Double Dipping in Tennessee Divorce Means Double Trouble (Part III)
In this final segment of our 3-part series on double dipping in Tennessee divorce, the trouble with double counting is focused on the closely held business or professional practice. (Read Part I and Part II of this series.)
When can double dipping into the family business be avoided in Tennessee divorce?
Anyone who has pushed through a business start-up appreciates the sweat equity required in the early days. Then something clicks. Years after the initial launch, the business becomes an income source for the owner. The business itself acquires assets, such as goodwill, real estate, and accounts receivable. In divorce, how should the business be handled? Is it a marital asset, income, or both? How can double counting be avoided?
We are not talking about hobbies. We are talking about small companies and professional practices, mainly, where the business represents the couple’s greatest asset – often more valuable than the marital home – and is the primary income source for the family. One spouse or both spouses may work at a single family business. Sometimes spouses have independent businesses (one a medical practice, for example, the other a retail shop).
Although spouses could continue as co-owners after divorcing, for most it is better that one spouse buy out the other’s interest in the business. If a buy-out does not occur, then the better solution is to give one party a majority share to avoid deadlocks. A 50-50 split of the family business after the divorce? Possible. But rarely do former spouses co-operate well enough to co-operate a profit-making enterprise together. Although not impossible, it is rare for that arrangement to work out to the fullest potential for the business’ continued success. In every instance, though, business valuation will be necessary. And that’s also where double dipping comes in.
Double-Dip into Family Business
In Tennessee divorce, double counting the business or professional practice may result in one spouse gaining an unfair advantage over the other. Substantially so. When intentional, double dipping is a divorce strategy. But there is the unintended occurrence of double dipping, too, often a consequence of inadequate (or non-existent) business valuation by a forensic accountant who is a Certified Public Accountant. By then it may be too late to undo the damage easily, if at all.
Negotiation and Settlement
Double dipping as a theory is not recognized in every jurisdiction, but it is recognized in the State of Tennessee. Although double counting is not unlawful in every divorce involving a business, but the impact on the division of property, alimony, and child support can be significant and problematic. Be mindful that Tennessee is with the majority of states as an equitable distribution jurisdiction. Many factors are considered by the court. See T.C.A. § 36-4-121(c). Be ready. Have a legal strategy.
If there is a small business among the marital assets, or if compensation is drawn from an enterprise that is one spouse’s separate property, then consult an experienced divorce attorney before negotiations begin with the other spouse and opposing counsel. Mistakes could be costly for the business owner who draws income from the company.
Business Income Available for Alimony and Child Support
Under Tennessee’s current property division statute, T.C.A. § 36-4-121(b)(1)(E) (effective July 1, 2015), marital property divided and distributed in divorce, including a business or professional practice, cannot be included as income when calculating child support or alimony. To wit:
(b)(1)(E) Property shall be considered marital property … for the sole purpose of dividing assets upon divorce or legal separation and for no other purpose; and assets distributed as marital property will not be considered as income for child support or alimony purposes, except to the extent the asset will create additional income after the division;
Without the ‘no double-dip’ statute, if the non-owner is the primary residential parent, for example, then the alternate residential parent (ARP) could be ordered to pay more child support. Why? Because the ARP’s income from the business was not adjusted downward to reflect the property division. Despite the statute, when not managed carefully, double dipping into the closely held company can still occur.
By the way, reverse dipping can occur when a business liability is used to reduce the net value of the company, also reducing the owner-spouse’s income for child support calculations. See Ghen v. Ghen, 575 Do.2d 1342 (Fla. Dist. Ct. App. 1991), where reverse-dip occurred when husband’s medical practice value was reduced by his $112,000.00 debt to Medicare.
In all fairness, after the business or its equivalent value is awarded to the non-owner as marital property, should not the owner’s income from the business reflect a lesser property interest?
According to Tracy Coenen, CPA, CFF (forensic accountant and principal of Sequence Inc., of Milwaukee, Wisconsin and Chicago, Illinois), accountants and lawyers focused on the numbers sometimes forget about the double-dip problem with business assets. With a business divided in divorce, where the non-owner spouse is awarded, as property, the value of a portion of the business income, that spouse should not be awarded alimony from the same portion – that’s double dipping. Coenen offers these recommendations:
- Know that the business owner’s compensation (wages and net income from the business) are factored into the business valuation. That valuation is used to divide the business value between the spouses.
- “When support calculations are being made, it is important to adjust the [business] owner’s compensation downward for any value awarded to the [other] spouse during the property division,” says Coenen. “If an adjustment is not made, the spouse retaining the business might end up paying support based on earnings that don’t really exist due to the property division.”
The Tennessee court is prohibited from repurposing a distributed marital asset as an income source for purposes of determining family support. With their attorney’s assistance, however, the parties are free to negotiate and tailor terms that provide a different result. Those terms would be included in the parties’ Marital Dissolution Agreement, or MDA.
