The stakes may be quite high when it comes time to get a business valuation in divorce. Frequently, business valuation has a major impact on entrepreneurs and their spouses when they divorce because the business may be their most valuable asset. It may help to have a working knowledge of the valuation process and how taxation may affect many aspects of a business valuation in divorce. Chapter 6 of my book, Frumkes & Vertz on Divorce Taxation, is devoted to analyzing the tax aspects of business valuation, with special attention to the issues and strategies applicable to divorce and child support disputes.
Tax affects all aspects of business valuation in divorce because valuation is frequently based upon the income generated by a business. The business earnings are projected into the future, after payment of expenses and taxes, to calculate their net present value. In other words, under the income approach, the value of a business is equal to what a buyer would pay to receive a future stream of income from the business.
Several tax-related issues may arise when performing a business valuation in divorce under the income approach:
- The capitalization rate, and the stream of income to which it is applied, must be matching, or the result will not be accurate.
- Businesses that do not pay tax at the corporate level (e.g., partnerships, LLCs and subchapter S corporations, known as “pass-through” entities) must be reconciled with those that do. One of the more controversial issues in business valuation is that of “tax-affecting” pass-through entities.
If an S corporation’s net income is greater than the net income of a similar C corporation, only because the C corporation pays corporate taxes, a business valuation will show the S corporation as more valuable. Yet, many experts do not believe that S corporations are inherently more valuable than similar C corporations. To rectify the discrepancy, some valuation experts have posited that a hypothetical entity-level income tax should be deducted from the income of subchapter S corporations. In 1999, the U.S. Tax Court rejected the practice of tax-affecting, Gross v. Commissioner, T.C. Memo 1999-254, but that was not the end of the controversy.
- Many business owners pay themselves more – or less – than they might receive as arms-length employees, often for tax reasons. When an income-based business valuation is performed, their wages must be adjusted to reasonable compensation. This topic intersects with the related concept, often litigated in Tax Court, of whether an owner’s salary is deductible as a business expense, or is a disguised dividend.
- Valuation discounts are another tax-related topic that affects business valuation in divorce. Valuation discounts are applied to recognize that privately-owned companies are not bought and sold as readily as publicly-traded stocks, particularly if the seller owns less than a controlling share. This topic is frequently litigated in the U.S. Tax Court and matrimonial courts to determine the fair market value of businesses. According to the father of business valuation, Shannon Pratt, valuation discounts are “big money issues,” because valuation discounts can reduce the fair market value of a business interest by up to 50%, or more, in many cases.
When it is time to go to court or settle a matrimonial dispute involving a family business, the lawyers and judge must be well-informed about business valuation in divorce. Business valuation is neither a science nor an art; it has been described as a “craft” where skill, experience, creativity and professional judgment have their impact on outcomes. Tax issues are pervasive, and just as importantly, business valuation issues are frequently litigated in U.S. Tax Court, not just in matrimonial cases but in estate and gift tax cases. Those who study business valuation in divorce may have an advantage in settling and litigating their cases, which is why we have devoted an entire chapter to the subject in my book.
For family law help in Western Pennsylvania, call Brian Vertz. For over 25 years, Brian has represented business owners, entrepreneurs and their spouses in complicated child support and divorce cases. In Pittsburgh and Western Pennsylvania, call Brian at 412-471-9000.