Articles

What to do if a Spouse Cheats … on Taxes

A married person filing jointly may be held responsible if a spouse cheats on their tax return. Photo by Burak Kostak from Pexels

When you got married, you knew it was for “better or worse.” But you might not know about laws that hold you responsible if your spouse cheats on a tax return.

Married couples filing jointly should be aware that:

  • You are both responsible for tax, interest and penalties — even after a divorce or the death of a spouse.
  • The IRS may hold you responsible for all the tax due even if there is a divorce decree stating that your ex-spouse is accountable for previous joint returns.
  • You can be liable for tax even if none of the income on a tax return is attributed to you.

To illustrate how the law works, let’s say you have a wage-earning job and your spouse is self-employed. You file joint tax returns. Next year, you get divorced and a year later, the IRS audits your tax return. Your ex-spouse is nowhere to be found, and auditors determine that he or she didn’t report all the income from the business.

What Could Happen?

You are generally liable for paying the tax due, plus interest and any penalties. Your wages can be seized by the IRS even if you paid every penny owed on your share of the family income.

Fortunately, there may be a way to get off the hook. In some situations, the tax law provides “innocent spouse” relief if you can prove:

  • There is a substantial understatement of tax attributable to the grossly erroneous items of your spouse or ex-spouse.
  • The hidden income belonged to your ex-spouse and you didn’t benefit from it.
  • You didn’t know or have reason to know about the understatement.
  • It would be inequitable to hold you liable.

In January 2012, the IRS released proposed streamlined procedures that make it easier to obtain equitable relief. The new guidelines also include an exception to the requirement that items must be attributable to the ex-spouse when that spouse’s fraud is the cause of the understatement or deficiency.

Be aware that the IRS is required to notify an ex-spouse that relief has been requested so that he or she can elect to participate. There are no exceptions, even for victims of domestic violence.

“Innocent” versus “Injured” Spouse

If your current or former spouse has gotten you into tax trouble, you may be able to get help from the IRS.
It all depends on whether the tax agency considers you “injured” or “innocent.” You probably think you qualify as both, but they are two different legal terms:

An injured spouse files a joint return and loses all or part of a refund because of a spouse’s debts.

An innocent spouse claims no liability for items on a joint tax return that belong to a spouse or ex-spouse. Let’s say you and your current spouse file a joint tax return and are expecting a large refund. But you receive a notice from the IRS stating that your refund is being seized to pay a debt owed only by your spouse. For example, back taxes from before you married, past due child support, a delinquent student loan or other federal debt.

You may be able to recover your portion of a joint tax refund that the IRS seized. To qualify, you must have earned your own income and made your own federal tax payments. Ask your tax advisor for more information if you think you qualify.

Advice: Don’t count on innocent spouse relief if you know your spouse is cheating on tax returns. The IRS often denies relief. Consider filing separate tax returns — especially if you’re in the process of a divorce. It may save you a bundle in the future. For more information about your situation, consult with your tax advisor.

If you require the valuation of a business, calculation of reasonable compensation or forensic assistance in a matrimonial matter, please contact Advent Valuation Advisors for trusted guidance. 

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© 2021, Powered by Thomson Reuters Checkpoint 

Compensation or Dividend: Know the Difference

The U.S. Tax Court recently ruled that payments made to a corporate taxpayer’s three shareholders were dividends — not compensation for personal services rendered. The court’s reasoning also may be relevant in shareholder disputes and divorce cases when the parties disagree about whether compensation should be deducted from earnings when valuing a business interest. (Aspro, Inc. v. Commissioner, T.C. Memo 2021-8, Jan. 21, 2021.)

Background

Under current tax law, a corporation may deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services rendered. In the case of compensation payments, a test of deductibility is whether they’re in fact payments purely for services.

On the other hand, distributions to shareholders disguised as compensation aren’t deductible for federal income tax purposes. Specifically, Internal Revenue Code Section 162 says:

Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock.

Case Facts

The taxpayer operated as an asphalt paving business. Most of its revenue came from contracts with government entities. These public projects are awarded to the low bidder.
Aspro has three owners:

  • Shareholder A is an individual who owned 20% of the company,
  • Shareholder B is a corporation that owned 40% of the company, and
  • Shareholder C is a corporation that owned 40% of the company.

