Business Valuation

October 2018 : Stock Redemptions

Posted by Joseph W. Cunningham, JD, CPA

View / Download October 2018 Article – PDF File

— With the Elimination of Taxable/Deductible Section 71 Payments Effective January 1, 2019, the Use of Stock Redemptions by which a Business Owner Spouse Buys Out the Other Spouse’s Marital Interest Will Be a Good Fit in Many Situations.

General

Section 71 payments have provided a means by which one spouse buys out the other’s marital interest in a business with pretax dollars. But, with the 2017 Tax Act’s repeal of the alimony deduction, this method will no longer be available beginning in 2019.

However, use of a stock redemption can be a “tax-smart” way to structure the buy-out. To do so, the owner spouse transfers stock to the non-owner, and it is then immediately redeemed by the corporation. The difference between what the non-owner receives and the owner’s carryover tax basis in the stock is taxed favorably as a capital gain or loss. Stock redemptions can be particularly suitable in the following circumstances:

  • The company has excess liquidity.
  • The stock has a relatively high tax basis (which is not uncommon if the company is an S corporation).
  • The spouse who will not end up with the business individually owns stock.
  • The owner spouse may not draw more compensation because of “reasonable compensation” tax constraints or legal restrictions.
  • The dilution, if any, caused by the redemption will not be problematic for the owner spouse.

Other than in a divorce context, this approach would be treated by the IRS as a step transaction—the non-owner spouse’s stock ownership would be considered merely transitory and lacking independent legal significance, which would result in a constructive dividend to the owner spouse. However, this technique is available in a divorce setting because of an expansive IRS interpretation of IRC 1041 incorporated in regulations the IRS issued in 2001. Treas Reg 1.1041-2.

Regulations and Illustrations

The following example explains the essential provisions of the regulations by way of illustration:

  • H and W each own 50 percent of ABC Company. They agree that H will continue to own and operate the company while W will tender her stock for redemption.
  • H has at no time assumed a “primary and unconditional obligation” to acquire W’s stock.
  • He has agreed, however, (1) to cooperate in his role as a corporate officer and shareholder so that the company implements the planned redemption and (2) to guarantee the company’s payment of the redemption proceeds.
  • Because H does not have a “primary and unconditional obligation” to acquire W’s stock before ABC redeems it, the redemption is not a constructive distribution to him.
  • Thus, W will be taxed at the long-term capital gain rate on the difference between the redemption proceeds she receives and her tax basis in the stock.

In the above illustration, both spouses own stock in the company. It is more common, of course, for the interest in the company to be owned by only one of the spouses. The regulations do not directly address the situation involving (1) one spouse—say, H—owning 100 percent of the stock and (2) a divorce settlement providing for the following transactions:

  • H’s transfer of 50 percent of his stock to W
  • W’s tender of the stock to the company for redemption of her newly acquired stock interest

Though not specifically addressed in the regulations, it appears that the tax treatment for this fact pattern would be the same as that which applies when both spouses initially own stock as follows:

  • The form of the transactions—(1) the nontaxable transfer under IRC 1041 of stock from, in our example, H to W, followed by (2) the redemption of W’s stock taxable at capital gains rates—will be honored provided H does not have a primary and unconditional obligation to pay W for her interest in the stock.
  • Alternatively, if there is such a primary and unconditional obligation, the redemption distribution would be deemed constructively received by H and taxed to him as a dividend.

To illustrate, assume that H is the sole owner of the company and that, as part of his divorce settlement with W, they agree he will transfer a 50 percent interest to her which she will tender to ABC in exchange for redemption proceeds. Though not expressly covered in the regulations, this fact scenario would appear subject to the following tax treatment:

• Provided H does not have a preexisting primary and unconditional obligation to pay W for her marital interest in the stock, the form of the two-step transaction will be honored for tax purposes.
• In effect, the transfer of the 50 percent interest from H to W as part of the divorce settlement will be tax free under IRC 1041, and the redemption distribution.

