An issue that befuddles some business owners during the course of their divorce litigation is how to regulate the operation and management of their businesses. In cases where both spouses own interests in the business, they may struggle for control of important business and financial decisions.

Some issues may be resolved under the company’s partnership agreement, shareholders’ agreement, limited liability company (LLC) agreement, or corporate by-laws. Yet, these agreements are often too vague to deal effectively with disputes between divorcing spouses who own businesses together.

Early in the evolution of the Divorce Code, the Superior Court of Pennsylvania authorized the Courts to appoint receivers or trustees to prevent the dissipation of an ongoing business concern. Mayhue v. Mayhue, 485 A.2d 494 (Pa.Super.1984). The Superior Court in Mayhue held that 23 Pa.C.S. § 3505(a) and 23 Pa.C.S. § 3323(f) authorized the Courts to enter an injunction to prevent a spouse from continuing a course of conduct calculated to defeat his wife’s property rights in the business. The Superior Court in Mayhue approved the trustee’s powers to liquidate assets to pay business debts, pay delinquent taxes, and satisfy intercompany debts.

The appointment of a receiver is not practical in every case because the expense of paying a receiver may not be justified. Still, there are some cases in which third party supervision of the business might be the only practical way t0 ensure continued smooth operation of a business caught in the middle.

The California Court of Appeal’s decision in Marriage of Blazer (2009) dealt not only with double dipping, but also with the exclusion of a company’s retained earnings when determining the owner’s income subject to an alimony obligation. After a 20 year marriage, Husband and Wife divorced, the husband retaining ownership of a berry distribution business. At trial, the husband’s expert testified that the berry company was thinly capitalized for its gross revenue. Wife’s expert agreed (if not grudgingly) that some earnings must be retained for capital reserves. The trial court excluded these retained earnings from the husband’s income for alimony purposes.

The husband’s expert also testified that retailers were seeking to eliminate middlemen, forcing the business to integrate vertically. The capital expenditures to purchase a growing farm and expand distribution were not added back to the company’s income, despite wife’s argument that husband “chose” to incur those expenses and would benefit from the enhancement in the company’s value. Again, the trial court adopted the position of the husband’s expert, over the opposition of wife’s expert.

On appeal, the California Court of Appeals affirmed the trial court’s decision under an “abuse of discretion” standard. The Court noted that there is no statutory definition of “income” for alimony cases in California, and it was unclear whether retained earnings could be properly categorized as “income” for alimony purposes. Case law held that the child support definition of “income” did not apply to alimony cases.

The Tennessee Court of Appeals recently held that a business owner’s spouse who signed a buy-sell agreement was bound by the value in a divorce action. In Inzer (2009), the husband and wife both signed a buy-sell agreement when they formed an LLC to purchase a Sonic Drive-In franchise. The buy-sell agreement granted other partners a right of first refusal to buy the interests of a withdrawing partner for the lesser of book value or the offer procured by the withdrawing partner. The owner’s expert presented evidence that the owner’s 24% interest in the franchise was worth $120,000 to $135,000 using capitalized cash flow or market methods, but only $16,000 net book value after discounts. Wife’s expert testified to a value of more than $500,000 after making adjustments to the owners’ compensation and ignoring discounts for lack of marketability, lack of control or the restrictive operating agreement.

The trial court valued the owner’s interest at $200,000 without much explanation. The Tennessee Court reversed, holding that the franchise was worth $33,000 book value without consideration of intangible value or discounts (as specified in the buy-sell agreement). The appellate court distinguished cases in which buy-sell agreements were not controlling, since the non-owner spouse in those cases did not sign the buy-sell.

Consider whether it was appropriate for Wife’s expert to perform  Type I adjustments in his normalization of the income statement, i.e., adjusting the owners’ compensation. Could a purchaser of a 24% interest compel the other owners to reduce their compensation? Even if the Court had not held the buy-sell to be controlling, it seems unlikely that Wife’s expert would have prevailed.

In divorce litigation where one of the spouses owns a professional practice, such as a medical practice, dental practice, law firm or accounting firm, the lawyers and their experts have to determine whether the business has value. Their determination depends upon whether the professional practice is believed to have enterprise goodwill.

Briefly, enterprise goodwill is the price that a buyer would pay for a professional practice over and above the value of its hard assets like equipment and supplies. In theoretical terms, enterprise goodwill is the reputation of the business that is not closely associated with a particular owner or professional. The opposite of enterprise goodwill is personal goodwill, which is the reputation and skill of the professional. Enterprise goodwill has value because it is transferrable but personal goodwill is not. Someone might be willing to pay for a name like Aspen Dental Systems, but what about Jane Doe, PC?

Increasingly, there is a market for professional practices that are not part of a regional or national chain. Dental practices, even those with a single location and single dentist, are bought and sold frequently. The same is true for specialty medical practics. Yet, primary care medical practices and legal practices are rarely bought or sold. So, how does a lawyer decide whether a professional practice should be evaluated by a business valuation specialist? Here are three signs that a professional practice might have value:

1. Actual transactions. If a professional or his/her partners have bought or sold their practices, it is more likely that there is transferrable enterprise goodwill. However, you must distinguish market transactions from succession planning. If the only transactions are between retiring partners and advancing associates, then there may not be much enterprise goodwill.