Shareholder A also served as the company’s president and was responsible for its day-to-day management. His responsibilities included bidding on projects. Shareholder A often spoke to the individuals who owned corporate shareholders B and C to get their advice on bidding for projects.

In 2014, Aspro paid management fees to its shareholders for their advisory services on how to bid for projects. Aspro then deducted these management fees for personal services rendered. Neither in 2014 nor in any prior year did Aspro pay dividends to its shareholders. The IRS denied the deduction, claiming the fees were actually dividends.

Tax Court Decision

The Tax Court agreed with the IRS. It didn’t dispute that a portion of payments made to Shareholder A potentially might have been compensation for personal services. However, since the payments weren’t purely compensation, they weren’t deductible for federal income tax purposes.

Factors underlying the court’s decision to classify the payments as dividends, not a form of compensation, include:

Lack of historical dividend payments. Aspro is a corporation with few shareholders that never distributed any dividends during its entire corporate history; it merely paid management fees.

Payments corresponding to ownership percentages. The management fees weren’t exactly pro rata among the three shareholders. However, the two corporate shareholders always got equal amounts, and the percentages of management fees all three shareholders received roughly corresponded to their respective ownership interests.

Payments to shareholders, not individuals. Aspro paid the amounts to corporate shareholders B and C, instead of to the individuals who actually performed the advisory services.

Timing. Aspro paid management fees as lump sums at yearend, rather than paying them throughout the year as the services were performed.

Lessons Learned

The appropriate treatment of payments to shareholders should be decided on a case-by-case basis. The decision has implications beyond federal income taxes. To the extent that a company’s value is based on its earnings or net free cash flow — say, under the income or market approaches — the deductibility of these payments can have a major impact on the value of a business interest.

The federal income tax rules for how to treat these expenses can provide objective guidance when classifying payments for other purposes. In some cases, it may be appropriate to adjust a company’s earnings for deductions that represent dividends, based on the facts of the case.

For more information about the classification of compensation and dividends or other valuation issues, please contact the professionals at Advent Valuation Advisors

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© 2021, Powered by Thomson Reuters Checkpoint 

Tax Treatment Complicates S Corp Valuation

So-called “pass-through” entities — including partnerships, limited liability companies (LLCs) and S corporations — generally aren’t required to pay entity-level taxes. So, when it comes to valuing a small business structured as a pass-through entity for tax purposes, people often wonder: Would investors pay a premium for an interest in this business compared to an interest in an otherwise identical C corporation? And, if so, how much is this favorable tax treatment worth? This is the crux of the tax-affecting debate.

Much of the litigation regarding this issue comes from the IRS and tax courts. But a recent Tennessee Court of Appeals decision discusses this issue in the context of a shareholder buyout. (Raley v. Brinkman, No. 2018-02002, Tenn. App., July 30, 2020)

Pros and Cons of Pass-Throughs

For pass-through entities, all items of income, loss, deduction and credit pass through to the owners’ individual tax returns, and taxes are paid at the personal level. Distributions to owners generally aren’t taxable to the extent that owners have positive tax basis in the entity.

If a pass-through entity distributes just enough of its earnings to cover the owners’ tax liabilities, there may be little potential valuation difference at the investor level between the pass-through entity and a taxable entity, assuming similar tax rates at the entity and the investor levels. If the pass-through entity distributes larger amounts of earnings to the owner, the interest becomes potentially more valuable than an equal interest in a taxable entity, all other things being equal. If the pass-through entity distributes less than the tax liability amount, an interest in the taxable entity could potentially be more valuable in the hands of the owner.

Court Allows Tax Affecting

The tax-affecting issue took center stage in a recent buyout case involving two equal partners in a restaurant that generated roughly $3.4 million in gross annual income in 2016. When the owners disagreed about how to manage their business, a Tennessee trial court ordered a buyout of one owner’s interest at “fair value” under applicable state law.

