Businesses present their own challenges when dividing property and establishing income in a divorce. A business can be anything from a retail store to a home-based operation. It can be a medical practice, a construction business, a day care center, a dental practice, a law firm, or some other business. Businesses can be owned in several different ways. They can operate as sole proprietorships, partnerships, corporations, or various other business entities.
You Have a Silent Partner in Your Business: Your Spouse
It was 3:00 on a hot afternoon when Vince Reed, MD, rolled into his divorce lawyer’s parking lot in his new Jaguar. The sign on the door read, “Lauren West, Attorney and Counselor at Law.”
Vince and Carla Reed had been married for eighteen years when they decided to get divorced. Vince is a successful orthopedic surgeon.
During the marriage, he joined a group of other physicians providing medical services in a surgery center owned by Emery Surgery Center, LLC, a limited liability company. Vince owned one share in the center equaling 1 percent. He had paid $30,000 for it. The center was so profitable that Vince recovered his entire investment in the first two months.
“OK, so I went to medical school,” Vince explained to his lawyer as he sat down at her desk. “I earned the money to invest in the surgery center. I found the investment. I worked each day to make it successful. And you’re telling me she gets half? I don’t get it.”
“It’s marital property,” Lauren responded.
Tip A business started or acquired during the marriage is marital or community property no matter whose name it is in.
How Businesses Are Valued in a Divorce
The conversation between Vince and Lauren continued. They discuss the division of property in a separation agreement and what to offer Carla for Vince’s share of the surgery center.
“Then offer her $15,000,” Vince said. “That’s half of what I paid for the surgery center. It’s also half of what I would get if I left the practice.”
“Your wife’s attorney wants to have a business appraiser value your interest in the surgery center,” Lauren said.
“OK. A business appraiser will tell her it’s worth $30,000,” Vince suggested.
“No. He won’t. It doesn’t work like that,” Lauren informed him. “He’ll want a lot of information. Then, he’ll put it all in his computer and come up with a much higher number.”
“What information?”
“Articles of incorporation, operating agreement, amendments, a list of members, ledgers, accounts receivable, a profit and loss statement, and a balance sheet, to name a few,” said Lauren.
“That’s a big list.”
Documents
Six months later, Vince was still sending documents to his attorney to forward to his wife’s business appraiser.
It was a rainy afternoon when Vince called his lawyer to say, “It seems like every time I give them what they ask for, they want something more. Is this ever going to end?”
“I’ll call them,” Lauren assured Vince. “Maybe I will be able to expedite matters.”
Lauren called Carla’s attorney, Mitch Handelman. “Hi, Mitch. Lauren West here. What can we do to speed up the Reed case?”
“Get me all the documents my expert needs,” answered Mitch.
“Isn’t there some way around that?” asked Lauren. “What if we make a generous settlement offer?”
“I can’t advise my client whether an offer is generous or not until I know the value of the business,” said Mitch. “And I can’t know the value of the business until my business valuation expert gets all the documents he needs.”
“Once you get all the documents, how long will it take your expert to give us his opinion of value?” Lauren proceeded to ask.
“Two weeks,” said Mitch.
“I’ll hold you to that.”
A month later, Mitch set up a meeting with Lauren to present the opinion he received from the expert. When he got to her office, he handed Lauren the written summary.
“You’ll see that our expert used the projected cash flow of the business to value your client’s shares,” said Mitch. “He used very conservative assumptions.”
“And what does he say it’s worth?” asked Lauren.
“Between $1 and 1.5 million.”
There was silence in the room. Finally, Lauren stated, “Well, we’ll see what our expert says and get back to you.”
Vince and Lauren got her expert, Albert Cassini, on a conference call. “Vince bought his interest in the surgery center for $30,000. The expert told them two other doctors have been brought into the practice and they each paid $30,000 for their shares. The best determination of the fair market value of something is what it sells for. There have been three sales in the recent past. So, the correct value is $30,000.”
“What about the opinion claimed by the expert for Carla’s lawyer suggesting that it’s worth between one and one-and-a-half-million dollars?” Lauren asked.
“He just put numbers in his computer spreadsheet and took the result it gave him without thinking it through,” replied Albert. “That’s a common mistake in our occupation. You have to look at the numbers, but you have to apply common sense as well.”
“Why would the sellers sell such an attractive income stream for so little?” asked Lauren.
“Because they want to acquire more patients and grow. So they are looking for doctors with a good client following. That limits the number of qualified buyers. A small number of qualified buyers means the buyers can negotiate a lower price. The doctors know they can buy the income stream at another clinic for $30,000 if they can’t get it at this one,” explained Albert.
