Business Ownership and Divorce in Massachusetts
David M. Bilodeau (Spring 2011)
This paper is meant to be a guide to explain the complex issues that arise when one or both of the parties to a divorce own a business or an interest in a business. This guide is not a substitute for the determinations of a valuation expert, rather it is meant to explore the important issues related to the topic and describe how the Massachusetts courts have ruled on those issues.
This guide will address the following topics: 1) Assignment of a spouse owned business or business interest to the marital estate; 2) Date of business valuation; 3) Methods for calculating the value of a spouse owned business; 4) Role of experts in divorce cases involving ownership of a business; and 5) Factors that can affect the value of a business.
II. Assignment to Marital Estate
It is well recognized in Massachusetts that upon the dissolution of a marriage, the marital estate should be divided equitably, as opposed to equally. In general, all property owned by either spouse is subject to division, regardless of when it was acquired. In making an equitable division of the marital estate, the judge must provide an express conclusion for his determination of the division. Judicial determination of equitable distribution will not be reversed unless found to be "plainly wrong and excessive."
In order to facilitate division, the present value of all assets in the marital estate must be determined. Where the present value of an asset is too speculative, courts will generally exclude that asset from the marital estate. Also, property acquired after the divorce cannot be included in the marital estate. Therefore, a business or interest in a business can be included in the marital estate so long as it is owned by at least one of the parties prior to the divorce and a present value of the business can be determined.
Where sufficient non-business assets exist, courts generally allow the business owner spouse to retain full ownership of their business or interest, while assigning other marital assets to the non-business owner spouse to ensure the equity of a division. However, if there is not sufficient non-business assets, courts generally assign a portion of the business to the non-business owner spouse and order the business owner spouse to buy out the other spouse's interest by either a lump sum cash payment or through a series of interest bearing installment payments. Similarly, when a business is owned by both spouses, it is likely that the court will order one of the parties to relinquish their share of ownership and receive payment by a method described above.
Where the non-business owner spouse has worked for the other spouse's business and increased the value of the business, it is appropriate to award the non-business owner spouse a credit based on the amount that their work increased the value of the business during the marriage. Courts have allowed spouses to enter into a non-compete contract with each other to prevent the spouse who was divested of their interest in the business from opening up a similar company immediately following the divorce.
Income earned by a spouse owned corporation may be imputed to that spouse to meet his child support obligation.
III. Date of Valuation
The date of valuation of a business is a critical decision which can drastically affect the final determination of an asset's value. Furthermore, the value of a business can change frequently.
Massachusetts courts employ the general rule that the value of the "marital estate is typically determined as of the date of the divorce trial." Despite the general rule, a "judge has the discretion to make that determination at another date when warranted by the circumstances of a particular case."
The court will value assets in the martial estate as of the date of separation where there is sufficient evidence that the parties' marital relationship ended on the date of separation. The court will weigh the following factors when determining if the marital relationship has ended: 1) whether the parties have ceased to hold themselves out as a married couple ; 2) whether the parties have engaged in other romantic relationships ; 3) whether the parties have made attempts to reconcile ; 4) whether the parties filed their tax returns together ; 5) whether either spouse induced hope in the other that the relationship would continue post separation ; 6) whether one spouse ceased to contribute to the marital relationship ; and 7) whether a spouse has provided financial and emotional care for a child of the marriage post separation.
The parties will share equitably in any change in value to the marital estate after separation if there is evidence that both spouses made contributions to the marital relationship post separation. Contributions to the marital relationship do not have to be of a romantic nature, but can include such things as support of a child, both financially and emotionally ; and conduct which increases (or decreases) the marital assets. A martial relationship will remain intact, for valuation purposes, where a spouse receives a post-separation financial benefit from the pre-separation efforts of the other spouse.
When property division is determined in a post divorce hearing, the marital assets will be valued as of the date of the court's order for division. In such a situation, the judge must decide whether there has been an increase (or decrease) in the value of the marital assets from the time of divorce to the time of the order for division and whether that change is attributable to either spouse. Where a change in value is the direct result of efforts made by both spouses, the difference can be distributed equitably between both parties. If the change in the asset's value is attributable to the efforts of only one spouse, then any change in value will be assigned only to that spouse. Like when both parties contribute to the financial change in a marital asset, when found that neither spouse contributed to the change in value of an asset, the parties will share equitably in the change of value.
The valuation date will not be changed because of a substantial decrease in the asset's value between the date of valuation and the date of division where the decrease was solely attributable to the owner spouse.
