Closely Held Corporations

by Wes Cowell; updated 1 September 2015 -- suggest a correction

 

Illinois divorce law says small businesses and closely held corporations acquired during the marriage are marital property and must be divided. You'll need a good businessvaluation and a lawyer who knows what he's doing.   Need advice?  Call, leave your info, or schedulescheduleschedule a consult.

 

For most small business owners, the business is their greatest source of income and their largest and most precious asset.  Closely held corporations are formed under either Subchapter S (that's subchapter S of section 1361 -- an “S corp.”), or Subchapter C (a “C corp.”) of the IRS code (26 U.S.C. §1361). The primary distinction is that an S corp. doesn't pay income tax and passes its income straight through to the owner and the owner is taxed for the income.   A “C corp.,” on the other hand, pays tax on its income and then may pay profits to the shareholder(s) in the form of dividends.  The character (marital or non-marital) of any business interest is determined as with any other asset:  if acquired during the marriage, the shares are presumed to be marital but the presumption may be overcome by evidence that it is really, non-marital in character.

 

When small business owner divorces, the three biggest issues to be resolved are:

1. the business valuation,

2. the treatment of any retained earnings, and

3. the treatment of personal goodwill.

 

These concerns are discussed below.

 

Valuation of Closely Held Business Interests: Several methods have developed by which to value the interest of a shareholding spouse.  Using the wrong method can financially destroy a shareholding spouse.  Where the small business owner may have to borrow against business assets to buy out the non-owning spouse, it may level a a death sentence to the business itself.

 

Countless businesses have been destroyed by poor divorce planning and strategy.  Consider In re Marriage of Cutler, 268 Ill.Dec. 496, 778 N.E.2d 762, 334 Ill. App.3d 731 (Ill. App., 2002)   where an insurance agency was valued at $243,000 using a flawed valuation method.  Not only was the valuation flawed in several ways, the court also considered the agency’s expected future earnings as part of a the valuation. On appeal, the the valuation was reduced – from $243,000 to a mere $32,000. The result after the appeal was a whopping a $211,000 savings; or roughly 87%.

 

Finding The Right Expert:  In any divorce case involving ownership of a closely held corporation (where the business has any value other than the services provided by the business owner) a qualified business appraiser should be brought in to value the corporation.  Although ordinary CPAs possess many of the tools needed to conduct a business appraisal, they are NOT necessarily qualified business valuators.  For a list of ABVs (Accredited Business Valuators) go to www.aicpa.org.  They maintain an online directory organized by state.

 

The American Institute for Certified Public Accountants requires a CPA to receive specialized training before being certified as an Accredited Business Valuator.  An apprenticeship program (10 business valuations) must be completed, the CPA must pass an exam and must maintain annual, continuing professional educational requirements.  In additional to AICPA, there is the American Society of Appraisers, the Institute for Business Appraisers and the National Association of Certified Appraisers.  If you need help finding a qualified, experienced business valuator, call my office to talk with an attorney who has the contacts to get the job done.

 

Revenue Ruling 59 – 60:  The IRS publishes “Revenue Rulings” to help guide valuators, tax lawyers, and divorce lawyers (among others) on how certain assets and liabilities should be treated for tax purposes.  Rev. Rul. 59-60 is the granddaddy of Revenue Rulings for business valuations for three significant reasons:

 

1.     It defines “fair market value” for transactions involving assets like closely held businesses.  Fair Market Value is defined as “ . . . the price at which the property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having knowledge of relevant facts.”

 

​2.     Rev. Rul. 59-60 sets out 8 factors that should considered in the valuation of any closely held business.  They eight factors are:

  • The nature and history of the business since inception.

  • The economic outlook, in general, and the condition and outlook of the specific industry in which the subject company operates.

  • The book value of the stock and the financial condition of the business.

  • The earnings capacity of the business.

  • The dividend-paying capacity of the business.

  • Whether or not the enterprise has a goodwill or other intangible value.

  • Sales of stock and the size of the block of stock to be valued.

  • The market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

  •  

3.     Rev. Rul. 59-60 addresses the impact of the loss of a “key person” on the valuation of a closely held.  Illinois divorce cases address this concern in the comparison of “personal goodwill” versus “enterprise goodwill;” but the foundation for all such analyses is found in Rev. Rul 59-60.  On this last point, Rev. Rul 59-60 says:

 

The loss of the manager of a so-called “one-man” business may have a depressing effect upon the value of the stock of such business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise.  In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business, and the absence of management-succession potentialities are pertinent factors to be taken into consideration.  On the other hand, there may be factors which offset, in whole or in part, the loss of the manager’s services.  For instance, the nature of the business and of its assets may be such that they will not be impaired by the loss of the manager.  Furthermore, the loss may be adequately covered by life insurance, or competent management might be employed on the basis of the consideration paid for the former manager’s services.  These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of the manager’s services in valuing the stock of the enterprise.

