Understanding the different facets of both divorce law and business valuation is crucial if either spouse owns a closely held business. When it comes to divorce, that ownership interest will be classified either as a “separate” asset and not included in the marital estate for equitable distribution, or it might be classified as a “marital” asset that the court would include in marital asset distribution. In some circumstances a portion of the value could be deemed separate and the balance marital. Accordingly, it becomes necessary to value the business. The courts generally have wide discretion to decide what is equitable when dividing property.
For the purpose of equitable distribution the valuation of a business will require numerous determinations. For example:
• What should the date of the valuation be?
• What methods should be used to determine the value?
• What does the business own?
• Who does the business owe?
• What is the business’s real profit?
This post will discuss some practical recommendations to consider when determining business profits. While measuring the profitability of the business is only one of the requirements to determining value, in the matrimonial litigation context, it is often one of the more contested issues because profits not only impact the value of the business, but may also impact spousal maintenance determinations. There are numerous ways in which “profit” can be calculated because businesses differ greatly on how “revenues” and “expenses” are recorded in their books. Consequently, one needs to carefully read the business’s financial records and books so that the true profit can be accurately determined.
If one spouse owns a business, there are several ways to learn what its income is; the simplest being just to ask. This is often more effective than many would think. Nevertheless, this may not be an alternative for many or often the response will not be accurate.
When this is the case a spouse’s lawyer may subpoena the business records. This may include internally prepared financial statements, bank statements and loan applications, as well as bank accounts and credit card statements, and/or accounting records. These financial documents contain a wealth of information and a skilled CPA can help examine the documents to establish what is the real economic income. For example, since small owner-controlled businesses will often pay personal expenses, even in a business with substantial revenues may still show little profit. While the expenses paid by the business are not a direct form of compensation, the practice can be very beneficial to the owner. These are often referred to as ‘perquisites’ and are added back when determining the true profitability of a business. Often detailed accounting records are required to identify and support these add backs
One should also obtain the personal or business tax return depending on how the business is structured. Obtaining the actual return filed with the IRS is a good place to start. In order to get a copy of the return, IRS form 4506 can be submitted to request a copy of the return filed with the IRS. This way, one can verify that disclosure is providing the real numbers and not a “second set of books.”
Business valuation is a very complex process and will usually require an expert. Be sure to hire a business appraiser who holds a recognized business valuation credential, such as an ASA, ABV, or CVA, and one who practices business valuation full time. You may also need a CPA to help with the income reconstruction. Here at Advent Valuation Advisors, all or professionals hold either a CPA license and an ABV business valuation designation or have an ASA credential (Accredited Senior Appraiser) in business valuation, an internationally recognized business valuation credential awarded to highly experienced appraisers by the American Society of Appraisers.