Where a marital asset has substantially increased in value after the entry of a judgment nisi but before a judgment absolute, a spouse can, upon motion, request that the court revisit the issue and its implications to the equity order. Although it is common for marital assets to change in value over a short period of time, a judge has discretion to amend a valuation date or reconsider the issue of valuation anew. The same is true even when a marital asset has substantially decreased in value.
IV. Method of Valuation
To determine the value of a publicly traded company, a court will look at the amount at which the stock is trading on a particular date, multiplied by the amount of shares owned by the spouse. However, the courts have struggled with valuation of privately held companies such as closely held corporations or partnerships because factors which affect the value of such a business can affect the valuation of each business differently. The most commonly used methods for valuing closely held corporations can be found in the 1987 practice aid published by the American Institute of Certified Public Accounts. Additionally, the Internal Revenue Service has provided guidelines to determine the value of a closely held business.
Due to the plethora of uncertain factors associated with the valuation of a privately held businesses, no one method of valuation will always be appropriate. For this reason, judges are given broad discretion to determine the proper method of valuation based on the unique circumstances of each particular case. A judge's determination of value will be upheld unless the method used "would clearly produce an arbitrary result," where the value of the business is without a rational basis in evidence, or where the method is "materially at odds with the totality of the circumstances or, at variance with the requirements of the equitable distribution statute, M.G.L. c.208, § 34." However, where a judge has failed to make express written findings, explaining his reasons for use of a particular method of valuation and his reasons for the inclusion or exclusion of particular factors in his determination, the judge's valuation can be overturned.
The capitalization of earnings method has been accepted by the court in several divorce cases to calculate the value of a spouse owed business. Capitalization of earnings method is used to determine the present value of a business by taking a measure of income, over a specific interval of time, and applying a capitalization rate. The formula is expressed by "dividing the expected income of a company by an appropriate capitalization rate." The capitalization rate can be calculated impliedly from the capitalization rates of publicly traded companies or by determining an appropriate discount rate and converting it to a capitalization rate. It has been held that this method is specifically appropriate for corporations and other businesses that have a perpetually infinite income stream.
The "capitalization of earnings method" is the suggested method of valuation in IRS Revenue Ruling 59-60, which has been referred to by the Massachusetts courts for valuing businesses for the purpose of equitable division in divorce proceedings. Under this method, the IRS has provided no specific formula but rather factors which should be considered to determine an appropriate value. IRS Ruling 59-60 does suggest that certain valuation factors should be capitalized. In addition, IRS Ruling 59-60 suggests that earnings should be calculated based on at least five years of historical data from the date of valuation and such data should be compiled by a weighted average, with the most current year having the greatest weight. Lastly, IRS Ruling 59-60 discourages the practice of averaging the results obtained by different valuation methods.
Another income valuation method that has been accepted by the Massachusetts courts is the "discounted cash flow method". This method is used to determine the present value of income to be received in the future over a finite period of years by applying a present value discount rate to the future expected income, taking into account income and appreciation (or depreciation). More specifically, the formula calculates present value by taking the expected future income divided by the sum of 1 (one) plus a rate of return, to the nth power, where n represents the number of years. The present value discount rate, also called "rate of return," is comprised of five factors: 1) risk-free rate of return ; 2) premium for risk ; 3) premium for size ; 4) premium for illiquidity ; and 5) premium for administrative costs . This method has been held to be applicable where a spouse's interest in a business is subject to a finite period of cash flow, ending when the individual retires, or terminates their position with the company.
In addition to these two methods, other valuation methods have been upheld by the court, including: valuation based on the enterprise value method, valuation based on the amount for which the assets were insured, valuation based on stockholder's equity, valuation by net book value of the corporation's stock, and valuation based on averaging the two parties' calculations of value.
Experts are often necessary to prove the value of a business. Experts frequently used include: the business's chief financial officer, a certified public accountant, the business owner spouse, a special appraiser appointed by the court for the purpose of valuing the business, or any other individual who has "sufficient information about the business and is experienced in valuing similar businesses."
Even where opposing experts choose the same method for valuation, they can arrive at substantially different results. Regardless of who the expert is and what their qualifications are, a judge has discretion to accept or refuse the opinion of either expert. In determining whether to accept an expert's valuation, the judge is likely to look at: the level of analysis conducted, whether the valuation is "results" driven, and how experienced the expert appears to be on the particular subject matter . It is within the sound discretion of the judge to consider an expert's experience when determining whether the valuation analysis is sound.
