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By Charles F. Vuotto, Jr., Esq.
There is little doubt that a divorce is one of the most traumatic events an individual can experience. Unless parties can reach an agreement, the essential elements of one’s life will be left to a judge to determine. The elements of a divorce include, but are not limited to, custody, timesharing, child support, alimony, and the distribution of property. In New Jersey, unlike some states, assets are distributed pursuant to an equitable distribution statute. New Jersey is not a community property state. The distribution of property is guided by certain statutory factors clarified over the years by an ever-growing body of case law. Assets that are legally or beneficially acquired during the marriage are subject to equitable distribution. Such assets include everything that is subject to ownership. In that pool of assets are closely held businesses. A closely held business is defined as a business whose shares are mostly owned by a family or small group of investors. Unlike many assets, the valuation and distribution of a closely held business presents certain unique problems. This article will attempt to highlight those problems as well as arguments that the business owner can employ to make sure that a fair result occurs.
The valuation of a business has always been more of an art than a science. There are various methodologies employed by valuation experts to arrive at a value. These include, most commonly, capitalization of income or a discounted cash flow analysis. Both of these valuation approaches are highly dependent on the income of the business. Until 2002, most divorce attorneys and valuation experts would have agreed that, notwithstanding the valuation methodology selected, the “standard of value” to be employed was “Fair Market Value”. The “standard of value” is that standard by which a property or asset is measured. Shannon Pratt, discussing the standard of value, stated that “the standard of value usually reflects an assumption as to who will be the buyer and who will be the seller in the hypothetical or actual sales transaction regarding the subject assets, properties or business interests. It defines or specifies the parties’ hypothetical transaction. In other words, the standard of value addresses the questions: “value to whom?” and “under what circumstances? “ The standard of value, either directly or, by statute (more often), which is interpreted in case law, often addresses what valuation methods are appropriate and what factors should or should not be considered”.[i]
The landscape of business valuation and divorce changed substantially in 2002 with the Appellate Division decision of Brown v. Brown. [ii] The essential holding changed the Standard of Value from Fair Market Value to Fair Value. The practical difference between the two standards of value was to eliminate the application of marketability or minority interest discounts. A marketability discount reflects a decrease in the value of a business owner’s interest in a business due to the time that it would take to sell the business. A minority interest discount reflects a decrease in value related to lack of control by that particular owner. By eliminating these two discounts, Brown essentially increased the value subject to equitable distribution.
Compounding the problem is the issue of the “double dip.” Since most business valuations calculate the value of the business owner’s interest in the business by capitalizing the income stream received by the owner from the business, there is overlap between the income used to value the business and the income used to fix alimony and child support. In essence, the exact same income is being used to value the business as is being used to form the basis for the supporting spouses’ alimony and child support obligations. The New Jersey Supreme Court, however, did not see the problem with the overlap as it is reflected in the 2004 decision of Steneken v. Steneken.[iii]
Perhaps the strongest argument against the Steneken decision is also the most basic; using the same stream of income that forms the basis of valuing the business when calculating alimony and child support provides the non-owning spouse with the benefit from the same stream of income twice. Further, the “double dip” conundrum is more problematic in a personal services business, which is highly dependent on the business owner’s presence and work effort to generate income.
Thus, the business owner is hit with a double whammy in New Jersey; he or she faces the elimination of marketability and minority interest discounts (thereby by increasing the value) and the use of the same stream of income for business valuation and fixing support obligations.
First and foremost, the business owner must be aware of these facts and discuss them thoroughly with his or her divorce attorney. These, as well as other factors, must be addressed when considering the distributable share to which the non-owning spouse is entitled. In other words, although there is case law that must be followed with regard to the standard of value and the downplaying of the double dip conundrum, these issues should be argued to the judge when discussing to what percentage of the value the non-owning spouse is entitled. The percentage share need not and often should not be the same as the other assets in the case.
