New Business Valuation Standards in Divorce

 

 

When should an attorney in New York pay attention to a Massachusetts court decision about business valuation issues in a divorce case?

 

When the Massachusetts Supreme Judicial Court (“SJC”) issues a landmark ruling over the on-going controversy of tax-affecting S corporations, discount issues regarding closely held businesses specific to divorce cases, how to rule when both experts are not deemed to have presented their valuations utilizing discernable facts, and when the ruling borrows techniques outlined in an entirely different state’s case (Delaware).

 

 

In Bernier, the SJC addressed and ruled upon several key (and very common) divorce valuation questions: is it valid to discount the value of an S corporation by tax-affecting income, if so, at what rate and what is the correct application of “key man” or marketability discounts on the value of a closely held business in a divorce case?

 

The decision may be summed up in these four points:

 

1)         Tax-affecting is necessary when valuing S corporations, but not at 35%,

2)         The court utilized the “fair value” valuation measure rather than traditional use of “fair market value” for divorce cases,

3)         Traditional discounts for “Key Man” and “Lack of Marketability” are not valid in situations when the owner does not intend to sell the business and/or is not critical to the success of the business,

4)         The trial judge is free to adopt his/her own valuation if neither side’s expert offers a valuation supported by facts.

 

In Bernier, the husband’s expert attempted to tax-affect the company earnings at an “average corporate tax rate” and reduced the S corporation income by 35%, while the wife’s expert did not tax-affect the income at all. The SJC (recognizing error on both sides) directed the trial judge to utilize the method of tax-affecting S corporation income included in the Delaware Chancery Court’s 2006 decision, “Delaware Open MRI Radiology Associates, P.A. v. Kessler, et al.” (April 26, 2006). This method/calculation resulted in the use of a 29.4% tax-affect rate against the S corporation income. This allowed the SJC to treat the S corporation shareholder as receiving the full benefit of untaxed dividends by equating its after-tax return to the after-tax dividend of a C corporation shareholder. Please note that this method/calculation would have to reflect the applicable individual tax rates in effect at the time the valuation is to be performed.

 

 

Business Valuations for divorce have traditionally been prepared using the fair market value standard. This standard of value is a pillar in the valuation community and became universally accepted after being defined within IRS Revenue Ruling 59-60, which states FMV “as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” In essence, the fair value standard (sometimes equated or associated with the investment value standard) is meant to calculate the value of a business from a specific investor perspective rather than an open market perspective. In Bernier, the SJC clearly attempts to deviate from the FMV standard of value by surmising that a divorce context is not dealing in an arm’s length transaction, especially when one of the spouses stands to acquire the marital asset in question. The SJC states, “the judge must take particular care to treat the parties not as arm’s length hypothetical buyers and sellers in an open market but as fiduciaries entitled to equitable distribution of their marital assets.” Some states, including New York, have already adopted this method known as “Fair Value.” It is often utilized within cases involving shareholder disputes. The Uniform Business Corporation Act defines the following, “Fair Value, with respect to a dissenter’s shares, means the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.”

 

In Bernier, the husband’s expert attempted to utilize both a “key man” discount and a discount for marketability. While they were both accepted at the trial court level, the SJC disallowed both discounts. The SJC stated, “given the husband’s uncontradicted testimony that he would maintain total control of the business, i.e. not sell it, it is beyond reason to conclude that the business’s value should be reduced to account for the loss of a man who is the whole show.”

 

Clearly these are all issues which have the potential to yield a (sometimes) dramatic effect on the results of a valuation calculation. It will be interesting to see if these specific rulings and/or the methodologies from within them will begin to be presented in our state.