A principal reason to assume the above tax treatment will apply when one spouse owns all the stock is the following statement in the background section of the regulations:

“By enacting the carryover basis rules in section 1041(b), Congress has, in essence, provided spouses with a mechanism for determining between themselves which one will pay tax upon the disposition of property outside the marital unit. For example, assume Spouse A owns appreciated property that he or she wishes to sell to a third party. The spouses may agree that Spouse A will sell the property to the third party and recognize the gain. Any subsequent transfer from Spouse A to Spouse B of the sales proceeds will be nontaxable under section 1041. In the alternative, the spouses may agree that Spouse A will first transfer the property to Spouse B. This transfer is nontaxable under section 1041, with Spouse B taking a carryover basis in the transferred property. Spouse B will then recognize the gain or loss on the sale of the property to the third party because a sale to a third party is not covered by section 1041. In this latter scenario, the tax consequences of the sale are shifted to Spouse B.”

 

66 Fed Reg 40,659 (2001).

Viability of Redemptions in Divorce

Certainty of Tax Treatment. Provided there is no such primary and unconditional obligation, the parties may structure a divorce-related redemption with certainty of the tax treatment. Nonetheless, because things change, including the minds of divorcing parties, a savings clause appears advisable.

Guarantee Allowed. With the IRS’s clear statement that a primary and unconditional obligation does not include a guarantee
of another party’s performance, there should be no concern to provide that the remaining shareholder guarantee the corporation’s performance under the redemption agreement.

This is highly significant because, without a guarantee, it is conceivable, particularly where the remaining spouse would transfer a minority interest to the other spouse, that the remaining spouse would use his or her influence to obstruct the redemption, leaving the other spouse with a minority interest in a closely held company.

More Useful Post 2017 Tax Act. Though rarely used in the past, the redemption approach to a buyout will be the best alternative in many situations from a tax standpoint beginning in 2019. That said, redemptions are a good fit presently in some divorce settlements.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Stock Redemptions”
View / Download October 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “October 2018 : Stock Redemptions”

May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2018 Article – PDF File

— Facts

  • During the parties’ 11 year marriage, H operated a successful business of which he was the sole corporate shareholder.
  • W was a stay-at-home mom tending to the parties’ two young children.
  • At the time of the divorce, W was earning $11,000 annually for part-time work at a charter school. She testified she was seeking a full-time job.
  • H drew $43,216 from the business in the most recent year.
  • During the pendency of proceedings, H paid W $500/month spousal support and paid all household/family bills pursuant to a status quo order.
  • H incurred substantial debt (1) to make the required support and status quo payments, (2) to pay his and W’s attorney fees, and (3) to pay business expenses. At the time of divorce, the business owed $108,000 including rent in arrears and tax deficiencies.
  • The trial court imputed $20,000 earnings to W and $40,000 to H.
  • The trial court awarded no spousal support to W because:
    • She had a Bachelor’s Degree in Fine Arts while H had just a high school education.
    • H had paid all family expenses during the pendency by incurring substantial business debt.
    • Since W benefitted from this, she was “partially responsible” for such debt.
    • Because H was assuming full responsibility to repay the debt, the trial court viewed this as a “favorable outcome” for W.

Court of Appeals (Court) Decision

  • The Court stated that the trial court failed to make a determination (1) “as to the origin of the debts” of H’s business and (2) “who was responsible for their creation.”
  • Further, the Court noted that W had little, if anything, to do with H’s business and, hence, likely had little, if anything, to do with incurring the debts.
  • The Court remanded the case for reconsideration of (1) W’s responsibility, if any, for the debts after thoroughly reviewing the origin of the debts and (2) the lack of a spousal support award to W.

Comments on the Case and on Treatment of Debts in Determining Money Available for Support

  • The Michigan Child Support Formula Manual (Manual) provides in Section 2.01(B):

    “The objective of determining income is to establish, as accurately as possible, how much money a parent should have available for support. All relevant aspects of a parent’s financial status are open to consideration when determining support.”
    (Emphasis added.)

  • Thus, if H in Bockart had to incur debts to pay family expenses, money used to make payments on the debts is simply not “available for support.”
  • If a business is required to pay on business loans incurred in the ordinary course of business, such as working capital loans or equipment purchase installment payment loans, then the money used to make payments is not available for support.
  • Such payments are not deductible in determining business net income and so must be separately identified when determining money available for support.
  • This is the flip side of adding back deductible depreciation (1) above straight line on personal property or (2) on real property – that is, converting net income to money available.
  • The Court’s focus on the “origin” of the debt seems misplaced. Whether W had any “responsibility” for creation of the debts should not be a deciding factor. Neither should whether the debts were incurred by H or by his company.
  • Rather, of significance is whether the funds from the debts were used for marital purposes. If so, they are debts of the marriage, however incurred.
  • This may not apply to debts to provide for payment of divorce attorney fees. Responsibility for such fees is generally separately considered in divorce settlements.