2.  Subordinates and equipment.  One reason why dental practices are increasingly transferrable is that dental procedures are performed by hygenists and associate dentists. If the owner of the practice is earning profit from other professionals and paraprofessionals, then a buyer might be willing to pay something to step into those shoes.

3.  Excess compensation. If a professional is earning substantially more than industry standards, then the professional’s practice might have enterprise goodwill. No buyer would pay to assume an existing practice if he or she could start a new practice for free – except if the existing practice were more profitable than a new practice would be. This criteria is based on the principle of substitution.

The U.S. Court of Appeals for the Seventh Circuit recently took up the case of Menard v. Commissioner, 560 F.3d 620 (2009), considering whether the CEO of a privately-held company was receiving a dividend disguised as salary from the business he controlled. The CEO whose salary was questioned was John Menard, founder and controlling shareholder of Menards, a chain of retail hardware and building supply stores. The Tax Court took the position that John Menard’s $20 million salary was really a disguised dividend because it was much greater than the salaries of the Home Depot and Lowe’s CEOs, who earned $2.8 million and $6.1 million respectively.

The appellate court’s opinion in this case is so well-researched that I cannot help but include large blocks of text, starting with its introduction to the subject:

The Internal Revenue Code allows a business to deduct from its taxable income a “reasonable allowance for salaries or other compensation for personal services actually rendered,”[or] “payments purely for services.” Occasionally the Internal Revenue Service challenges the deduction of a corporate salary on the ground that it’s really a dividend. A dividend, like salary, is taxable to the recipient, but unlike salary is not deductible from the corporation’s taxable income. So by treating a dividend as salary, a corporation can reduce its income tax liability without increasing the income tax of the recipient. . . As a result of a change in law in 2003, dividends are now taxed at a lower maximum rate than salaries—15 percent, versus 35 percent for salary. 26 U.S.C. § 1(h)(11). This makes the tradeoff more complex; although the corporation avoids tax by treating the dividend as a salary, which is deductible, the employee pays a higher tax. But depending on its tax bracket, the corporation may still save more in tax than the employee pays, and in that event, if the employee owns stock in the corporation, he may, depending on how much of the stock he owns, prefer dividends to be treated as salary. . . . Even before the change in the Internal Revenue Code, treating a dividend as salary was less likely to be attempted in a publicly held corporation, because if the CEO or other officers or employees receive dividends called salary beyond what they are entitled to by virtue of owning stock in the corporation, the other shareholders suffer. But in a closely held corporation, the owners might decide to take their dividends in the form of salary in order to beat the corporate income tax, and there would be no one to complain—except the Internal Revenue Service.

The usual case for forbidding the reclassification (for tax purposes) of dividends as salary is thus that “of a corporation having few shareholders, practically all of whom draw salaries,” Treas. Reg. § 1.162-7(b)(1), especially if the corporation does not pay dividends (as such) and some of the shareholders do no work for the corporation but merely cash a “salary” check. A difficult case—which is this case—is thus that of a corporation that pays a high salary to its CEO who works full time but is also the controlling shareholder. The Treasury regulation defines a “reasonable” salary as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances,” § 1.162-7(b)(3), but that is not an operational standard. No two enterprises are alike and no two chief executive officers are alike, and anyway the comparison should be between the total compensation package of the CEOs being compared, and that requires consideration of deferred compensation, including severance packages, the amount of risk in the executives’ compensation, and perks.

Courts have attempted to operationalize the Treasury’s standard by considering multiple factors that relate to optimal compensation. [Citations omitted.] We reviewed a number of these attempts in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.1999), and concluded that they were too vague, and too difficult to operationalize, to be of much utility. Multifactor tests with no weight assigned to any factor are bad enough from the standpoint of providing an objective basis for a judicial decision [citations omitted]; multifactor tests when none of the factors is concrete are worse, and that is the character of most of the multifactor tests of excessive compensation. . . . All businesses are different, all CEOs are different, and all compensation packages for CEOs are different.

In Exacto, in an effort to bring a modicum of objectivity to the determination of whether a corporate owner/employee’s compensation is “reasonable,” we created the presumption that “when . . . the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner/employee’s] salary is presumptively reasonable.” But we added that the presumption could be rebutted by evidence that the company’s success was the result of extraneous factors, such as an unexpected discovery of oil under the company’s land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. 196 F.3d at 839.

The strongest ground for rebuttal, which brings us back to the basic purpose of disallowing “unreasonable” compensation, is that the employee does no work for the corporation; he is merely a shareholder. [Citations omitted.] Comparison with the compensation of executives of other companies can be helpful if—but it is a big if—the comparison takes into account the details of the compensation package of each of the compared executives, and not just the bottom-line salary. This qualification will turn out to be critical in this case.