The business operated as an LLC that elected to be treated as an S corporation for income tax purposes. The trial court allowed the buyout price to include a hypothetical 38% corporate income tax rate to the restaurant’s earnings. But the seller (plaintiff) appealed, arguing that tax affecting wasn’t appropriate for a pass-through business that wasn’t subject to entity-level tax.

The buyer (defendant) contended that tax affecting was appropriate because the income from an S corporation passes through to the owners’ individual tax returns and is taxed at the owners’ personal tax rates. He also argued that valuation experts commonly use after-tax income values to calculate the capitalization rate under the income approach.

The appellate court explained that the problem with using the income approach to value a pass-through entity is that it’s designed to discount cash flows of C corporations, which are taxed at both the entity and the shareholder level. Income from an S corporation is taxed only at the shareholders’ personal level.

Citing the landmark Delaware Open MRI Radiology Associates case, the appellate court concluded that declining to tax affect an S corporation’s earnings would overvalue it, but charging the full corporate rate would undervalue it by failing to recognize the tax advantages of S status. The court also determined that it was appropriate to use an after-tax earnings stream because the expert’s capitalization rate was based on after-tax values.

Finally, the appellate court cited the Estate of Jones. In this U.S. Tax Court case, the court concluded that the cash flows and discount rate should be treated consistently when valuing a pass-through entity.

IRS Job Aid Provides Insight

The debate over tax affecting pass-through entities has persisted for decades. To help clarify matters, the IRS has published a job aid entitled “Valuation of Non-Controlling Interests in Business Entities Electing To Be Treated As S Corporations for Federal Tax Purposes.” This document helps IRS valuation analysts evaluate appraisals of minority interests in S corporations for federal tax purposes.

However, the job aid provides useful guidance on the issue of tax affecting that may be applied more generally to all types of pass-through entities that are appraised for any purposes, not just for tax reasons. Business valuation experts may use this job aid as a reference tool to help support their decisions to apply tax rates to the earnings of pass-through entities when projecting future cash flows.

No Bright-Line Rules

When it comes to tax affecting pass-through entities, there’s no clear-cut guidance that prescribes a specific tax rate — or denies tax affecting altogether. Rather, tax affecting may be permitted on a case-by-case basis, depending on the facts and circumstances.

© 2021, Powered by Thomson Reuters Checkpoint 

Price-to-EBITDA Multiples Decline During First Quarter, According to DealStats

The median price-to-EBITDA multiple among deals reported to DealStats fell slightly to 3.8 during the first quarter of 2021, down from 3.9 in the fourth quarter of 2020, suggesting transaction prices remain under pressure from the coronavirus pandemic.

According to the latest edition of DealStats Value Index, the four-quarter average EBITDA (earnings before interest, taxes, depreciation and amortization) multiple for the year ending in March 2021 was 3.9, the lowest such average since the period ending in the third quarter of 2016.

EBITDA measured as a percentage of net sales fell to 10 percent in the first quarter of 2020, due at least in part the ongoing economic toll of the pandemic and resulting restrictions. The reduction also reflects a longer-term trend of lower margins. EBITDA margins for transacted businesses have fluctuated between roughly 10.5 percent and 12 percent since late 2018, according to DealStats. From 2015 to 2018, they generally moved between 11 percent and 14.5 percent. DealStats does not indicate if the EBITDA margin metric is a median or an average.

Transaction reporting appears to have slowed with the pandemic. Of 15 sectors tracked by DealStats, just three met the minimum of 10 reported transactions during the first quarter required for the inclusion of sector-specific multiples.

DealStats is a database of private-company transactions maintained by Business Valuation Resources. The database is used by business appraisers when applying the market approach to valuation. Multiples such as sale price-to-EBITDA can be derived from transactions involving similar businesses and used to estimate the value of a company, subject to adjustments for unique characteristics of the business being valued.

How Reasonable is Your Owners’ Compensation?

There are many factors to consider when determining reasonable owners’ compensation. Photo by Matthew Henry from Burst

For most privately held businesses, owners’ compensation is one of the largest expenses on the income statement, especially when all the related perks and hidden costs are calculated. Compensation should accurately reflect what others would receive for similar duties in a similar setting. Reasonable compensation levels are important not only for state and federal tax purposes, but also to get an accurate estimate of the fair market value of the business.  

