Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

Divorce business valuations: double dip, reasonable compensation conundrums

divorce business valuationsFamily Law Court magistrates often face two dilemmas regarding what monthly spousal maintenance payments should be when a business is owned by the divorcing couple and is an asset to be distributed in the property settlement part of the divorce.

For purposes of discussion, let us assume that the spouse who runs the couple’s business is Husband and that he will pay Wife for her 50% equity interest and he will continue to operate the business as his own; and, that Wife does not work in the business. Let us also assume that the only compensation going to the marital community is the compensation Husband earns out of the family business.

The dilemmas faced by the judge are these: 1. If Wife gets her 50% interest in the business bought out by Husband, should she also get spousal maintenance payments; and, 2. if Wife gets paid for her 50% business interest by Husband, should the amount of Husband’s compensation used to calculate the spousal maintenance payments be the same compensation deemed as a reasonable expense in valuing the business under an income approach?

Dilemma 1

Dilemma 1 is frequently protested in divorce by Husband who has to purchase Wife’s 50% business interest and also has to make monthly spousal maintenance payments. Husband will often cry “foul” and contend that this is a case of “double dipping”. That is, Wife already receives her interest in all future compensation of Husband because it is already contemplated in the business valuation. Some business appraisal experts do not agree with this thought process. The reason is this: The value of the business is the value of a marital asset, usually done at some date near the date of service of notice of divorce. This is no different than determining the value of a home, a marital asset which is also to be considered for property settlement purposes.

The value of the business is calculated on the amount of earnings or cash flows remaining after reasonable compensation has been deducted. It is this remainder or “excess,” generally after an estimate for income taxes has been removed, that will be valued in arriving at the portion of the value of the business asset to be distributed to Wife. There is, therefore, no double dip involved if spousal maintenance is to be paid by Husband. On the other hand, if no compensation expense is considered by the business appraiser in arriving at a value for the business, some appraisers then believe double dipping is occurring; that is, that the same compensation is being, in effect, considered twice: 1. by its exclusion in the valuation of the business thus overvaluing Wife’s interest; and 2. by it also being used in the spousal maintenance calculations.

Dilemma 2

Dilemma 2 may also bring opposition by Husband, who operates the couple’s business, and who also has to pay spousal maintenance. Husband, however, may find himself in his own dilemma. For example, in the valuation of an interest in a professional practice, say a medical one, reasonable compensation may be researched by the business appraiser to be $400,000, when the Husband/Doctor actually averages about $700,000 annually, and has done so for the last five years and likely will, for the next five. Husband will argue that his compensation for spousal maintenance purposes should be based on the $400,000 number and not the $700,000 amount.

One school of thought by business appraisal experts is that using the $400,000 as the benchmark for basing future spousal maintenance payments would be a mistake. The reason is this: The $400,000 is used for business valuation purposes as reasonable compensation to be paid to Husband/Doctor solely to arrive at a value under the standard of fair market value (*) . It is what the “market” at large would consider as reasonable compensation. Another way of thinking about this is to imagine what an absentee owner would pay to a physician to take the place of Husband to be involved in the practice: $700,000, or the market rate of $400,000 annually. If spousal maintenance is based on only the $400,000 amount, Wife will be losing out on an average of $300,000 per year on which her spousal maintenance payments would also be based.

Another school of thought is that only the $400,000 amount should be used for determining spousal maintenance in order to avoid, or lessen the effect of, the “double-dip” scenario mentioned previously.

Concluding thought

If you are thinking these dilemmas have to be something that gives judges gray hair in trying to determine what is equitable to the divorcing spouses, my impression is that you are… absolutely right!

Writer’s note: The foregoing comments are reflective of issues involving divorce cases occurring in Maricopa County, Arizona and may not be what happens in divorce matters in other jurisdictions. Other states, for example, may treat these two dilemmas entirely different than what has been depicted in this article.

Don R. Bays CPA, ABV, CVA, CFF

(*) Fair Market Value is defined in the Statement on Standards for Valuation Services, No. 1, of the American Institute of CPAs as: (T)he price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.