Discounts
Lauren’s expert proceeded to educate Lauren and Vince. “There are also certain discounts that may be applied to value a business properly.”
“Like what?” asked Vince.
“There are four things,” explained the expert and then went on to describe them. They can be categorized as follows:
- Lack of Control: As stated by the expert, “We can discount the share value for lack of control. Since your shares aren’t the controlling ones for the business, they are worth less than shares that are.”
- Lack of Marketability:The next point the expert made was, “When a business interest would be hard to sell, its lack of marketability creates a discount. IBM stock is easy to sell because there is a market for it. An interest in a medical practice is not as marketable.”
- Personal Goodwill: The next discount he described to them was goodwill. “You are also entitled to a discount for personal goodwill. Goodwill is the portion of the business that is attributed to the owner rather than the business. For example, if people come to the business because of the reputation and skill of the owner, that’s personal goodwill. If a business has several different stores and employees, then there may be less personal goodwill and more business goodwill. Many states treat personal goodwill as separate property in a divorce, subtracting it from the value of the business.”
- Uncle Sam: “If you sell your business at a profit, you would have to pay a capital gains tax,” said the business valuator. “Future taxes will therefore also be considered as a discount to value. However, some judges will not take taxes into account because there is no actual sale of the business in a divorce.”
“These, among other reasons, are why your portion of the business, Vince, is worth just $30,000 in my view,” the expert concluded.
Lauren thanks the expert, and the call is ended. She and Vince continue talking.
“Vince, there are a couple of other things you need to know,” Lauren says.
Tip Have your business valued by an expert. If your spouse has an expert, be prepared to argue for your value compared with the value she comes up with.
Double-Dipping
“There is also an argument that your spouse is double-dipping,” said Lauren.
“What do you mean?” asked Vincent.
“The double-dipping argument goes like this,” started Lauren. “First, the judge determines alimony and child support based on your income. The income he considers is all from the earnings of the business. Next, the judge will determine a division of marital property. The judge may choose to use the value presented by your wife’s expert, in which case you will have to pay half the present value of your future earnings to your wife for a buyout. Your wife’s expert will use the future earnings of the business to come up with the value. That’s in addition to support. So, she has effectively used the same earnings twice, once for alimony and once for the business buyout. That’s double-dipping.”
“So what do we do?” asked Vince.
“We try to settle,” replied Lauren. “We agree on a price and terms for you to buy her interest with payments over time.
“And what if we can’t settle?”
“Then the judge will listen to both experts and decide for you.”
Valuing Business Assets
The family business is usually a main source of income. Therefore, it is probably a valuable asset worth fighting over in a divorce.
You fail to value the family business at your own peril in a divorce. Take Ron, who bought a tree-chipping company. He had several contracts with local governments and was very successful. In his divorce, he told his wife, Louise, that his accountant had valued the business at about $250,000. He offered to pay her half of that. Louise ran that by her attorney, who recommended she get the business valued on her own. She did and the appraiser said it was worth $600,000. She finally settled on a $250,000 payment. Although she had to pay $5,000 for the appraisal, it was worth it for her to receive $125,000 more than the original offer.
A business owner may benefit from an evaluation also. Steve owned a company that sold paper rolls for cash registers and credit card machines. His wife, Sandy, was a salesperson for the company and responsible for most of its success. Her accountant valued the business at $2 million based on its discounted future earnings. Steve’s expert valued the business at $600,000 and then discounted that by 50 percent for lack of marketability. The judge found Steve’s expert to be more believable and gave Sandy an award of $300,000.
There is a temptation to hire the accountant for the business to value it. After all, the accountant already has the financial information. This may work for settlement purposes. But for trial, your accountant must have expertise in valuing businesses in order to qualify to testify as an expert and give an opinion of value. Otherwise, consider hiring a certified business appraiser (CBA).
But be aware that even experts can make mistakes. In one case, Sarah bought a company that published an advertising magazine for realtors. She and her husband, Mark, also owned a home and a rental property. She offered to trade his interest in her business for her interest in the couple’s real estate. In order to do this, they agreed to jointly hire an expert to value the business. The expert discovered the lingerie she purchased at Victoria’s Secret on the company credit card but somehow failed to notice the $300,000 she paid to herself and her husband last year as dividends. He valued the company at $150,000. The equity in the two real properties also totaled about $150,000, so the deal was made.
So ask your expert to identify any errors or weaknesses in the report of your spouse’s expert. Appraisers use assumptions when valuing a business. So different appraisers can have widely differing values.
