Professionals who are partners, shareholders, or solo practitioners of a professional practice have no doubt already consulted attorneys and accountants on the most advantageous way to set up the practice, focusing on the twin issues of professional liability and tax liability. Smart planners may have already considered the consequences of divorce by prenuptial agreements or other pre-divorce planning devices. Most, however, have not.
The first thing to remember when a professional divorces is “Don’t Panic.” Underlying the obviousness of the advice is an important legal principle: undertaking asset liquidation or other moves outside the ordinary course of business can open up a spouse to the charge of “dissipation of marital assets,” that is, taking assets out of the marital estate for the sole benefit of one partner to the detriment of the other partner.
Trying to manipulate assets during the breakdown of a marriage is also a good way to lose credibility with a court as the divorce wends its way through the legal system. Judges simply don’t like spouses who try to hide or shield assets in ways that are not specifically sanctioned in the tax code. It is therefore important for a professional to continue to operate the practice without regard to the divorce to the largest extent possible.
The Discovery Process
During the divorce process, the lawyers will engage in discovery to ascertain the marital estate, that is, all the assets acquired by the parties during the marriage. Just because a spouse started or joined a professional practice before the marriage, however, does not mean that none of the professional practice is part of the marital estate.
The increase in value of the professional practice that occurred during the marriage is part of the marital estate. Thus, the attorneys have the right to undertake discovery to determine the value of the professional practice both at the time of the marriage and at the time of divorce in order to determine what portion of the value of the professional practice is part of the marital estate.
In the discovery process, all financial records of the practice are open to scrutiny. This does not mean that confidential patient information is also open to discovery. State statutes regarding confidentiality as well as the federal Health Insurance Portability and Accountability
Act (HIPAA) will shield these records.
The Most Important Issue: Valuing the Professional Practice
There are many reasons one might need to value a professional practice: admitting a new partner or expelling an existing partner, the death of a partner, the purchase or sale of the merging practices, estate planning, financing, inter-partner disputes, and, of course, divorce.
When a professional practice is valued for divorce, the method of valuation can differ from the method used in other situations. For example, the partnership agreement may specify that in the case of one partner leaving the practice, “book value” will be used to determine each partner’s share. This method of valuation, however, is not appropriate in divorces.
Moreover, professional practices, as opposed to other businesses, have special valuation issues that do nor arise in other businesses, the most important of which is the concept of “professional goodwill” or “personal goodwill.”
Standard of Value
The first step in valuing a professional practice is to determine the standard of value to be used. There are a few generally accepted standards of value:
- Fair market value
- Liquidation value
- Going concern value
- Book value
- Original cost value
Other standards of value include replacement value, appraised value, investment value, and intrinsic value.
Fair market value is defined as the price that a willing buyer would pay to purchase the asset on the open market from a willing seller, with neither party being under any compulsion to complete the transaction. In the divorce context, the court must find present net fair market value, i.e., fair market value reduced by the value of any liens or other debts that encumber the business, as of the appropriate date of valuation. Most courts agree that in reaching “net” fair market value, even though fair market value assumes a hypothetical sale, unless a sale is actually contemplated, it is inappropriate to deduct the costs of a hypothetical sale. It is also important to note that the date of valuation is determined by statute or case law, and varies from state to state. It is therefore important to determine the appropriate date of valuation.
Liquidation value is defined as the amount the owner would receive if the owner were forced to sell the asset on the date of valuation. Liquidation value assumes a sale under compulsion, and almost always yields a value lower than fair market value. Courts have generally rejected liquidation value as a standard of value.
Going concern value is, in actuality, a broad term that comprises a group of standards of value that look to the value of the business as an ongoing functioning enterprise. The distinguishing feature of going concern value is that it emphatically rejects liquidation value or book value.
Book value is defined as the value arrived at by adding all assets and deducting all liabilities. Book value is highly subject to manipulation and is thus generally not used by divorce courts as the standard. Many courts, however, consider book value as one piece of evidence in determining fair market value.
Original cost is the purchase cost of the business or the start-up cost of the business. Because most, if not all, professional practices increase in value after the initial costs of tangible assets are acquired, original cost is not an appropriate measure for a professional practice.
Of course, in the divorce context, the parties are free to agree or stipulate to the valuation of a particular business. Such agreements or stipulations are ordinarily binding on the parties in the absence of fraud, duress, overreaching, and other contract defenses.
Valuation Methods
Although the goal of valuation is to reach a determination of “present net fair market value,” the courts do not require any one particular method of reaching that determination. The following are commonly accepted methods of valuing of a professional practice:
- Revenue Ruling 59-60
- Total value method,
Under either of these methods, the court adds the value of the physical assets and the accounts receivable, and subtracts the liabilities. If the business has divisible goodwill, the court must also value the goodwill as a component of the practice’s value.
Valuation of divisible goodwill has its own subset of valuation methods:
- Capitalization of excess earnings
- Comparable sales
- Subjective estimation
- Subjective Estimation
Under the capitalization of excess earnings approach, the court computes the difference between the actual earnings of the business and the earnings of the “average” business. This difference is then capitalized, i.e., multiplied by a factor of between one and five. Capitalization of excess earnings is the most generally accepted valuation method where goodwill is divisible. If the business owner has deliberately depressed the business earnings in order to minimize the value of goodwill, then this approach will yield an incorrect value. Thus, dissipation should always be considered if goodwill is valued at zero.
Under the comparable sales approach, the valuator looks at sales of similar businesses in the same area near or on the date of valuation. Goodwill is determined by subtracting the total sale price in the comparable sales from the total value of tangible assets.
