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Family Law: The Valuation Analyst's Role

Greg A. Raffaele CPA CVA FCPA

FACT: Statistics show that one out of two marriages fail. For some, divorce is just another crossroad in life. For most, it is a major crisis. Our system of justice is based on conflict that greatly increases the emotional and financial expense of divorce. If you and your spouse can otherwise reasonably negotiate your divorce, you can avoid most of the expense. But even with limited assistance from an attorney not representing either spouse, a peaceful negotiation over the value and distribution of marital property often becomes controversial and difficult to resolve.

Often the business or business interest (fractional ownership) is the largest asset in the marital estate. If conflict runs high while negotiating either, an attorney's representation may be the only option. Though an attorney sometimes involves a valuation analyst in other asset distribution and support issues, the focus will be on the analyst's role in identifying and valuing the business or business interest included in the marital estate.

Valuation Approach

Family law courts generally recognize the basic approaches to business valuation: Income, Market and Asset-Based. Though these approaches do not change in divorce cases, the differences among states and even counties require a valuation analyst to know and properly apply the approach in the jurisdiction the divorce was filed. An analyst must also know and stay current with tax laws surrounding divorce and the applicable valuation date. An analyst cannot be assumed to be responsible for achieving the value in a purchase and cannot be relied on to disclose errors, irregularities or illegal acts that exist.

Marital Property

Marital property and how they are divided differs from state to state. Marital property in California is community property and therefore jointly owned and equally divided. Marital property includes assets acquired during marriage and excludes assets acquired or inherited before marriage. Exempt assets commingled with marital assets may be combined and distributed. Assets acquired after the divorce action has been filed or included in a valid prenuptial agreement are excluded from the martial assets. A prenuptial agreement is not enforceable if the party enforced upon proves that either the agreement was not voluntarily executed or was unreasonable at the time it was executed. Mid-marriage agreements could exclude assets from distribution.

Value Standard

The standard of value to use and the relevance of valuation discounts are among the most debated topics in divorce valuation. The debate is largely the result of confusing and sometimes bad case law like when judges misuse the 'fair market value' standard in their decisions. While many appraisers support this standard, the fair market value standard and Revenue Ruling 59-60 do not bind the courts. The judges more often do not apply valuation discounts in their decisions on divorce valuations. Case law in some jurisdictions prefer and even prohibit using certain methods.

There are several reasons against fair market value: there is no contemplated sale, there is no market or hypothetical buyer and the real value to the marital estate is to the present owner. For these reasons, there is increasing momentum in the legal community to use a valuation standard often referred to as "divorce value" or "value to the marital estate," which is the investment value to a specific owner -- the present owner.

Tax Rule

Internal Revenue Code (IRC) Section 1041 allows property to be transferred between spouses without tax consequence if the transfer is incident to divorce. Courts generally ignore the eventual tax liability attached to an asset unless its sale and resulting tax are imminent. If a family business has been valued and distribution agreed upon, the non-transferor (receiving) spouse or the corporation could buy out the transferor spouse. Courts also generally do not force the sale of a business just to buy out one spouse and do not consider differences between an asset's fair market value and its tax basis for distribution purposes.

A valuation analyst must know the tax consequences of an imminent sale in order to give the attorney guidance. In settled cases, language in the property settlement agreement must be carefully worded to possibly avoid any potential tax liability to the non-transferor spouse. Well-constructed agreements could shift this tax burden to the transferor spouse and in some cases avoid the tax liability to either. The non-transferor spouse (say the wife) could be seen as receiving a constructive dividend and may have to pay taxes if the divorce decree does not relieve the transferor of his 'primary and unconditional' obligation.

Marital Effort

An increase in value of a separate asset due to "marital effort" is part of the martial estate that needs identification and measurement. If the non-business spouse is actively involved in the family business, then the appreciation is included as marital effort and the valuation analyst has to identify the resulting increase in value. There is no marital effort if the increase was instead of a strong economy, which is an external or outside factor. In the valuation of marital effort, the analyst must use sound judgment and methods that will stand up in Court. The attorney must be aware of all the strengths and weaknesses of an analyst's valuation.

Miscellany

Practice goodwill is associated with the practice separate and apart from the professional(s) who owns the practice. It includes such intangibles as location, telephone number, client list, staff and time in business. Personal goodwill includes those characteristics that go to an individual such as reputation, professional competence and age. Some jurisdictions separate goodwill associated with the practice from the goodwill associated with the professional in that practice. Other jurisdictions regard both as one. Though non-competition agreements are treated as valuations in some jurisdictions, it is not marital property. Case law determines the relevance of a buy-sell agreement. Some jurisdictions consider the agreement to have more weight than a valuation prepared under any standard of value. Other jurisdictions regard it as providing minimal guidance or discount it completely.

Valuation Report

Divorce valuation reports are mostly affected by the facts and circumstances surrounding the case and less affected by statute or case law. Often a valuation analyst just gives the attorney a range of value as of several valuation dates (e.g. marriage date, separation date and divorce filing date). A simple letter with or without calculations attached may be all an attorney needs. The risk, however, in doing something so simple that an analyst's character and expertise could be undermined at trial during cross examination. Sometimes a full valuation report is required if the business is large, the marital assets plentiful and the likelihood of trial is high. A formal report used in divorce litigation is distributed to only those involved.

Attorneys are involved in most divorces with income and assets that need to be identified and distributed to satisfy either the Court or the parties. When the parties agree on the division, there is little need to go to Court other than to formally end the marriage. But when the parties cannot agree, the Court must decide on the distribution. The objective of valuation is to estimate the fair market value or some other value of the business or business interest. To be a better advisor to attorneys, a valuation analyst must know and stay current with tax laws and the rules where the divorce was filed.

Other than in divorce, valuations by a CVA (or other valuation analyst) are important in financial, tax and litigation matters.

We proudly serve Orange County and Greater Los Angeles. We are dedicated to serving the business valuation and forensic accounting needs of business owners, especially small business owners. We are also dedicated to serving the business valuation and forensic accounting needs of attorneys, CPAs and their clients. We are a solid alternative to high-priced business valuation and forensic accounting firms. We are a solid value. Contact us for a free consultation.