Total Compensation Package

Before compensation can be assessed as reasonable, all components of the package must be calculated, including:

  • Direct salaries, bonuses and commissions,
  • Stock options and contingent payments,
  • Payouts under golden parachute clauses,
  • Shareholder loans with low (or no) interest and other favorable terms,
  • Company-owned or leased vehicles and vehicle allowances,
  • Moving and relocation expenses,
  • Subsidized housing and educational reimbursements,
  • Excessive life insurance or disability payments, and
  • Other perks, such as cafeteria plans, athletic club dues, vacations and discounted services or products.

In addition, owners’ compensation may be buried in such accounts as management and consulting fees, rent expense and noncompete covenants.

IRS Guidance

The IRS has published a guide titled, “Reasonable Compensation: Job Aid for IRS Professionals.” IRS field agents use this guide when conducting audits to help determine what’s reasonable and how to estimate an owner’s total compensation package.

The IRS is on the lookout for C corporations that pay employee-shareholders excessive salaries in place of dividends. This tactic lowers the overall taxes paid, because salaries are a tax-deductible expense and dividends aren’t.

Owner-employees of C corporations pay income tax on salaries at the personal level, but dividends are subject to double taxation (at the corporate level and at each owner’s personal tax rate). If the IRS decides that a C corporation is overpaying owners, it may reclassify part of their salaries as dividends.

For S corporations, partnerships and other pass-through entities, the IRS looks for businesses that underpay owners’ salaries to minimize state and federal payroll taxes. Rather than pay salaries, S corps are more likely to pay distributions to owners. That’s because distributions are generally tax-fee to the extent that the owner has a positive tax basis in the company.

The IRS job aid lists several sources of objective data that can be used to support compensation levels, including:

  • General industry surveys by Standard Industry Code (SIC) or North American Industry Classification Systems (NAICS),
  • Salary surveys published by trade groups or industry analysts,
  • Proxy statements and annual reports of public companies, and
  • Private company compensation reports such as data published by Willis Towers Watson, Dun & Bradstreet, the Risk Management Association or the Economic Research Institute.

“Reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances,” states the IRS job aid.

Compensation Benchmarks

Beyond IRS audits, the issue of reasonable compensation may become an issue in shareholder disputes, marital dissolutions and other litigation matters. When valuing a business for these purposes, a company’s income statement may need to be adjusted for owners’ compensation that is above or below market rates.

Courts often rely on market data to support owners’ compensation assessments. But it can be a challenge to find comparable companies — and comparable employees within those companies. The five areas that courts consider when evaluating reasonable compensation are:

  1. The individual’s role in the company,
  2. External comparisons of the salary with amounts paid to similar individuals in similar roles,
  3. Character and condition of the company,
  4. Potential conflicts of interest between the individual and the company, and
  5. Internal inconsistency in the way employees are treated within the organization.

Owners can control compensation, and that creates an inherent conflict of interest when estimating what’s reasonable. External comparisons are key to supporting compensation levels. Business valuation experts typically interview owners to get a clearer picture of their experience, duties, knowledge and responsibilities.

Get It Right

For more information about reasonable owners’ compensation, please contact the business valuation professionals at Advent Valuation Advisors. We can help estimate total compensation levels, find objective market data and adjust deductions that are above or below market rates.

Prep Your Business Before You List It

Make your business sparkle – and tidy up the books, too – to help ensure a successful sale. Photo by Verne Ho on Unsplash

The COVID-19 pandemic has put unprecedented stress on private business owners. Some are now considering selling their businesses before Congress has a chance to increase the rates on long-term capital gains. Before putting your business on the market, it’s important to prepare it for sale. Here are six steps to consider.

1. Clean Up the Financials

Buyers are most interested in an acquisition target’s core competencies, and they usually prefer a clean, simple transaction. Consider buying out minority investors who could object to a deal and removing nonessential items from your balance sheet. Items that could complicate a sale include underperforming segments,nonoperating assets, andshareholder loans.

Sales are often based on multiples of earnings or earnings before interest, taxes, depreciation and amortization (EBITDA). Do what you can to maximize your bottom line. That includes cutting extraneous expenses and operating as lean as possible.