Goodwill Valuation in Tennessee Divorce
In family law cases, valuation of goodwill is not the same as a real world business appraisal. In a divorce, the court cannot use a projection of future earnings to establish income for alimony or child support. Donald Miod, CPA, ABV, CVA, CBA, says doing so would be too speculative. See The Double Dip in Valuing Goodwill in Divorce. We all know there are no guarantees. Businesses fail, regulations change, people become infirm, life happens.
Miod explains that, when the marital property “includes a business to be valued, it will most likely include both tangible and intangible assets. If the value of the intangible asset, such as goodwill, is charged to one party, the income stream, which is being used for the calculation of income available for support, is most likely the same income stream that was used for the computation of goodwill. Hence the double dip.”
Valuation of goodwill for family law purposes does not fit neatly into generally accepted accounting principles. Why? Because support payments are based on the payor’s actual income (historical marital earnings to the present) and not on the payor’s projected income from the business (future expected compensation). This is an important distinction.
Double Dipping into Business Goodwill
Consider this double-dip situation. The value of business goodwill is distributed as a marital asset while the income stream available to pay alimony or child support is the same income stream used to compute the value of the business goodwill.
Should professional goodwill be divided as a marital asset? Or should it be allocated to the owner-spouse’s income?
In Valuing Goodwill and the Danger of the Double Dip (2014), Colorado attorney Carolyn Witkus discusses four ways the states address double dipping when a commercial enterprise is a marital asset. The few jurisdictions with tailored solutions that factor-in business goodwill have effectively minimized the double counting problem. A minority of jurisdictions include goodwill in business valuations even when the firm’s success is wholly dependent upon the personal reputation of the owner.
A majority of jurisdictions distinguish enterprise goodwill (a.k.a. business goodwill) which is directly connected to the company, from personal goodwill (a.k.a. professional goodwill) which is directly connected to the individual owner’s special efforts and unique attributes. Enterprise goodwill is included in the business valuation as an asset; while personal goodwill is allocated to the owner-spouse’s income. Thus avoiding a double-dip. Tennessee is mostly in the camp of the majority.
Non-Owner Spouse Should Take Additional Measures
Personal goodwill is an intangible asset, but the court should not include its value when dividing the business as a marital asset in Tennessee divorce. Some argue that to not include professional goodwill as a marital asset could put the non-owner at an economic disadvantage. Without consideration of personal goodwill, the valuation of the business may be incomplete, presenting a tepid or even falsely low valuation.
To obtain a fair award, the non-owner spouse should take additional measures by discussing the following with a divorce attorney who has substantial experience in business valuation:
- Quantifying professional goodwill even though it’s not a stand-alone asset for division;
- Seeking a larger portion of other marital assets;
- Asking the court to consider the economically disadvantaged spouse’s circumstances compared to the owner-spouse’s; and
- Seeking a larger portion of the owner’s income as alimony if that spouse is to get the business asset at a reduced value.
Having a legal strategy for the business and a forensic accountant who works closely with the attorney is crucial to achieving a reasonable settlement.
Double Counting a Professional Degree
Jeffrey A. Landers, CDFA, author and regular contributor to Forbes.com and The Huffington Post, mostly saw double dipping with professional degrees in divorce. Today, New York state no longer values medical, law, or other professional degrees as marital assets. However, “[i]f a degree was valued and divided as a marital asset, then in most cases alimony would be based on what the degree-holder’s salary would have been if there was no such degree. It would be double dipping … to divide the value of the degree as a marital asset and to base alimony on those enhanced earnings as a result of having that degree.” Landers commented further on how “we still see similar situations nationwide when the value of a business is divided and alimony is based on the business owner’s income as if he or she still owned 100% of the business.” That is a recurring problem.
Strategy: Segregate Business Property from Income
One divorce strategy is to segregate business property from the owner-spouse’s income. When the business is deemed both “property” and “income,” the owner-spouse needs to be careful to separate the two in order to avoid a double-dip. Why does that matter? If the owner does not segregate business property from business income, then the enterprise could be divided with the other spouse receiving a share of the marital asset. And the business owner then being ordered to pay alimony based upon income from the whole entity when, in fact, the business is already-divided. The same strategy applies to child support obligations.
When the business is not marital property, but is the source of the owner’s income, then that income source should be included when calculating child support and spousal support. For example:
- A Memphis dental practice;
- A Bartlett auto repair and body shop;
- A bakery and delicatessen;
- A restaurateur-chef’s Germantown eatery;
- A greenhouse and landscaping services company; or
- An art gallery in Collierville.
There are as many small business sources of income as there are entrepreneurs!
Rarely would a court award half the party’s income from the business to the non-owner spouse as alimony. However, awarding approximately half of the value of the business to each spouse as marital property is not uncommon in most states and could certainly be the result in a Tennessee divorce.
Assuming the business asset is awarded to the owner in the divorce, the non-owner would be allocated other assets to equalize the division of property as alimony in solido, or lump sum alimony. As characterized by Witkus, where there is no income from the business unless the owner is working, all that spouse has been awarded is the “right to keep working.” Double dipping adds insult to injury, requiring the business owner to pay alimony and child support from income that was determined based upon the business valuation before division as a marital asset. For many, the outcome is a far cry from just, fair, or equitable.