Experts are held to the same standards as a judge regarding whether a valuation will be accepted as valid. Upon acceptance of an expert's valuation, a judge is obligated to make express findings which explain why he preferred one expert over the other, but he is not obligated to justify every detail of the valuation. Even when an expert's valuation is accepted, the judge may modify any portion of the accepted valuation as he deems appropriate.
Expert testimony is not required for a judge to make a determination of value. Where testimony is given by the business owner spouse in place of an expert, the opposing party must make a timely objection regarding the witness's competency for valuation, else they shall lose
the right to appeal on that issue later. A party cannot argue against the method of valuation used by the opposing party's expert where their own expert used the same methodology.
VI. Additional Valuation Factors
i. Capital Gains Tax
Tax consequences arising from the distribution of marital assets should be considered by a judge, however there is no obligation to do so unless one of the parties raises the issue and
provides applicable evidence. A party, who failed to raise tax issues at trial can make a motion to the court for proper consideration of those tax issues.
Massachusetts courts have found it appropriate to tax affect the value of a spouse's business where the asset business will be transferred, at least in part, to the other spouse. It is not appropriate to tax affect a closely held corporation at the standard federal tax rate (entity level) where the business is to be equitably divided in a marital dissolution case. Valuation of a business, specifically for the purpose of distribution in a marital dissolution case, as opposed to a valuation to transact a fair market purchase, should not be made at arm's length, but rather the parties must treat each other as fiduciaries. Therefore, a more appropriate tax rate, which accounts for the benefits that an owner of such a business would receive, must be used to determine the value of a closely held corporation or other privately held business.
In Bernier v. Bernier, the Massachusetts Supreme Judicial Court held that the appropriate method for tax affecting a closely held corporation for the purpose of marital distribution is to determine what the tax rate, at the entity level, of a C-corporation would be if the shareholder received a distribution as he would from an S-corporation.
ii. Lack of Marketability
It is appropriate to discount the value of a closely held corporation for lack of marketability where there is evidence that the business will be sold. This discount recognizes the fact that there is a limited amount of would-be buyers of a stock in a closely held corporation.
The court has also recognized the applicability of a marketability discount where a spouse has a minority interest in a closely held corporation on the theory that a minority interest in a company is less desirable to purchase than a controlling interest.
In either case, there is no specific rule regarding the applicable percentage that should be used for this discount as such a determination is within the discretion of the presiding judge.
iii. Owner Compensation
Massachusetts courts have recognized that a judge may separate the business owner spouse's income from the value of the business for the purpose of valuing the business in a marital dissolution proceeding. This process can help avoid a common pit fall in valuing closely held corporations that will not to be sold, otherwise referred to as "double dipping." In the case where the expert has used an income method for valuation, the task of separating income is simpler because the method requires subtraction of a reasonable salary for the owner-operator of the business. The business owner spouse's income may be determined by looking at past tax returns or by looking at the business's deduction expenses.
Massachusetts courts have also ruled that "double dipping" is not prohibited by case law or statute. In cases where it is difficult to differentiate between the owner spouse's income and the business's income, the judge is not required to re-determine equitable distribution so long as inequities are avoided.
Where a business entity is created to hide the income of a spouse, the court can attribute the gross sales of the business to the spouse as income. The court may also attribute income to a spouse when it is apparent from the evidence that the spouse's income is much higher than reported because he has access to the cash flow of the business.
iv. Restrictive Agreements
Where stock in a closely held corporation is subject to transfer restrictions it may be applicable to apply a discount to the value of the business. However, a transfer restriction on stock may not always be a limiting factor, therefore, it is important that it be considered as part of the valuation analysis.
v. Key Man
A key man discount may be applied to the value of the business where there is no guarantee that the "key man" will remain with the business upon its sale to another. A key man is a person whose role in the business is unique and irreplaceable. When an interest in the business is purchased and sold from one member of a closely held corporation to another, no key man discount should be taken.
Where a business is found to have a certain amount of goodwill, that amount must be assigned a value of the business. Goodwill that is attributable to the owner spouse and not to the business itself, must be excluded from the value of the business.
vii. Growth Rate
It may be necessary to increase the value of a business by applying a growth rate multiplier when it can be shown that the company will enjoy revenue growth equal to or greater than the growth it had previously experience and that the future growth would not otherwise fall short of the applied growth rate.
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