Buyers also want an income statement that requires minimal adjustments. For example, they tend to be leery of businesses that count as expenses personal items (such as country club dues or vacations) or engage in above-or below-market related party transactions (such as leases with family members and relatives on the payroll).

2. Highlight Strengths and Opportunities

Private business owners nearing retirement may lose the drive to grow the business and, instead, operate the company like a “cash cow.” But buyers are interested in a company’s potential. Achieving top dollar requires a tack-sharp sales team, a pipeline of research and development projects and well-maintained equipment. It’s also helpful to have a marketing department that’s strategically positioning the company to take advantage of market changes and opportunities, particularly in today’s volatile market conditions.

3. Downplay (or Eliminate) Risks

It’s no surprise that businesses with higher risks tend to sell for lower prices. No company is perfect, but industry leaders identify internal weaknesses (such as gaps in managerial expertise and internal control deficiencies) and external threats (such as increased government regulation and pending lawsuits). Honestly disclose shortcomings to potential buyers and then discuss steps you have taken to mitigate risks. Proactive businesses are worth more than reactive ones.

4. Prepare a Comprehensive Offer Package

Potential buyers will want more than just financial statements and tax returns to conduct their due diligence. Depending on the industry and level of sophistication, they may ask for such items as:

  • Marketing collateral,
  • Business plans and financial projections,
  • Fixed asset registers and inventory listings,
  • Lease documents,
  • Insurance policies,
  • Franchise contracts,
  • Employee noncompete agreements, and
  • Loan documents.

Before you give out any information or allow potential buyers to tour your facilities, enter into a confidentiality agreement to protect your proprietary information from being leaked to a competitor.

5. Review Deal Terms

Evaluate different ways to structure your sale to minimize taxes and maximize selling price. For example, one popular element is an earnout, where part of the selling price is contingent on the business achieving agreed-upon financial benchmarks over a specified time. Earnouts allow buyers to mitigate performance risks and give sellers an incentive to provide post-sale assistance.

Some buyers also may ask owners to stay on the payroll for a period of time to help smooth the transition. Seller financing and installment sales also are commonly used.

6. Hire a Valuator

A fundamental question buyers and sellers both ask is what the company is worth in the current market. To find the answer, business valuation professionals look beyond net book value and industry rules of thumb.

For instance, a business valuation professional can access private transaction databases that provide details on thousands of comparable business sales. These “comparables” can be filtered and analyzed to develop pricing multiples to value your business.

Alternatively, a valuation expert might project the company’s future earnings and then calculate their net present value using discounted cash flow analyses. These calculations help buyers set asking prices that are based on real market data, rather than gut instinct. However, final sale prices are influenced by many factors and can be higher or lower than a company’s appraised value.

They can also estimate the value of buyer-specific synergies that result from cost-saving or revenue-boosting opportunities created by a deal. Synergistic expectations entice buyers to pay a premium above fair market value.

Planning for a Sale

Operating in a sale-ready condition is prudent, even if you’re not planning on selling your business anytime soon. Our experiences in 2020 have taught us to expect the unexpected: You never know when you’ll receive a purchase offer, and some transfers are involuntary.

The professionals at Advent can help you prepare for a sale whether in 2021 or beyond.

© 2021, Powered by Thomson Reuters Checkpoint 

Divorce Case Highlights Value of Goodwill

Photo by Nosiuol on Unsplash

While not a New York case, a recent divorce case in Delaware Family Court sheds new light on an old precedent for the treatment of enterprise goodwill in a sole proprietorship.

The couple in A.A. v. B.A. married in 1979 and divorced in February 2017, but the case lingered, with a decision regarding the valuation of the husband’s financial advisory practice, a sole proprietorship, coming in October 2020.

Both spouses hired experts to value the business. The experts reached widely divergent conclusions, with the husband’s expert valuing the business at $255,000, while the wife’s arrived at a value of $3,488,0000 to $3,500,000.

The court rejected the report by the husband’s expert, taking issue with both its failure to consider the business’s goodwill and its reliance on a flawed asset approach.

