Business Valuation in a Divorce in Arizona
Arizona Divorce: Dividing a Business
Business valuations and appraisals in an Arizona divorce case are necessary when one or both spouses have an ownership interest in a business. Business evaluations and assessments, however, occur in only a small percentage of divorce cases due to the relatively limited number of business owners compared to the significantly larger number of employed individuals.
So, it is important to work with a divorce attorney who has a lot of experience dealing with how a business is divided in a divorce in Arizona. The court may not only divide the value of the business based upon its value but may also divide business profits earning while the divorce is pending.
Most people who own a business and are facing a divorce own an interest in what is referred to as an S corporation. These corporations are known as tax pass-through corporations and are not subject to corporate taxes; although the owner pays taxes at his or her personal income tax rate. The status of a company as an S corporation can affect the value of the company due to the lack of corporate income taxes.
As a result, it is important to ensure your family law attorney fully understands the principles and practices of business evaluations and appraisals in the context of a divorce. The establishment of the community property interest of a business in a divorce case is critical to both spouses.
Courts will almost never simply hand over the operation of the business to both spouses as equal owners. In some cases, a Court may be prohibited from awarding each spouse equal ownership in the business if, for example, there are other non-related owners of the business whose interests would be affected by forcing that person to operate the business with the non-participating spouse.
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Both spouses typically have a vested interest in completing a business evaluation and appraisal to assign a value to the business. Specifically, the spouse who will retain the business after the divorce has an interest in establishing its value because the court will likely order the business interest sold if reasonably reliable evidence of the value of that business is not presented to the court at trial.
The non-participating spouse, likewise, has an interest in the business evaluation and appraisal because he or she should expect to receive a fair share of the community property interest in that business.
If you built a business during the marriage or if you owned a business before marriage but you increased the income or value of that business during the marriage, the community may have a financial interest (i.e., community property interest) in that business.
This interest is referred to as a community lien against the sole and separate business of one of the spouse’s, subject to a counter-argument called the “fair use” or “fairly compensated” defenses to undermine that community lien claim. For more in-depth information regarding community liens, as well as the “fair use” and “fairly compensated” defenses to community liens, please review our synopsis of the Arizona Court of Appeals decision in the Potthoff v. Potthoff case.
In the event of a business created and built entirely during the marriage, the community would have an interest in the value of that entire business in most circumstances. If the business was owned before marriage but increased in value during the marriage, the community does not have ownership in the business but may have a community lien for any increased profits and increased value of that business.
It is incredibly important to understand the various business appraisal methodologies an appraiser may apply, as well as the different discounts, such as a minority shareholder discount and lack of marketability discount, that may impact the value of the business. Your attorney must have a good understanding of these methodologies to ensure the business appraisal is not unfair to his or her client.
You should read the Arizona Court of Appeals decision in the Schickner v. Schickner case for a more in-depth analysis whether a “minority shareholder” discount or “marketability” discount is appropriate, as both discounts can substantially decrease the final appraised value of the business.
Many divorce attorneys leave it up to the business appraiser to make an income determination related to a business on their own and to make the valuation decisions on their own. We are very different. We go through all of the financial statements on our own.
We look at where we may be able to identify where hidden income may be located. We watch the value of the assets. We make sure those assets are appraised so, for example, if the balance sheet shows a depreciated value of a building that is not reflective of its actual value.
You may need to obtain an appraisal to determine how much that building is worth, as well as the other physical and intellectual property assets of the business. We go through all of the detail to ensure the business appraiser does not miss anything to make sure our clients get the best results possible from that business evaluation.
Understanding the Different Business Valuation Methodologies in a Divorce in Arizona
Many different valuation methodologies may be adopted by a business appraiser; depending upon the purpose of the business appraisal. An appraiser would use a different valuation method when valuing a business for a divorce, which would differ from a valuation methodology that would be utilized in an IRS tax case and different than what would be used in a probate case.
Even so, there is not just one business valuation methodology in a divorce case. Different assessment approaches in an Arizona case can bring about enormous differences in the value of a community business.
