When setting up a professional practice, attorneys and accountants were most likely consulted to determine the best way to set up the practice to minimize professional liability and tax liability. Some planners even set up prenuptial agreements and other pre-divorce planning agreements to protect their professional practice in case of divorce. However, the majority of professionals have not considered the impact of divorce on their business.
“Don’t panic” is the first piece of advice for professionals divorcing their spouse. It is important to not do anything rash that you might regret later. Trying to liquidize your business assets or anything similar that is not typically done as a regular part of your business could results in charges, like “dissipation of marital assets.” Dissipation of marital assets is purposefully taking assets that are in the marital estate out to the detriment of the other spouse and for the sole benefit of the other spouse. The courts look unfavorably at people who attempt to manipulate assets during a divorce. It is imperative that a business professional continue to run the business the same way they did prior to the divorce as much as possible.
Discovery is completed by attorneys during a divorce to learn about the marital estate and all the assets of the marriage. Marital estate can include a portion of a professional practice; even if the spouse belonged to or started the practice prior to the marriage. If the value of the practice increases during the time of the marriage, that increase would be part of the marital estate. Therefore, the divorce attorneys would be able to examine the business as part of discovery to determine the value of the business at both the date of the marriage and the date of the separation to figure out the amount of the practice that belongs in the marital estate.
What is open to scrutiny? All financial records are able to be checked during the discovery process. One thing that is not open to discovery is any patient records and information. There are state statutes that protect confidentiality and Federal Health Insurance Portability and Accountability Act (HIPPA).
Valuing a Professional Practice
Professional practices can be valued at any time when the circumstance warrants it. Some of the reasons for a valuation would be: gaining a new partner, firing an existing partner, the death of a partner, estate planning, financing needs, disputes among partners, or a personal divorce.
Valuation methods used for a divorce are different than the methods used for other situations. Sometimes, a partnership agreement will state how a company is to value the business if someone is leaving the company. That method is not what would be used for a divorce valuation. Professional practices also, unlike other business, have a unique valuation issue that does not apply to other businesses called goodwill, both professional and personal.
Standard of Value
To value a professional practice, your first step is to decide what standard of value you will use. The following are the acceptable standards of value:
- Fair Market Value
- Liquidation Value
- Going Concern Value
- Book Value
- Original Cost Value
The following are other standards of value:
- Replacement value
- Appraised Value
- Investment Value
- Intrinsic Value
The price a buyer is willing to pay to buy the asset from a seller without either person being forced into the transaction is called the fair market value. In a divorce, the court has to find the net fair market value (fair market value minus debts, at the correct date of valuation) of the professional business. Each state has different dates of valuation, which is determined by state statute or case law. It is important to review the laws of the state you reside in to make sure you are using the correct date of valuation.
Liquidation value would be the amount of money an owner would receive if they were forced to sell the business on the date of valuation. The key to liquidation value is that the value is based on a sale that is done under force, and sales under duress almost always sell for an amount lower than fair market value. Liquidation value is usually rejected by the court as an appropriate standard of value.
Going concern value is simply looking at the value of the business as an ongoing enterprise. The difference in going concern value from other types of valuation is that it does not take into account liquidation valuation or book value.
Book value is the value that is computed when you add all the assets of the practice and then deduct all the practice’s liabilities. This method is considered to be easily manipulated so courts do not use it during divorce as the standard for valuation. Some courts use the book value, not as the method of valuation but as evidence when trying to figure out the fair market value of the practice.
Original cost is the valuation of a business using the original costs paid to start the business. There are very few professional practices that do not increase their value, which is why original cost would not be the appropriate way to determine the value of the professional practice.
The parties of the divorce do not have to use any of the methods above for valuing the professional practice. During a divorce, the spouses can agree, or stipulate, to a specific value for the professional practice. As long as no fraud, duress, overreaching, or other contract defense is used, the agreement will be binding to the court.
Method of Valuation
A determination of the current fair market value is the goal of valuation. The courts do not require one specific method to determine the current fair market value but the two most commonly acceptable methods are Revenue Ruling 59-60, and Total Value Method. With both methods, physical assets and accounts receivables are added together for a total value, and then liabilities of the practice are subtracted. What if the company has goodwill? The court values goodwill as part of the value of the practice. The valuation methods for divisible goodwill are different than the valuation of a professional practice. The methods to value goodwill are:
- Capitalization of excess earnings
- Comparable sales
- Subjective estimation
The capitalization of excess earnings approach figures out what your business actually earns and what the average business earns and subtracts the numbers to find the difference. The amount of the difference is then multiplied by a number between 1 and 5 (called capitalization). This approach of capitalizing excess earnings is considered the most accepted method of valuation when you have a situation with divisible goodwill. When a business owner purposefully lowers the earnings of the business to create a lower goodwill value, you will get an incorrect value using this approach. If a business’s goodwill is zero, you need to consider that the earnings were purposefully lowered.