“From the outset, husband’s expert’s opinion was limited by his belief that Delaware law was settled that there could not be good will in a sole proprietorship,” reads the decision.

The husband’s expert had relied on a 1983 Delaware Supreme Court decision. In E.E.C. v. E.J.C., (457 A. 2d 688, Del. 1982), the court had rejected the consideration of goodwill in the valuation of a sole practitioner’s law practice. According to the decision in A.A. v. B.A., the husband’s expert took that oft-cited decision as an indication that Delaware case law does not permit the use of goodwill in valuing sole proprietorships under any circumstances.

The court rejected this premise: “The court notes that husband’s business in the present case is not a law firm and the practice and means of generating income are different. The court does not read E.E.C. as stating every sole proprietorship in every case has no professional good will.”

The court agreed with the wife’s expert, who assigned 5 percent of the total goodwill to the husband based on the value of his noncompete agreement, and the remaining 95 percent to the business. The court said both experts agreed that, if the husband could transfer goodwill such that he could transfer to a buyer his client base and stream of income, or even 95 percent of his stream of income, he could receive about $3.5 million for the business.

Misassessed assets

The court also took issue with the husband’s expert’s asset approach, which did not consider income earned but not yet paid to the business as of the separation: “Husband continued to run the business and the value receive[d] by husband through receivables, work in process or residual commission tails was well beyond the amount placed on it by husband’s expert. This would probably explain why the husband himself placed a value of $10 million on the business in his financial statements.”

The decision notes that, between the date of separation and late 2019, the husband extracted more than $4 million from the business, including commissions for work done during the marriage. This included a $600,000 commission received in 2018 that had been in the making for perhaps three years, according to the husband’s testimony.

The wife’s expert used a weighted combination of the income approach (capitalized income method) and market approach (transaction and guideline public company methods). The court relied on the wife’s expert, determining that the business’s value was $3,488,000.

The case is A.A. v. B.A., CN16-05018 (Del. Fam. Oct. 9, 2020). Read the decision here.

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If you require assistance with the valuation of your business in a matrimonial matter, please contact Advent for trusted guidance.

Buy-Sell Agreements Vital in the Age of COVID

A smartly crafted buy-sell agreement can spare you and your business from complications down the road. Photo by Marcelo Dias from Pexels

When a business is owned by more than one person, it’s generally advisable for the owners to enter into a contractual agreement that prescribes what will happen if an owner dies, becomes disabled, retires or otherwise leaves the company.

Some market analysts predict that the COVID-19 crisis may trigger an increase in buyouts. For example, some struggling owners may decide to throw in the towel after months of teetering on the verge of bankruptcy. Or squabbling partners may disagree about the future of the business and decide to part ways.

So, now is a good time for owners to draft or update a buy-sell agreement. Here’s a look at common valuation issues and potential pitfalls to avoid.

Valuation Considerations

“Buy-sells,” as they’re often called, may be standalone agreements or a provision within a broader agreement (such as a partners’ or shareholders’ agreement). To avoid misunderstandings and delays when redeeming a departing owner’s interest, a buy-sell should address the following key elements:

  • Appropriate standard of value (such as fair market value or fair value)
  • Definition of the standard of value
  • List of applicable valuation adjustments and discounts
  • Relevant method of quantifying valuation adjustments and discounts
  • Effective date of the valuation (for example, the year-end nearest the triggering event)
  • Buyout terms (including who will buy the interest and how payments will be made), and
  • Appraisal/redemption deadline (for example, within 30 or 90 days of the triggering event).

The buy-sell should also specify the parties’ preferred method of appraisal. Examples include a fixed price, a prescribed formula or the use of credentialed business valuation professionals.

In some cases, the owners agree to use the company’s CPA firm to perform an independent valuation of the departing owner’s interest. Other buy-sells require two outside appraisals: one for the buyer and another for the seller; the value of the departing owner’s interest is then determined by averaging the results of the two conclusions.

Potential Pitfalls

Ambiguous or outdated buy-sells can cause problems when it’s time for a buyout. For example, an agreement containing undefined valuation terminology — such as “earnings” or “value” — may be subject to different interpretations.

