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Dividing Businesses and Professional Practices in a California Divorce
In today's economy, the stakes are higher than ever for business owners, and the correct determination of a business's value can be a complex question during a divorce proceeding.
May 20, 2010 /Personal Finance PR News/ -- Contentious issues can arise whenever professionals and small business owners divorce. When a business was started during the marriage it is likely to be community property. If a business owned pre-marriage gained value during the marriage it may likely be partially community property and the community portion must be determined. In both cases the community interest must be properly valued and divided equitably between the divorcing spouses.
In today's economy, the stakes are higher than ever, but the correct determination of a business's value can be a complex question. Appraisers have traditionally taken past earnings into account during business valuation. Today, companies that have been stable and profitable for years are facing unforeseen challenges. Should the economic downturn be taken into account when valuing a business?
How Do California Divorce Courts Determine a Business's Value?
California courts rely on a variety of factors to properly value businesses and professional practices. According to the leading case, In re Marriage of Foster, courts are free to accept any legitimate, evidence-based valuation.
In California, professional practices are typically valued as of the day after the date of separation. In another leading case, In re Marriage of Lopez, the Court of Appeal described what assets of a professional practice (in that case a law practice) require valuation:
(a) fixed assets, which we deem to include cash, furniture, equipment, supplies and law library; (b) other assets, including properly aged accounts receivable, costs advanced with due regard for their collectability; work in progress partially completed but not billed as a receivable, and work completed but not billed; (c) goodwill of the practitioner in his law business as a going concern; and (d) liabilities of the practitioner related to his business.
Quoting U.S. regulations, the Court of Appeal held in the case of In re Marriage of Hewitson that fixed assets are to be valued at fair market value, defined as "'the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell' and both having reasonable knowledge of relevant facts." The proper valuation of a business' or a professional's goodwill, if any, is the source of some debate.
Inclusion of Business and Personal Goodwill in the Community Estate
To be divided during divorce, any asset must be part of the community estate, which means that the professional-spouse must have had an ownership interest in that asset during the period of the marriage.
The Foster court, quoting the California Business and Professional Code, defines goodwill as "the expectation of continued public patronage." Business goodwill can only be attributed to the owners of the business. If the professional-spouse owns a share of a business, it is assumed that he or she also owns a share of the value of that goodwill.
In some cases, partnership or shareholder agreements explicitly provide that individual partners or shareholders have no ownership interest in intangible assets such as accounts receivable, work in progress or goodwill. In such cases, courts have concluded that no interest in those assets could be considered part of the community estate.
At the same time, courts have recognized that individual practitioners may have personal goodwill, which must be valued and divided.
Valuation Methodology for Goodwill
Foster approved the use of what is known as the "excess earnings method" to determine the value of goodwill. In this method, the appraiser compares the professional's annual net earnings to those of a similarly situated professional. First deducting a fair return for the business, the appraiser then subtracts the earnings of the similarly situated professional from those of the professional spouse in the case. Finally, the appraiser capitalizes those excess earnings over a period of years.
Although this gives the impression that a clear rule has been created, the Court of Appeal explicitly pointed out in Lopez that "no rigid or unvarying rule has been enunciated by our courts for determining the existence or value of the 'goodwill' of a law practice or any other profession as a going business."
In Foster, the Court of Appeal held that the trial court was not obliged to rely completely on the opinion of the appraiser. It could take into account factors such as the location of the business, its patronage, customer habits, the business's duration and even the personality of the partners or co-owners.
The Lopez court also mentioned a number of factors that could be taken into account, including the practitioner's demonstrated earning capacity, expected future earnings, the practitioner's reputation for judgment and skill, the duration of the business or partnership in the firm and the practitioner's age and health.
Should the Economic Downturn Affect Business Valuations?
Despite the breadth of factors approved by the Foster and Lopez courts, it is unclear whether the State of California will consider a business's loss of value due to economic conditions to be an acceptable factor to consider.
Lopez and other cases have used in their analysis IRS Revenue Ruling 59-60, which lists factors to be used in the valuation of closely held stock. The second of eight factors is "The economic outlook in general and the condition and outlook of the specific industry in particular."
No California trend has developed in response to current conditions, but a Florida appellate court recently denied a husband's petition to have the economic downturn taken into account in the valuation of his restaurant. The court held that "economic recessions, like other vagaries in the business cycle, are contingencies appraisers must take into account in valuing a business."
If you are contemplating divorce in California and have questions regarding the business valuation process, please speak to an experienced family law attorney in your area. A lawyer can answer any questions you may have and assist you though the divorce process.
Article provided by John S. Yohanan
Visit us at www.jsyohananlaw.com
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