Understanding and being able to effectively argue which methodology is best for each client requires your attorney to understand the methods used to appraise a business in an Arizona divorce. In a nutshell, two primary valuation approaches are used by business appraisers in a divorce in Arizona. Specifically, the Fair Market Value approach and the Fair Value approach.
The Business Appraisal Process in an Arizona Divorce
Understanding the process of determining the value of a business, as well as the numerous factors and the different valuation methodologies that will increase or decrease that assessment, is critical to representing a spouse’s financial interests in a divorce.
The business evaluation and appraisal process are important because it will also establish the amount of income the owner receives from the business, which will significantly impact the court’s calculation of child support and spousal maintenance.
A spouse may believe he or she knows the value of his or her own company. However, the opinions of a business owner regarding the value of his or her company are typically given very little weight by most judges because of the inherent bias of the business owner to understate the real value of the business in a divorce case.
Frequently, the factors impacting the business evaluation and appraisal and, hence, the value of the company is not readily apparent and may have even been unknown or overlooked by the business owner and even the business evaluator and appraiser.
Retaining a divorce lawyer who understands the intricacies of proper business evaluations and appraisals is, therefore, critical to ensuring a fair and accurate assessment of the value and income derived from a business.
Other factors may also significantly affect the value of a business in a business evaluation and appraisal. For example, the condition of the economy as a whole, the health of the industry in which the company operates, the status of competitors in the same industry, and the ability of the company to access capital or debt to expand or even maintain operations, just to name a few.
A thorough business evaluation and appraisal are essential to determining the value of a business in a divorce to ensure the fair distribution of the business as a marital asset and to ensure accurate income figures are utilized in the calculation of child support and spousal maintenance. You should also be aware the court may also divide the profits of the business produced by the business during the pendency of the divorce case, depending upon the particular factors that apply.
Please click on the Schickner v. Schickner Arizona Court of Appeals case for more detailed analysis on what factors a divorce court may consider when dividing profits from a business during the pendency of the divorce case.
“Fair Market Value” Standard of value when Appraising a Business During an Arizona Divorce
The United States Federal Code of Regulations defines the Fair Market Value method as “the net amount which a willing purchaser, whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts”.
It is important to note that the concept of the term “market” in “fair market value” does not depend upon what a particular buyer may offer to pay for the business. That is because it excludes consideration of the other buyers willing to pay more or less for the business if the business was placed on the market for sale and exposed to all potential purchasers of the business.
The fair market value approach also precludes from consideration any special selling financial arrangements used to secure the sale of the business, such as creative financing options or other concessions agreed upon by the business owner and a prospective purchaser of the property, which would artificially decrease or increase the actual real market value of the business.
It is also important to understand an argument may be made in an Arizona divorce that fair market value is designed to find the highest value of the business. As opposed to the most probable sale price, which will include the highest and best use of the business even if the current owner of the business may not be taking advantage of those other opportunities.
This can pose a significant problem in a divorce if the business valuation is driven higher than the current income supports because of opportunities the present owner of the business has not pursued.
One of the more significant impacts a “fair market value” approach may have on a business valuation during an Arizona divorce is from the potential application of lack of marketability or minority shareholder discount, which can decrease the value of the business between 10% to 30% or more.
The “lack of marketability” discount is based on the assumption that a small business is less marketable and, hence, sells for less money than, let’s say, a publically traded business on the stock market. The “minority shareholder” discount is applied when the spouse has less than 51% of the shares of the company and also lacks authority or control over the business in the corporate bylaws.
It is applied based upon the presumption that someone purchasing that share of the business would pay less because he or she has no control over the major business decisions.
“Fair Value” Standard of Value Method of Appraising a Business During an Arizona Divorce
The “fair method” approach to valuation of a business as community property in Arizona is that it does provide for “lack of marketability” or “minority shareholder” discounts. Excluding those discounts from the valuation process, therefore, increases the value of the business over a fair market value approach.
