in a social circle that few could otherwise achieve, rubbing elbows with sports heroes, politicians, film and music stars, and moguls of weath and power. Perhaps there is some economic opportunity that can be realized by such access, but in most instances, I would venture to guess, the benefit is entirely personal and not financial.

I’m running out to get my copy of Forbes, just to find out what methodology they used in estimating the value of NFL franchises. I know they won’t go into much detail, but I’m curious. To me, it’s a fascinating subject.

Alimony Irony

From a recent news report:

LOS ANGELES, California (AP) — A judge has ordered a man to continue paying alimony to his ex-wife — even though she’s in a registered domestic partnership with another woman and even uses the other woman’s last name.

California marriage laws say alimony ends when a former spouse remarries, and Ron Garber thought that meant he was off the hook when he learned his ex-wife had registered her new relationship under the state’s domestic partnership law.

An Orange County judge didn’t see it that way.

The judge ruled that a registered partnership is cohabitation, not marriage, and that Garber must keep writing the checks, $1,250 a month, to his ex-wife, Melinda Kirkwood. Garber plans to appeal.

The case highlights questions about the legal status of domestic partnerships, an issue the California Supreme Court is weighing as it considers whether same-sex marriage is legal. An appeals court upheld the state’s ban on same-sex marriage last year, citing the state’s domestic partners law and ruling that it was up to the Legislature to decide whether gays could wed.

Lawyers arguing in favor of same-sex marriage say they will cite the June ruling in the Orange County case as a reason to unite gay and heterosexual couples under one system: marriage.

In legal briefs due in August to the California Supreme Court, Therese Stewart, chief deputy city attorney for San Francisco, intends to argue that same sex couples should have access to marriage and that domestic partnership doesn’t provide the same reverence and respect as marriage.

The alimony ruling shows “the irrationality of having a separate, unequal scheme” for same-sex partners, Stewart said.

Garber knew his former wife was living with another woman when he agreed to the alimony, but he said he didn’t know the two women had registered with the state as domestic partners under a law that was intended to mirror marriage.

“This is not about gay or lesbian,” Garber said. “This is about the law being fair.”

Kirkwood’s attorney, Edwin Fahlen, said the agreement was binding regardless of whether his client was registered as a domestic partner or even married. He said both sides agreed the pact could not be modified and Garber waived his right to investigate the nature of Kirkwood’s relationship.

Garber’s attorney, William M. Hulsy, disagreed.

“If he had signed that agreement under the same factual scenario except marriage, not domestic partnership, his agreement to pay spousal support would be null and void,” Hulsy said. E-mail to a friend

Copyright 2007 The Associated Press. All rights reserved.This material may not be published, broadcast, rewritten, or redistributed.