Understand that there is no double dip problem when the business is either property or income. Double dipping rears its ugly head when the business is identified as a combination of income and property. That’s when it’s time to brew the coffee, sharpen the pencils, and clean the spectacles. Failing to carefully, cautiously, diligently separate business property from the business income stream could be disastrous for the owner.
Realistically, though, most small businesses are indeed going to be a blend of both property and income. Depending upon how the numbers work out, one spouse has an incentive to characterize it marital property and the other has an incentive to characterize it as income. Yet as previously noted, in most instances the business is a primary income source and a divisible marital asset. Those two aspects of the enterprise – income and property – must be segregated and kept separate to prevent double dipping in divorce.
Treatment of Goodwill in Tennessee Divorce
How do our courts address the issue of business goodwill in divorce case? On the one hand, Tennessee courts do not generally include personal goodwill as marital property divisible in divorce. Instead, it’s allocated to the person’s income.
On the other hand, if it is enterprise goodwill, then it is sometimes regarded as a marital asset in Tennessee, and sometimes not. In Memphis, Robert Vance, CPA, ABV, CFF, CVA, CFP (forensic accountant and principal of Forensic & Valuation Services, PLC), commented on Fuller v. Fuller, E2016-00243-COA-R3-CV (Tenn. Ct. App., Dec. 21, 2016): “The courts in Tennessee have consistently ruled that personal or professional goodwill is not a divisible marital asset, but have inconsistently ruled on the divisibility of enterprise or business goodwill.” Vance went on to say that, “[e]nterprise goodwill has generally been determined to be divisible by the Tennessee Court of Appeals,” but in the Eastern Section, the enterprise goodwill of a sole proprietorship is not likely to be a marital asset. Citing Lunn v. Lunn, No. E2014-00865-COA-R3-CV (Tenn. Ct. App. June 29, 2015).
With business valuation, Vance points out that the important thing about enterprise goodwill (and characterizing it as divisible marital property) should be whether it can be sold as an intangible asset. And that it should not matter how the business is organized as a limited liability company, sole proprietorship, corporation, or other entity.
Valuation of Business Goodwill for Property Division
What business valuation method is best? Choose the one that carries out legal strategy and is appropriate for the type of business being valued.
Enterprise goodwill must be quantified because it represents business reputation and ability to generate future income for the owner. Basically, there are four steps to valuating business goodwill:
- Determine the business’ income.
- Compare the business to similarly situated companies.
- Determine how much the business over-performs or under-performs the competition.
- Capitalize any benefit into the future “using multiples built up by very smart accountants to generate a present value” for the business goodwill. See Witkus.
Personal Goodwill as Income
Particularly with valuation of a service business (for example, a plumber, electrician, contractor, or landscaper) or professional practice (for example, a lawyer, accountant, physician, or counselor) the company’s goodwill – it’s reputation and ability to generate future income for the owner – is as much a reflection of the owner’s work ethic, diligence, ability, marketing, and sheer luck as it is the actual success of the business organization as an independent entity.
Legal Strategy in Business Valuation
Given the family business needs valuation so it can be properly, equitably divided as a marital asset, the spouses have disparate motives. Their legal strategies will reflect those motives. The owner-spouse of a service company, for instance, is motivated to undervalue or deflate the value of the business (as well as any personal goodwill as an income source). The non-owner spouse is motivated to overvalue or inflate the value of the business (as well any personal goodwill as an income source for support). Therefore, proper valuation is essential.
Method of Business Valuation
In valuing a business, the “cash flows capitalized to determine … present overall value of business” are also the cash flows used to determine income for support. See The ‘Double Dipping’ Concept in Business Valuation for Divorce Purposes by attorney Robert J. Rivers (2006). A fundamental principal of business valuation is that the value is, says Rivers, “equal to the present worth of the future benefits of ownership.” That is, the value is a “projection as to what the future income will be based upon a review of the historical earnings of the company.”
Choose a Business Valuation Method
When the business is a marital asset, its value must be established before the court will divide it. It is possible, too, that the business is operating well into the red and is not an asset but a liability, a debt for the spouses to share. That debt would also be separate from income drawn by the owner. Obtaining the spouses’ agreement on a valuation method would be optimal. However, if there is no agreement, then each party is free to hire an expert business valuator, typically a forensic accountant, who will use one of several recognized valuation methods. Be forewarned, this can get costly. The judge determines the final value based upon the experts’ testimony and valuations.
To learn more about business valuation, read our discussion on Business Valuation in Tennessee Divorce Law. For real-life examples, take a look at our blog for case summaries under the Tennessee Business Valuation category.
What business valuation method is best? Choose the one that carries out your legal strategy and is appropriate for the type of business being valued. Strategically, it may be more beneficial to obtain a low valuation, or the opposite may be true. Say, for example, that the owner-spouse will buy-out the other’s marital interest in the company. If the business is over-valued, then the non-owner spouse receives the better deal. If under-valued, then the owner gets the better deal by retaining more after the buy-out.
Placing a reasonably accurate value on something as unique as a family-owned business is always challenging, but is absolutely necessary for the best possible outcome in the Tennessee divorce.