Having explained the context of this case, the Circuit Court next explained why the Tax Court’s analysis was wrong, especially its comparison of John Menard’s salary to the salaries earned by the Home Depot and Lowe’s CEOs in that year. The appellate court first rejected the notion that the taxpayer’s $17 million bonus, which was equal to 5% of the company’s net income before taxes, was more likely to be a dividend than salary because it was paid at year’s end; was approved by a board that the CEO controlled without outside directors; must be returned if the IRS should disallow the company’s tax deduction as salary; and exceeded the salaries earned by the CEOs of publicly-traded competitors (Home Depot and Lowe’s). The appellate court noted that the managers of privately-held companies often face greater risk than public companies, warranting greater reward for success:

Of particular importance to this case is the amount of risk in the compensation structure. Risk in corporate compensation is significant in two respects. First, most people are risk averse, and the scholarly literature on corporate compensation suggests that risk aversion is actually an obstacle to efficient corporate management because managers tend to be more risk averse than shareholders. Shareholders can diversify the risk of a particular company by owning a diversified portfolio, but a manager tends to have most of his financial, reputational, and “specific human” capital tied up in his job. [Citations omitted.] So the riskier the compensation structure, other things being equal, the higher the executive’s salary must be to compensate him for bearing the additional risk.

That is not a critical consideration in this case because, as we said, management and ownership in Menards are not divorced. But a second significance of risk in a compensation structure is fully applicable to this case. A risky compensation structure implies that the executive’s salary is likely to vary substantially from year to year—high when the company has a good year, low when it has a bad one. Mr. Menard’s average annual income may thus have been considerably less than $20 million—a possibility the Tax Court ignored. Had the corporation lost money in 1998, Menard’s total compensation would have been only $157,500—less than the salary of a federal judge—even if the loss had not been his fault. The 5 percent bonus plan was in effect for a quarter of a century before the IRS pounced; was it just waiting for Menard to have such a great year that the IRS would
have a great-looking case?

The appellate court also noted that the Tax Court had not considered the total compensation packages of the CEOs from the public companies, such as equity compensation, severance packages, retirement plans, and perks. The appellate court noted that the CEO of Home Depot, whose salary was used as a benchmark, actually earned $124 million over six years, and a $210 million severance package when he was forced out. The Court of Appeals also noted that the Tax Court had not considered the salaries of other senior managers, both of Menards and of the benchmark public companies, which may have indicated that this CEO was more productive and delegated less than average. The Court observed that John Menard worked 14 to 16 hours per day, six to seven days per week.

The Seventh Circuit adopted a skeptical, even sarcastic, tone toward the Tax Court’s remark that the owner of a business has no need for incentive compensation because ownership is incentive enough. The Court of Appeals held that owners should not be treated differently from other managers.

Having concluded that John Menard’s $20 million salary was not excessive, the Court of Appeals reversed.

Gallows humor is intended to comfort us in troubling times, I suppose. An article in the New York Times offered a new definition of “goodwill” appropriate to the ongoing economic recession. In “Losses in Goodwill Values Dog Bank Deals,” the NYT defined goodwill as “the amount they overpaid for a business compared with the sum of its parts.”

Goodwill appears on the balance sheet of a business when it purchases other businesses. In that context, goodwill is equal to the price paid for the acquisition target in excess of its book value. Every good joke contains a kernel of truth.

BVWire recently published a follow-up to its teleconference, Valuing Dental Practices, by raising a question about business valuation using the excess earnings method (also known as Treasury Method).

Where do you get your cap rates under an excess earnings method? It’s a question that came up at the recent BVR teleconference, Valuing Dental Practices, featuring BV experts James Andersen, Ron Seigneur, and Stephen Persichetti, a practicing dentist and professor of dental practice management. In answer to the query, one panelist explained, “When you’re using excess earnings, it’s appraiser’s judgment. I’ve seen reports that use Ibbotson or D&P. But your cap rate has to be larger, and sometimes significantly higher, as much as 40% and 60%.”

The BVWire™put the question to Seigneur, who cautioned, “There is no holy grail for developing the capitalization rate under the excess earnings method.” That said, he offered the following insights as a “reality check” for BV experts:

When breaking the economic returns of an enterprise out between the returns on tangible assets and the returns on the intangible assets, it is commonly accepted theory that the returns on the tangible asset base is less risky, and therefore, require a lower economic return to justify the risks associated with the tangible assets. On the other hand, the rates of return required for each class of assets (be they tangible, like cash, inventory, fixed assets, etc., or intangible, such as the reputation of the business, the customer base, etc.) must collectively reconcile to the overall economic return (e.g. capitalization rate) on the overall, all in, benefit stream of the entity.

For example:

If the enterprise is assumed to justify a 30% overall capitalization rate, the returns on the various categories of tangible assets will likely each be below this 30% combined return. The returns required to capture the risks of the various intangibles will likely each be above 30%, with the overall weighted or blended rates tying back to the 30% overall risk adjusted rate associated with the entity take as a whole.

I’m not sure I know the answer to this one, so I’m throwing it out there for comments.

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.

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.