Custody, parenting, child support and property and debt division issues
are typical in a divorce. However, dentists, doctors, accountants, architects,
lawyers and other professionals with independent practices – and
their spouses – often encounter additional complexities as they
value and sometimes divide their business and professional assets. The
methods used to value a professional practice are complex and, as a result,
most professionals (and sometimes, their spouses) hire expert business
valuators (usually, business appraisers, accountants or business brokers).
This article outlines the most common issues that arise during the valuation
process and how they can affect a divorce settlement.
The first step in valuing a practice for purposes of a divorce is establishing
whether the business is considered community property and, thus, is divisible
under Washington State law. Washington is one of fourteen community property
states. In Washington, property acquired during a marriage is presumed
to be community property. Whether an asset is considered community property
or property of only one party depends upon the date of its purchase or
acquisition. That status can only be changed by agreement or by operation
of law. The community property presumption can only be overcome with clear
and convincing proof that the transaction through which the property was
acquired falls within the definition of separate property. A party asserting
the separate character in an asset must be able to trace “with some
degree of particularity” the separate source of the funds or the
separate properties used to purchase or acquire the asset.
To make matters more complex, a professional practice may encompass competing
principles of community property. For instance, if a professional practice
were established prior to the marriage, it would be considered separate
property. But, how should it be handled if the practice grows during the
marriage, increasing the value substantially? Case law has established
rules on balancing these competing interests, but each case must be evaluated
based upon its own unique circumstances.
(For purposes of this article, assume the professional practices were started
or acquired during the marriage, making them community property.)
The standard used by the courts to divide community property is “a
just and equitable” standard. Usually in the case of a closely held
business or professional practice, the business is not divided between
the spouses. Instead, one spouse keeps the business and the other receives
different assets of equal value or a cash transfer payment equivalent
to their interest in the business.
In many divorce cases, the business can be the most complex and valuable
asset of the marital estate, so valuing the business is critical to the
divorce settlement. The parties can agree to conduct a joint business
valuation or each can retain their own business valuator.
Valuing a Professional Practice
In a typical business valuation, the professional will be asked for an
extensive list of financial information, including financial statements,
balance sheets, federal income tax returns, aged accounts receivable reports,
accounts payable reports, a fixed-asset registry, lists of items comprising
significant other asset balances and accrued liabilities reports. For
dental or medical practices, existing and new patient count reports, practice
demographic reports, capital equipment lists (which include a fixed asset
registry) and previous practice appraisals are also needed to value a practice.
Unlike some states, Washington includes “goodwill” when valuing
a business. Goodwill is the expectation of continued public patronage
and is considered an intangible asset. It can exist for a number of reasons
including the location of the business, the amount of patronage, the personalities
and skill level of the parties engaged in the business, how long the business
has been in operation, and the likelihood of repeat business. Profitability
of the business is an important factor in determining goodwill. Goodwill
does not exist in every business. When considering an asset division,
the court must determine first whether goodwill exists and then determine
the reasonable value of the goodwill.
Goodwill should not be confused with the earning capacity of a spouse.
A salaried professional such as an associate in a practice with no ownership
interest in a business has earning capacity, but no goodwill.
Goodwill can exist in the business or in the person that owns the business.
An example of goodwill in a business would be a franchised business with
notoriety, such as Starbucks or McDonalds. The personality of the owner
does not make the business profitable. An example of goodwill in the owner
of a business would be a dental practice. The dentist’s personality
and skill determines the success of the business.
To determine the value of a professional’s goodwill, the court will
take into account a person’s age, health, demonstrated earning power,
reputation in the community as to judgment, skill, knowledge and comparative
professional success. These factors are known as the Fleege factors because
they were first set forth In re the Marriage of Fleege in 1979.
Next, the court must determine the reasonable value of goodwill. There
are different recognized methods of evaluating goodwill which supplement
the Fleege factors which include:
- The Straight Capitalization Accounting Method
- The Capitalization of Excess Earnings Method
- The IRS Capitalization of Excess Earnings Method
- The Market Value Method
- The Buy/Sell Agreement Method
The court may use one or a combination of these methods to determine the
value. The court has full discretion as to which method to use.
Several months may pass from the beginning of a business valuation until
its completion. The valuation often begins the process of negotiation
during a divorce. For many, it creates momentum because the parties have
a sum certain value to one of the most important assets in the marital
estate. In making a “just and equitable” division of the property
the court’s decision may result in a 50/50 division of the assets,
but this is not always the case.
Professional Degrees & Licenses
In some cases, allocating a disproportionate share of the assets to one
spouse is justified. For example, a professional license or degree obtained
during a marriage is not considered community property. However, the spouse
who contributed to the acquisition of the degree may be entitled to compensation
in the form of spousal maintenance and/or a disproportionate share of
the assets. The theory behind compensation is to replace the benefit of
the professional degree or license lost as a result of the divorce (based
on the assumption that the non-professional or lower earning spouse will
be “left behind”). Generally, courts give more weight to the
non-professional spouse when he or she has made significant contributions
that have helped the other obtain the degree or license. The perception
is that the non-professional or lower earning spouse will be “left
behind,” or otherwise that failure to compensate for the value provided
by the non-professional spouse would be unjust and inequitable. It is
in the court’s discretion to permit compensation.
When determining the allocation, the court will also take into account:
- the amount of community funds spent on educational costs
- the amount which the community would have earned had the efforts of the
student spouse not been directed toward studies
- any educational or career opportunities which the supporting spouse forewent
to assist the student spouse obtain their education or to move to the
location of the school
- the future earning prospects of each spouse
Every case is considered based upon its own unique circumstances. This
same theory applies in other situations in which the full value of a community
interest has not or may not have been realized until after the divorce.
This includes real estate licenses or broker’s licenses.
A professional practice is a unique creature in a divorce matter. Not only
is it the most valuable asset in a many marital estates, but its value
can be highly dependent on one spouse’s own personality, skill and
reputation. A spouse has an interest in the professional spouse’s
goodwill. Keep in mind that obtaining the necessary information needed
for a business valuation is not always easy, especially for the non-professional
spouse who may have had little to do with the professional practice. If
you are considering divorce, consult an attorney early on so that you
can put safeguards in place to prevent one spouse from transferring, concealing
or wasting valuable documents or assets. The attorneys at McKinley Irvin
have represented many clients whose cases involved the valuation and distribution
of businesses and professional practices.