 

Minority Interest vs. Controlling Interest:  A good business valuation must account for any “minority discount” or “controlling premium.”  Small businesses, with only a few shareholders, usually have a controlling shareholder and minority shareholders.  Imagine a business where one partner owns 51% of the shares and the remaining 49% are equally divided between seven others.  On paper, the majority shareholder’s interest is worth 51% of the business’s value and the minority shareholders each hold an interest worth 7% of the business’s value.  In reality, the majority shareholder’s interest is worth much more than 51%:  he determines policy, makes the decisions, determines compensation, he determines the fate of the business.  Conversely, the value of the minority interests each probably are worth less than 7% of the business because (even if they banded together as a bloc) they have no control over the fate of the business.  Because the majority shareholder wields such power, his shares may be valued with a “controlling premium” and the minority shares may be valued with a “minority discount.”  The premium and discount reflect the added value (or diminution) to shares that allow the shareholder to control (or limit the shareholder’s control of) the business.  The Ohio Supreme Court succinctly expressed the idea in a business valuation case.  It recounted John Doyle's (he had been the president of the Ohio State Bar Association in 1893) address on the (lack of) rights of minority shareholders:

 

'In a corporation represented by 100 shares of capital stock, the owners of 51 shares could manage the corporation without the voice of the remaining 49 shares being heard, and the one odd share would be the available power; the 51 shares might be made very valuable, while the 49 could be rendered valueless, and the odd share or the balance of power receive an immense value. These suggestions will show that any statute providing for minority representation in corporations would not lead to 'absurd or improbable results,' but would be marked with wisdom and a fair regard for the rights of the parties.

 

'The old story, so often told, of a prominent Eastern newspaperman's reply to the question of what the shares in his company were worth, is very apt:

 

'There are 51 shares,' said he, 'that are worth $250,000. There are 49 shares that are not worth a _____.'

 

 Humphrys v. Winous Co., 133 N.E.2d 780, 783 (Ohio Supreme Ct., 1956)

 

Another majority/minority problem presented by small, family-owned businesses usually have several shareholders spread over a few generations.  It’s not unusual, for example, for a parent to hold a controlling interest (say, 52%) and a few members of the next generation to hold the balance (say, two brothers, each holding 24%).  Often, as the parent ages and the brothers assume more of the business’s operations, one brother begins to assume more responsibility in the management and operation of the business and, quite naturally soon finds the parent acquiescing to his decisions.  On paper, that brother owns only 24% of the business.  In reality, that brother controls 76%.  The question then arises:  if that brother suffers a divorce, how is his interest in the business valued?

 

Another problem arises when a husband and wife each hold shares in a family business.  Illinois courts prefer to allocate all of the shares to only one spouse rather than have the spouses continue in the business relationship after the divorce.  Imagine a three-person business where the husband and wife each hold 25% and a third party holds the remaining 50%. When the husband and wife divorce, should the court consider the separate values of the two 25% interests, or should it consider the value of a 50% interest (since either the husband or the wife will leave the divorce with both blocs)?

 

Other Discounts and Premiums:  In addition to the minority interest discount and the controlling interest premium, your business valuation may reference a number of other discounts or premiums, including:  a marketability discount, a trapped capital gains discount, a voting vs. non-voting shares discount, a litigation risk discount, an environmental risk discount, a portfolio discount, and a key-person discount, among others.

 

(Un)Reasonable Compensation:  Controlling shareholders hold a significant benefit in privately held companies:  they may set their own compensation.  A divorcing spouse holding a controlling interest in a small business may want to try to use that benefit to advantage in the divorce.  For example, a divorcing parent may want to reduce his or her compensation to show an inability to pay an otherwise reasonable amount in the way of maintenance (alimony) or child support.  Conversely, a divorcing spouse may want to take too much in the way of compensation to deplete the business of funds, thereby decreasing the business’s value.  A business appraiser will seek to normalize the compensation of a controlling shareholder by establishing a fair compensation and a reasonable return on capital.

 

Valuation Approaches and Methods:  There are three basic approaches to business valuations.  Illinois law says  "

In determining the value of assets or property under this Section, the court shall employ a fair market value standard."  750 ILCS 5/503(k).  The particular facts of the case will determine the approach used by the business valuator.  

 

The “Market Approach” determines a business’s value by looking at various transactions involving the subject business or similar businesses.  For example, the valuator may consider similar businesses that are publicly traded and for which financial data are available.  The valuator may also be able to consider recent buy/sell transactions for similar privately-held businesses.  Like comparables in real estate appraisals, recent buy/sell transactions for similar businesses offer one way to estimate a business’s value.  Finally, under the Market Approach, a valuator may look to past stock transactions between shareholders within the subject business.  This last issue comes up a lot in divorce cases and must be considered with great care and skepticism.  A spouse seeing a divorce on the horizon may collude with another shareholder to transfer shares for safekeeping until the divorce is over.  Such a transaction, however, can only be effective if the stock is sold for far less than its actual value.  The divorce lawyer and valuator must work closely together to thwart the attempted fraudulent transfer.  In particularly egregious cases, the non-shareholding spouse may consider an action for money damagers against the conspiring spouse and the co-conspirators under the federal RICO law.