The comparable sales approach consists of looking at the sales around the same time of the valuation that have the following qualities: similar business and same general physical location. You start with the total value of all the tangible assets of business and then subtract the sale price of the comparable sales to get the total amount for goodwill.
Subjective estimation is an estimate of the goodwill value made by an expert based on age of practitioner, health, past earning power, reputation, professional success, and other factors considered to be subjective.
Goodwill or Not?
The division on the divisibility of goodwill sounds complex and confusing. More simply put, when people are buying and selling businesses, the sale price is usually higher than what the total value is of all the tangible assets of the business. The increase in the sale price is because of the goodwill of the business. So what is goodwill? Business goodwill is defined 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 personality of those conducting it, nature of location, its reputation for skill or promptitude or any other circumstance incidental to the business and tending to make it permanent.”
Goodwill is that difference between the sale price of the business and the actual value of the tangible assets of the business when sold. The most important factor in goodwill is, can the business even be sold and purchased? If goodwill is able to be bought and sold as part of the business, the goodwill is called realizable goodwill. In contrast, if the business is not able to be sold, any goodwill in the business is considered to be unrealizable goodwill.
Classifying realizable goodwill is easy. If an owner is able to sell their businesses goodwill for cash when they sell their business, the goodwill is considered marital property. With immediate cash value for goodwill, you are not able to consider the realizable goodwill as future earnings. Sometimes, people try to argue that realized goodwill’s value is actually speculative but the courts have disagreed with this argument. It is important to consult with your attorney about the courts opinions are in regard to realizable goodwill in your state.
When a business is not able to be sold in the open market, the classification and division of goodwill is not as clear. Sometimes, goodwill is not able to be separated from the owner’s reputation. This commonly occurs in professional practices of doctors, lawyers, and mental health professionals. If the professional that owns the practice dies, there is nothing left to the practice, also call unrealizable goodwill. There is nothing in the practice that would be able to be sold to another person. The files and clients are not able to be transferred to another person because the practice is solely dependent on that particular professional. About half of the states believe that unrealizable goodwill is divisible property while the other half believes that it is not divisible property. The North Carolina courts hold that the unrealizable goodwill goes to the value of the marital property to be divided between the spouses.
The courts will expect a well-qualified expert witness to testify in court about valuation of the business. The expert you hire needs to be able to talk clearly about the facts of your specific case and be able to spell out the details on how they came to the exact valuation of the business. Not only do you need a valuation expert that is able to talk clearly to the court and be persuasive, but you also need an attorney that understands the laws in regard to divorce and property division.
Other Issues with Valuation
It is important that you do not overlook the other assets in your professional practice. The fair market value needs to include the business’s tangible assets, accounts receivables, contingency fees, retirement accounts, and any other employment pensions. All these elements need to be valued and divided between both spouses.
Dividing a Practice
During a divorce, the court will divide a marital estate between the two spouses. But, a court does not divide a professional practice so that both parties can become owners, partners, or shareholders. There are two reasons for this, the first being that state statute prohibits ownership by a non-professional in a professional practice. The second reason is that the purpose of a divorce is to separate the two people and all their financial affairs, not to put them together in a business arrangement.
The North Carolina courts will not order the sale of a professional practice in order for the money to be divided between the spouses. As noted above, North Carolina courts consider unrealized goodwill marital property. Imagine forcing a professional to sell their business, the business’s sale price would be less than the actual value, causing both parties to lose out on the higher value that the business is actually worth.
The courts won’t force a sale of a professional business, so what is the alternative? The spouse that owns the business will keep their business but they will pay their spouse their fair share of the business or the court can increase the non-owner spouse’s portion of the marital property equaling the share of the business they are owed (called offsetting property award). The presumption in North Carolina is to do the offsetting property award to the spouse that does not own the professional practice.
In cases where the primary asset of the marriage is professional practice, the court will not award the other spouse an offsetting property award. Instead, the court would look at awarding a monetary award to the spouse. The court would set up a payment plan that will have the money paid as soon as possible as to not further burden the spouse with no money from the marriage estate. There are no adverse tax consequences no matter how the court awards half the professional practice. 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.
In contrast, the tax consequences will be different if the spouse that owes the money assigns income to the other spouse to pay the award as ordered by the court. Income assignment is a taxable transaction for both parties.