Commentary: New business valuation standards in divorce?

Daily Record (Rochester, NY), Feb 8, 2008 by James Schnell

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 issues a landmark ruling over the ongoing 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 valuations using discernable facts, and when the ruling borrows techniques outlined in an entirely different state's case (Delaware).

Bernier v. Bernier

In Bernier, the Massachutsetts court addressed several key -- and very common -- divorce valuation questions: Is it valid to discount the value of an S corp by tax-affecting income and, if so, at what rate? 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 can be summarized in these four points:

* Tax-affecting is necessary when valuing S corporations, but not at 35 percent;

* The "fair value" valuation measure rather than traditional use of "fair market value" can be used for divorce cases;

* 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;

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

Tax-affecting S corporations

In Bernier, (SJC-09836, Sept.14, 2007), the husband's expert attempted to tax-affect company earnings at an "average corporate tax rate" and reduced the S corp income by 35 percent, while the wife's expert did not tax-affect the income at all. The court, recognizing error on both sides, directed the use of the method included in the Delaware Chancery Court's 2006 decision in Delaware Open MRI Radiology Associates PA v. Kessler, et. al. (April 26, 2006). This method resulted in the use of a 29.4 percent tax-affect rate against the S corp income, allowing the S corp to be treated as a shareholder receiving the full benefit of untaxed dividends by equating the after-tax return to the after-tax dividend of a C corp shareholder. Please note that this method would have to reflect the applicable individual tax rates in effect at the time the valuation is to be performed.

Investment value standard

Business valuations for divorce traditionally are prepared using the fair market value (FMV) standard, a pillar in the valuation community and universally accepted after being defined within IRS Revenue Ruling 59-60: "[T]he 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 court clearly attempts to deviate from the FMV standard 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 decision states: "[T]he 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, already adopted this method, known as "Fair Value." It is often used in cases involving shareholder disputes. The Uniform Business Corporation Act defines "fair value" as "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."

Closely-held company discounts

In Bernier, the husband's expert attempted to use both a "key man" discount and a discount for marketability. While both were accepted at the trial court level, the higher court disallowed both discounts and stated in its decision that, "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 issues have the potential to yield a sometimes dramatic effect on the results of a valuation calculation. It will be interesting to see whether these specific rulings and/or their methodologies will start to be presented in our own state.

Jim Schnell is a tax and business valuation partner with Mengel, Metzger, Barr & Co. LLP. He may be reached at jschnell@mmb-co.com.