 

The “Income Approach:” The most common business valuation approach used in divorce cases – looks to the business’s cash flow as the primary consideration in determining the business’s present value.  The business valuator may look at the business’s income stream from either of two perspectives, or “methods.”  The “capitalized return” method calculates the business’s value by looking at a specific period of normalized income.  The valuator considers the company’s historical returns and, where a business has been operating smoothly, profitably, and predictably, the valuator will project that performance into the future to determine the business’s present value.

 

The Discounted Income Approach:  Alternatively, the valuator may employ the “discounted income” (or discounted future cash flows) method and consider cash flow in several future time frames (the business must provide earnings projections) to determine the business’s present value.  The valuator determines a “discount rate” by considering the risks that would be faced by an investor in the business.  The greater the risk, the greater rate of return an investor would demand before investing in the business.   The cash flow projections are divided by the determined discount rate.  This function determines the present value of the “discounted cash flows.”  Obviously, a little change in the discount rate (the denominator) can make a big difference in the final business value.  Finally, the sum of the discounted cash flows is added to a “current value;” that is, the value of the business’s current cash flow assumed to run forever.  The sum of the discounted cash flows and the current value defines the present value of the business.

 

The “Asset Approach” looks at a business not as a whole, but rather as the sum of its parts.  The asset approach ignores the cash-flow of the business and instead values each asset of the subject business and looks to the sum of the value of those assets, less its liabilities, to determine the overall value of the business.  The reasoning is that a hypothetical investor could purchase similar assets of equal utility and, essentially, supplant the subject business.

 

Nearly all businesses, however, are valuable to their investors not for the assets that make up the business, but for the cash-flow those assets produce.  For this reason, the “asset approach” – which ignores cash-flow – is flawed for most applications.  It may be of some utility when valuing those few businesses with substantial assets but little or no cash-flow:  holding companies, real estate partnerships, start-up businesses, etc.

 

Treatment of Specific Business Assets:  A good valuation will properly treat accounts receivable (they should be considered an asset and properly discounted) and outstanding contingency fees (they are not to be considered assets as they are too speculative), cash on hand (asset), cash surrender value of life insurance (asset) and loans due from officers.

 

Intangible assets:  There are several ways to measure intangible assets.  Illinois courts have done a very good job in laying out valuation methods for many intangibles.  Where there appears to be no appropriate method, divorce lawyers and business appraisers fall back on the “formula” method.  Originally defined in 1920 by the Treasury Department (to determine the declines in value suffered by breweries due to Prohibition), the “formula” method was adopted by the IRS in 1968 in Revenue Ruling 68-609.  The formula method treats valuation of intangible assets in a rather ham-fisted way.  For that reason, Rev. Rul. 68-609 specifically warns “ . . . the “formula” approach may be used for determining the fair market value of intangible assets of a business only if there is no better basis therefore available..”

 

Goodwill -- Enterprise, Personal, and Professional Practice: A spouse's interest in a business that is acquired after the marriage is, of course, presumed to be marital property. The "goodwill" of a business is, essentially, its good reputation.  When you need a pen you can count on, you probably think "Bic."  Thinking of renting a car? Hertz probably comes to mind.  If it "absolutely, positively, has to be there overnight," you probably think of Federal Express. Those are examples of "enterprise goodwill."

 

When a business is known primarily for the person or persons behind it, however, that is referred to as the individual's "personal goodwill" – sometimes called "professional goodwill." Medical practices, car dealerships, law practices, and finer restaurants with a particular chef, are all good examples. The difference between a business' value when a person is – and is not – affiliated with a company is the "personal goodwill" brought to the organization by that individual.

 

When a marriage is dissolved the value of a marital business (or the marital portion of a business interest) or professional practice must be considered.  Enterprise goodwill usually is considered when dividing assets, and personal goodwill usually is considered when awarding maintenance.

 

Generally speaking, enterprise goodwill is part of the value of a business – that’s an asset and should be divided in the property settlement or by the court at trial.  On the other hand, personal goodwill is more often thought of as inhering to the individual – creating a continuing stream of income – and should be considered as either part of the value of the business (for property division purposes) or as part of the individual's future income-earning ability (a factor in determining maintenance awards) but not both. The trick for Illinois divorce lawyers is to distinguish between the two so as to prevent double-dipping.

 

Double-dipping can occur even where there has been a waiver of maintenance. When it comes to divorce and professional practices or closely-held family businesses, be careful and work closely with your attorney.  Knowledgeable lawyers may be able to keep "personal goodwill" out of the picture altogether, or may employstrategies involving maintenance to keep a spouse's personal goodwill in the marital estate and require the professional spouse to, essentially, buy back the right to his own name.   You will need to work with a knowledgeable attorney and a reputable expert to value both the personal goodwill of the individual and the enterprise goodwill or the business.  Special rules of evidence must be reckoned with to ensure the court will consider all proper evidence and expert testimony.  

 

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