Sometimes, people confuse business assets and individual assets. For example, if your spouse has an automobile, you will want to examine the title to see if it is owned by your spouse or your spouse’s business. If it is owned by the business, it will be taken into account when the business is valued. In other words, the value of the automobile will be included in the price of the stock owned your spouse (if the business is a corporation). The same goes for office equipment, computers, and inventory.
What to Do with the Business
If you both own the business, one option is to do nothing. You can continue to operate the business as partners after the divorce. Some people are able to do this successfully. But most couples prefer not to continue in business with an ex-spouse.
Stan and Stella owned a jewelry business together with four stores. Stella was in charge of buying and selling jewelry. Stan took care of hiring and firing people, negotiating the leases, and supervising the build-out of the stores. They tried running the business together after their divorce, but they had constant disputes, causing Stella to hide some of the inventory and Stan to sue to appoint a receiver. They finally reached an agreement for Stella to buy out Stan’s interest in the business over time.
If you are lucky enough to have a business that can be divided into two approximately equal businesses, then each spouse can take one part of the business.
You can also sell the business outright and split the proceeds. Doing this will allow the parties to take the proceeds and start new businesses on their own if they wish or retire. You will need to agree on how decisions will be made until a buyer is found. And it may take a while to find the right buyer. Also, there will be a capital gains tax to be paid if the business is sold for a profit.
The approach that most people take is for one spouse to buy the other’s interest in the business. You can pay in cash or trade other assets, like a pension plan or equity in the house. If there is not enough cash or other assets, you can agree to payments over time. The parties can agree on a buyout price or have their business appraised. When one spouse transfers appreciated assets in a divorce, there is no capital gains tax. That tax will be collected from the spouse who keeps the business if it is sold for a profit in a subsequent transaction.
Note Unless you can work together after the divorce, or the business is easily divided, you will have to sell it or one of you will have to buy out the other.
Professional Degrees and Licenses
Rachel sacrificed her own education to work to put Tim through medical school. Once Tim graduated and started his internship, they separated and Tim filed for divorce. Is this fair to Rachel? Should she be compensated somehow? How much?
Most states say a degree or license is not property and cannot be equitably divided in a divorce.
A few states, like New York and Massachusetts, disagree. They permit an expert to place a value on a degree. This is usually accomplished by estimating the difference in lifetime earnings of the person with a professional degree and the one without a degree.
Louisiana allows a spouse in this situation to claim reimbursement for the cost of obtaining the degree.
Intellectual Property: Patents, Trademarks, Copyrights, Royalties
Max was a famous painter. His artwork sold in galleries around the world. While he was a gifted artist, it was his wife Nora who inspired him to paint for a living and who managed the business aspects of his career and artwork. It was she, for example, who obtained the contracts for reprints. In their divorce, they were able to agree on support and dividing his inventory of paintings, but they were stuck on how to divide future royalties that he would receive for reprints of paintings created during the marriage. They ultimately agreed to set up a trust for their children and deposit a portion of the royalties into that trust.
In dividing a marital estate, don’t overlook intellectual property like inventions, patents, trademarks, copyrights, royalties, and trade secrets that were acquired during the marriage.
Note Professional degrees and licenses are not marital property in most states, but intellectual property is.
Income
The income of a business owner is used to determine child support, and it is one of the factors considered in determining spousal support. But a business owner who has control is able to manipulate income and even hide money.
In the year of the divorce, a business owner can delay collection of receivables or even lose payments by customers in a desk drawer and forget to deposit them.
A business owner can speed up the payment of bills and pay in advance. Most business owners pay estimated taxes quarterly. One trick is to pay more taxes than you owe and then file for a refund after the divorce.
A business owner can also stock up on inventory. There will usually be a line of credit from a bank. A business owner can borrow to meet cash flow needs and claim these are borrowed funds rather than income. Then the owner can pay the loan off after the divorce.
An accountant or the expert you use to value the business can determine the true income of a business owner by looking at the books and records of the business. The expert will look at the records for several years of business operations and not just for the year of the divorce.
Tip A business owner with control can manipulate income for the year of the divorce. An accountant or other financial expert can tell if there has been manipulation in the figures and give an opinion of true income. So, have your expert take a good look if you suspect there is more income to be uncovered in a business.
Summary
A family business can add complexity to dividing marital assets and determining income in a divorce. You will need your own expert to value the business and determine the income it produces. If your and your spouse’s experts have opinions that are far apart, the judge may have to decide. In most states, a professional degree or license is not marital property. Neither is the personal goodwill of a business. In the next chapter, we’ll examine the division of bank accounts, stocks, and other assets.