Likewise, the use of a prescribed formula that’s based on a simplistic industry rule of thumb might cause problems when a buyout happens several years after the agreement was executed. Industry and economic conditions may have changed, or the company’s product or service lines might have evolved.

For instance, some companies have pivoted during the COVID-19 crisis to take advantage of new market opportunities, automate certain processes, or minimize face-to-face interactions with customers.

Fixed valuation formulas that were valid before the pandemic may no longer be relevant in the new normal. This underscores the importance of creating a “living” buy-sell that’s reviewed and updated regularly to stay current.

One More Word of Caution

During a buyout, the buyer is typically either the company or the remaining owners. The seller is usually either the departing owner or the departing owner’s heirs. Because the buyer controls how financial results are reported after the seller leaves the business, the seller should be wary of the potential for financial misstatement. Financial statements often are used to value the departing owner’s interest. So, the buyer has an incentive to understate revenue and assets or overstate expenses and liabilities. These manipulations can lower the buyout price, unless adjustments are made to the company’s financial statements.

Outside Expertise

There is no one-size-fits-all buy-sell agreement. The input of a business valuation professional when drafting or updating a buy-sell can help achieve the owners’ buyout objectives and reduce disputes when and if the agreement is triggered. If you have any questions, the professionals at Advent Valuation Advisors are here to help.

For more information on buy-sell agreements, read our previous blog post here.

Lawsuit Turns on Credibility of Valuations

A shareholder dispute involving a Nassau County business was decided based on the relative merits of two experts’ valuation reports. Photo by Matthew Henry from Burst

What makes the difference between your company being valued at $30 million or $6 million?

Sometimes, it comes down to which valuation expert’s report the judge finds more credible.

That’s what the owners of Kraus USA, Inc., a Long Island business selling fine plumbing fixtures, learned earlier this year. Sergio Magarik sued his co-owners, Michael Rukhlin and Russell Levi, in 2015, seeking to dissolve the company. (Read the petition here.) The respondents elected to buy out his interest in the company, and as a result, various claims and counterclaims were discontinued, leaving but one matter to be determined by the court: the value of Magarik’s shares. 

This required a determination of the fair value of the company as of September 20, 2015, the day before the petition was filed. Kraus is an internet-based business that sells faucets, sinks, plumbing fixtures and related items, primarily through third-party retailers. Its products are manufactured in China. The company grew rapidly, from $21 million in sales in 2012 to $36 million in 2015, but had negative cash flow and a significant amount of debt. Magarik owned 24 percent of the company, Levi, 51 percent and Rukhlin, 25 percent.

The trial included testimony from the three owners, Kraus’ controller and the valuation experts for each side. Each expert prepared a valuation based on an income and a market approach to value. Magarik’s expert arrived at a value of about $30 million for Kraus, the average of his discounted cash flow income approach ($21.9 million) and guideline public company market approach ($38.8 million).

The valuation echoed projected earnings prepared months earlier by Kraus’ controller in connection with a loan application in which Kraus’ owners represented that the company was worth more than $30 million. 

The respondents’ expert estimated Kraus was worth $6.05 million, about one-fifth the amount of the other expert’s estimate. He presented an income approach based on capitalization of earnings ($6.16 million) and cash flow ($5.9 million and $6.1 million). His market approach, a “merged and acquired company method” method relying on Pratt’s Stats database (now DealStats) for comparable transactions, resulted in a range of values from $5.3 million to $6.1 million. 

Justice Vito DeStefano found that Magarik’s expert did not sufficiently account for the level of competition Kraus faced or its lack of cash flow, and that it overestimated the value of the Kraus brand, which Kraus did not actually own. 

“The court does not accept the valuations provided by petitioner’s expert … as they exceeded the true value of the business, were based on income projections that were unrealistic and optimistic and not based on appropriate comparable businesses. Moreover, the two valuations provided were vastly disparate from each other, underscoring mistaken premises and assumptions.”

“In reality,” the justice wrote, “the value of the business was never $30 million and the projections contained in the loan application were never realized.” Justice DeStefano accepted the $6.05 million valuation presented by the respondents’ expert, which he found to be “supported by the credible evidence which demonstrated a successful and growing business that was not especially liquid.” (Read the decision here.) He applied a 5 percent discount for lack of marketability – less than the 25 percent DLOM sought by the respondents. The petitioner had not applied a DLOM.