Further, it must not be forgotten that equitable distribution of assets is relevant to support. The law of the State of New Jersey has long since held that equitable distribution and support obligations are closely related. [iv] In fact, the equitable distribution statute mandates that a trial court, in setting alimony, is required to consider the property division. [v] This statutory factor provides that among the considerations of alimony is “the equitable distribution of property ordered and any payouts on equitable distribution directly or indirectly, out of current income, to the extent this consideration is reasonable, just and fair.” Therefore, there is a statutory mandate for considering the “double dip.” The question is how to fairly do so. If we simply give lip service to the double dip problem by loosely directing courts to consider the issue in the percentage entitlements and business interests valued under a “Fair Value” standard, the statutory mandate will be left meaningless.
Therefore, when the business owner discusses these issues with his or her divorce attorney, there are various factors that should be discussed and argued to the extent they are appropriate to the facts of his or her case. Every situation must be addressed on a case by case basis between a litigant and his or her attorney. This article is intended to provide certain talking points between the business owner and his or her divorce attorney to help develop a strategy of the case in order to achieve a fair result. The following factors are suggested to be addressed when determining a non-owning spouse’s share of the value of an owning spouse’s interest in a closely held business:
1. Uncertainty of Business Valuations: Courts must consider the fact that the business valuation is more of an art than a science. Multiple experts can arrive at different values. The resulting values are “soft” rather than hard and fast figures such as would be applied to a bank or brokerage account, or even the value of a piece of real estate. As such, great care must be given when awarding a spouse a share of “soft” value, which will be paid with cold hard cash.
2. “Fair Value” and Lack of Discounts: The distribution of a very theoretical value such as “Fair Value” (as mandated by Brown) versus distribution of a value that more easily translates into “hard dollars” (i.e., Fair Market Value”) must also be weighed heavily in the equitable distribution process.
3. Fault: Consideration of the extent to which the application of the dissenting or oppressed shareholder rights (as those terms are defined with the applicable statutes, to wit: N.J.S.A. 14A:11-1 to 11 and N.J.S.A.14A:12-7(1)(c)) as required by Brown necessitates the inclusion of marital fault in the calculus of the non-owning spouse’s distributive share. To a large degree, the application or non-application of discounts in civil shareholder disputes rests on a determination of the good or bad faith of the competing shareholders. If “Fair Value” is to be applied in divorce, the concept of fault considerations (which exists on the civil side) should be taken into account.
4. “Double-Dip”: As explained throughout this article, the impact of using the same stream of income to fix support, that was also used to value and distribute a business must be factored in so that the non-owning spouse does not receive the same benefit twice.
5. Taxes: Although Orgler[vi] prohibits courts from reducing the value of an asset by taxes due upon its sale unless the sale is imminent, courts are still required to “consider” these taxes.
6. Passive/Active Increases in Exempt Business Interest: When distributing the increase in a business interest that was pre-marital, gifted or inherited, courts must consider the extent to which the increase in value was active or passive. Even if an active increase, a court must be reminded that the non-owning spouse is not entitled to a share of that increase if he/she did not contribute to it in any way. See Sculler v. Sculler, 348 N.J. Super. 374, 381 (Ch. Div. 2002) (holding that “proof” that an asset is immune from equitable distribution raises a rebuttable presumption that any subsequent increase in value will also be immune. The burden then shifts to the non-owner spouse to demonstrate that …the increase in value is active and can be linked in some fashion to the efforts of the non-owner spouse.).
7. Contributions to the Business: Without diminishing the non-financial contributions of a stay-at-home spouse and parent, courts should not assume that these contributions are equal to those of the working spouse.
With the foregoing factors adequately considered, the author believes that a fair distribution between the parties will occur.
Charles F. Vuotto, Esq. is a partner with the Matawan-based Law Firm of Tonneman, Vuotto, & Enis, LLC. He is the Chair of the Family Law Section of the New Jersey State Bar Association. Mr. Vuotto is certified by the Supreme Court of the State of New Jersey as a Matrimonial Law Attorney. He has been selected by his peers for inclusion in the 2009 Edition of the Best Lawyers of America® in the area of Family Law. Mr. Vuotto is one of two Co-Managing Editors of the New Jersey Family Lawyer, which is a highly respected and quoted publication of the Family Law Section. Mr. Vuotto writes and lectures extensively on the topic of Family Law.