Some courts have accepted subjective estimations made by expert witnesses when those estimations are based on factors such as the practitioner’s age, health, past earning power, reputation, professional success, and other subjective factors such as whether the business is highly dependent on one customer.
Goodwill or Not Goodwill?
The first step in understanding the division of authority on the divisibility of goodwill is to define goodwill accurately. When businesses are bought and sold on the open market under conditions far removed from any divorce case, the negotiated sale price is often greater than the total value of the tangible assets of the business involved. This value is “goodwill.” The “goodwill” of a business is defined in Webster’s Third New International Dictionary as “favor or advantage in the way of custom that a business has acquired beyond the mere value of what it sells whether due to the personality of those conducting it, the nature of its location, its reputation for skill or promptitude or any other circumstance incidental to the business and tending to make it permanent.”
Because the definition of goodwill is based upon the observed difference between the tangible asset value and the actual sale price when a business is sold on the open market, the question of whether a business can be actually bought and sold is crucial to determining the divisibility of goodwill. If the goodwill can actually be bought and sold, then the goodwill is realizable goodwill (sometimes referred to as “enterprise goodwill”) and can be valued. If it cannot be bought and sold, the goodwill is unrealizable goodwill (sometimes referred to as “professional goodwill” or “personal goodwill”).
Realizable Goodwill
The easiest type of goodwill to classify is realizable goodwill: goodwill that the owner can convert into cash at any time by selling his business on the open market. Where goodwill is readily convertible into a cash equivalent, the cases agree almost uniformly that it constitutes marital property that can be valued. Since realizable goodwill has an immediate cash value, it cannot be argued that it represents nothing more than future earnings. It could, perhaps, be argued that the value of such goodwill is speculative, but the courts have generally held to the contrary. If increased future earnings are sufficiently likely that buyers in arm’s- length transactions are willing to pay an enhanced price, it is hard to argue that the increased earnings are so speculative as to make valuation impossible. As a Maryland court noted, “True goodwill reflects not simply a possibility of future earnings, but a probability based on existing circumstances.”
One state, South Carolina, has held that all goodwill, including realizable goodwill, is not divisible marital property.
Unrealizable Goodwill
Division of goodwill is a much, much closer issue when the business in question cannot be sold on the open market. This situation applies most frequently in professional practices, such as doctors, lawyers, and mental health professionals, where the goodwill is indistinguishable from the personal reputation of the owning spouse. In the case of unrealizable goodwill, when the professional dies or retires, nothing remains. The professional’s files and lists of clients are of no use to others. The very nature of a professional practice is that it is totally dependent upon the professional. The states are now almost evenly divided on the question of whether such unrealizable goodwill is divisible property. In North Carolina, the courts have held that unrealizable goodwill is of value to the marital estate’s divisible property.
The Valuation Procedure
The most important witness in a complex valuation case is going to be the expert hired to value the business. Courts prefer well-qualified witnesses conversant with the particular facts of the case and able to clearly articulate the basis for his or her valuation. When an attorney understands the law and the valuation expert is able to render a persuasive opinion, the client has a winning team.
Other Valuation Issues
While valuing the goodwill of the professional practice is the most tricky valuation issue when a professional divorces, other assets associated with the professional practice should not be overlooked. As noted above, the fair market value of the professional practice is the standard, and this includes the tangible assets of the business, as well as accounts receivable and even contingency fees for work performed during the marriage.
Retirement accounts, including 401(k)s, IRAs, and other employment-related pension vehicles are also valued and divided.
Dividing the Practice
Although divorce courts “divide” the marital estate, a court will never “divide” a professional practice so that both spouses are owners (partners or shareholders) of the practice for two reasons. First, state statutes prevent a non-professional from having an ownership share in a professional practice. Second, having spouses as co- owners of a business keeps the spouses’ financial lives entangled, and one of the goals of divorce is to untangle the parties’ financial affairs.
In North Carolina, a court will also never order that the professional practice be sold and the proceeds split between the parties. Remember, in North Carolina, unrealizable goodwill is considered part of the marital estate because it has value to one of the spouses. If a sale were forced, the sale price (fair market value including enterprise goodwill) would never equal the value placed on the professional practice, which also includes personal goodwill; the parties would thus lose a great amount of value as a result of a sale, and this would be immensely unfair.
What the court will do is award the owning spouse the professional practice and either order the owning spouse to pay the non-owning spouse an amount representing the non-owning spouse’s share (a monetary award) or grant to the non-owning spouse an amount of other marital property equal to the non-owning spouse’s share (an offsetting property award). In North Carolina, there is a presumption in favor of an offsetting property award.
If the marital estate’s primary asset is the professional practice, the court can’t order an offsetting property award–there isn’t enough property to offset the spouse’s share of the professional practice. In that event, the court may make a monetary award, payable at a rate that pays off the award as soon as practicable. Monetary awards that take years and years are not fair to the non-owning spouse, even if the award has interest.
No matter whether the court orders a monetary award or an offsetting property award, there should be no adverse tax consequences. Internal Revenue Code § 1041 provides that a transfer of property between a husband and wife, or a former husband and wife, incident to divorce, is a nontaxable transaction in which the recipient assumes the existing adjusted basis in the property and all liability for any capital gains tax incurred in the event of a subsequent taxable disposition of the property.
The tax consequences are not the same, however, if the owning spouse assigns income to the non-owning spouse as a means of paying a monetary award. An assignment of income is not a nontaxable transaction, and thus there are tax consequences to both the assignor and the assignee.