The resulting value of Magarik’s 24 percent interest was calculated to be $1,379,400. Justice DeStefano added interest of 9 percent dating back to the filing of the petition, and gave Kraus two years to make the payment, in deference to the company’s cash flow difficulties.

For more on the two valuations, you can read the parties’ post-trial memoranda here and here. The case is Sergio Magarik v. Kraus USA, Inc., Michael Rukhlin and Russell Levi, Index No. 606128-15, Nassau County Supreme Court.

The decision in Magarik underscores the importance of securing a credible, defensible business valuation. The professionals at Advent Valuation Advisors offer a full range of business valuation and litigation support services. If you have any valuation needs, the professionals at Advent are here to provide a credible valuation.

First Round Goes to Insurers in COVID-19 Court Fight

More than 140 lawsuits have been filed against insurers over claims for business interruptions caused by the COVID-19 pandemic. Photo by Matthew Henry from Burst

An insurer scored a significant win in what is believed to be the first court decision involving a COVID-19-related business interruption claim. 

On July 1, 2020, 30th Circuit Judge Joyce Draganchuk in Ingham County, Michigan, dismissed a lawsuit by the owner of two restaurants in Lansing Michigan, siding with the insurer’s decision to deny a claim for business-interruption coverage because the eateries did not sustain “direct physical loss or damage.”

The decision in Gavrilides Management Company v. Michigan Insurance Co. was previously reported by the National Law Review, among others.  Gavrilides Management sought $650,000 from Michigan Insurance Co. for losses it sustained after Gov. Gretchen Whitmer issued executive orders in March that limited its two restaurants to delivery and take-out orders.

Judge Draganchuck said it is clear from the wording of the insurance policy that only direct physical loss to the properties is covered. She rejected as “simply nonsense” the plaintiff’s claim that the restaurants were damaged “because people were physically restricted from dine-in services.”

“Direct physical loss of or damage to the property has to be something with material existence, something that is tangible, something … that alters the physical integrity of the property. The complaint here does not allege any physical loss of or damage to the property,” the judge said during the July 1 video court session. “The complaint alleges a loss of business due to executive orders shutting down the restaurants for dining … in the restaurant due to the COVID-19 threat, but the complaint also states that, at no time has COVID-19 entered the Soup Spoon or the Bistro through any employee or customer.”

The judge noted that the insurance policy also has a virus and bacteria exclusion, and that loss of access to the premises due to government action is not covered. 

You can watch a recording of the virtual court appearance here.

Testing the Limits of Coverage

Business interruption insurance typically covers the loss of income that a business suffers due to the disaster-related closing of the business and the rebuilding process after a disaster. The COVID-19 pandemic is testing the limits of this coverage and its applicability to unprecedented circumstances.
Countless businesses were forced to close as a result of the COVID-19 pandemic and the ensuing emergency orders. While many businesses have been able to reopen since, often on a limited basis, the losses sustained have been steep and, in many cases, ongoing. 

Several state legislatures, including New York’s, have introduced bills that would require insurers to cover business-interruption losses stemming from COVID-19, even if the policies specifically exclude such coverage. Meanwhile, more than 140 COVID-19-related business interruption cases have been filed in federal courts nationwide, including several filed in U.S. District Court for the Southern District of New York. To read three of the complaints, click on the links below.

Broadway 104, LLC, dba Café Du Soleil, v. Axa Financial, Inc.; XL Insurance America, Inc., No. 1:20-cv-03813, SDNY

Food for Thought Caterers Corp. v. The Hartford Financial Services Group, Inc., and Sentinel Insurance Company, LTD., No. 1:20-cv-03418, SDNY

Gio Pizzeria & Bar Hospitality LLC v. Certain Underwriters at Lloyd’s, London, No. 1:20-cv-03107, SDNY

Advent Valuation Advisors provides a variety of litigation support services, including the assessment of damages from business interruption. For more information on business interruption claims, read our blog posts here and here. If you have any questions, please contact us.