The Arizona Legislature passed a statute that applied to what is referred to as Dissenters Rights Cases, which are cases involving shareholders who lack control over an Arizona corporation and disagree with a decision being made by the company and, therefore, wish to sell their shares back to the corporation. The statute applies to protect minority shareholders based upon the decisions being made which are out of the minority shareholders’ control.
“Fair Market Value” vs. “Fair Value” Standard of Value of a Business in an Arizona Divorce
The million dollar question, therefore, is whether it is appropriate to use a fair market value or fair value approach in assessing the value of a business in an Arizona divorce. There is no single clear answer to this question because judges have broad discretion to apply the valuation methodology he or she believes results in the more fair and equitable result.
Also, the facts of each case relating to a community property business are different and may lead to a judge favoring one methodology over the other. Having an experienced divorce attorney is imperative to make the arguments that will most fairly and equitably apply to your case.
Choosing the Valuation Date for Valuation of a Business During an Arizona Divorce
Parties in a divorce have to pick a valuation date for the assessment of the business. The reason a valuation date is necessary is that business appraiser must look at the specific economic and market conditions applicable to the business to include in his or her appraisal.
The housing crash that occurred provided a great example when we heard statements like “wow, I could have made hundreds of thousands of dollars if I had sold my home a year ago”. The economic and market conditions that existed in the past are not relevant to a business appraiser.
Prior or potential future economic or market conditions have nothing to do with the value of a business today because it does not represent the current “fair market value” that exists today.
“Premise of Value” in a Business Valuation During an Arizona Divorce
Choosing the correct “premise of value” will also materially affect the cost of a business during a divorce in Arizona. The appraiser will either be told by the parties or the court to apply a particular “premise of value”. The appraiser may elect or be directed to provide appraisals of the business based upon all possible “premises of value” and leave the presentation of the evidence and arguments to the attorneys to convince the court which premise of value is the fairest and equitable given all of the circumstances existing.
The four premises of value Arizona court’s may apply to a business appraisal in a divorce case are the “going concern premise”, “value of the assets premise”, “value of the sale of the assets premise”, “value of the assets in an expedited liquidation premise”. Let’s cover each of these concepts individually.
The “going concern premise” assumes the business will continue operating. The appraiser will not only value the physical and intellectual property assets will be valued, as well as the profits of the business, in determining the value of the business. This typically results in the highest value for a business in an Arizona divorce.
The “value of the assets premise” is the value of the property without any consideration of the income those assets may be able to produce and does not contemplate the sale of the property.
The “value of the sale of the asset premise” is the value of property placed on the market for sale with no particular deadline for sale to provide the sufficient market time to provide a suitable buyer to purchase the property at their real value.
The “value of the property in an expedited liquidation premise” assumes the assets will be short in a concise time and, therefore, will not receive suitable time on the market resulting in expected lower sales prices received for the assets. You could compare this to the proverbial “fire sale”.
The premise of value in a divorce case is typically a “going concern” premise unless it can be shown the business is failing and another premise should be used. For example, if the carrying costs associated with expensive equipment is causing too much of a cash drain and argument could be made the premise should be ‘value of the assets in an expedited liquidation” premise.
You should also be aware that different premises of value may be applied by a business appraiser on the same business depending upon the circumstances. For example, the appraiser may use the “going concern” valuation methodology for the business operations but may use a “value of the sale of the assets” premise for equipment that may not be deemed necessary to the functioning of the business. For example, the corporate jet may be subject to the “value of the sale of the asset” premise if the business owner completes all of his business operations in town.
Chris Hildebrand wrote this article about dividing a business in divorce in Arizona to ensure everyone has access to information about community property laws in Arizona. Chris is a family law attorney at Hildebrand Law, PC. He has over 24 years of Arizona family law experience and has received multiple awards, including US News and World Report “Top Arizona Divorce Attorneys”, Phoenix Magazine “Top Divorce Law Firms”, and Arizona Foothills Magazine “Best of the Valley” award. He believes the policies and procedures he uses to get his clients through a divorce should all be guided by the principles of honesty, integrity, and actually caring about what his clients are going through.
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