Concluding Comments

  • Like so many matters in divorce, determining money available for support is a case specific exercise.
  • This is particularly so if one party owns a business or professional practice – both (1) to ensure all items of “indirect” income (excessive perks, etc.) are identified and (2) that legitimate debt payments are excluded from money available for support.
  • Often balance sheets need to be reviewed in addition to income statements.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”
View / Download May 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”

January 2018 : Court of Appeals (1) Rules on Marital Property Status of Gift of a Vet Practice and (2) Rejects a Bright-Line Rule Re Excluding Personal Goodwill from Practice Value – Brusach No. 334550 (10/17/2017)

Posted by Joseph W. Cunningham, JD, CPA
Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Facts

  • W purchased a veterinarian practice from her father at a substantially discounted price. The discount was a gift from dad to daughter.
  • H assisted W in various capacities in maintaining the vet practice during the marriage.
  • The vet practice was valued by experts working on behalf of H and W, respectively.
  • The trial court selected a value within the two calculated by the two experts and found that the gift component of the value had lost its separate property character due to (1) H’s active involvement and (2) the commingling of practice income with the marital estate.
  • W objected to this finding and to the inclusion of her personal goodwill in the practice value.
  • In her appeal on the personal goodwill issue, she claimed personal goodwill should be excluded from the marital estate because:
    1. It is the equivalent of future earning ability, which is not marital; and,
    2. It results in double-dipping since future earnings are factored in to setting spousal support.

Court Of Appeals (COA/Court) Decision

  • In an unpublished opinion, the COA upheld the trial court decision.
  • Regarding the gift component of the practice value, the Court, on reviewing the record, stated that it could not conclude that “the trial court made a mistake in finding that the gift lost any characteristic of being separate property.”
  • It agreed that the gift portion of the practice had essentially been transformed to marital property during the marriage.
  • Regarding W’s personal goodwill claim, the COA cited the 2012 Loutts decision, 298 Mich App 21, in ruling that double-dipping issues are determined on a case by case basis and, accordingly, “there is no room for *** rigid and arbitrary formulas when determining *** spousal support.”
  • Further, the Court stated: “Accordingly, there is no brightline rule for whether the value of a business can be used in determining property distribution and awarding spousal support.”

Comments on the Case

  • Whether separate property is transformed into marital property is a “facts and circumstances” determination.
  • Commingling of income from the separate property with marital income, as occurred in this case, is one factor suggesting property has been converted to marital.
  • The Court has previously indicated that personal goodwill is includable in value for divorce purposes, stating: “We are unpersuaded of the need to adopt a distinction between personal and business goodwill for purposes of valuing business assets in the context of a divorce action.” Conger, Mich App No. 219373 (12/26/00).

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Court of Appeals (1) Rules on Marital Property Status of Gift of a Vet Practice and (2) Rejects a Bright-Line Rule Re Excluding Personal Goodwill from Practice Value – Brusach No. 334550 (10/17/2017)”
View / Download January 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “January 2018 : Court of Appeals (1) Rules on Marital Property Status of Gift of a Vet Practice and (2) Rejects a Bright-Line Rule Re Excluding Personal Goodwill from Practice Value – Brusach No. 334550 (10/17/2017)”

June / July 2017 : Expediting the Business/Professional Practice Valuation Process

Posted by Joseph W. Cunningham, JD, CPA
Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

When a business or professional practice is involved in a divorce, there is often considerable difficulty and expense in determining a settlement value acceptable to both parties. This frequently is a major impediment to reaching settlement.

The fees to value a business or professional practice – and time required – can be significant, especially if two – or three – valuation experts are involved.

The following presents two methods to facilitate resolution of the valuation issue on a cost-effective, expeditious basis.

Abbreviated valuation analysis for mediation and/or settlement negotiations is often effective at providing a reliable value without “going the whole 9 yards” on the valuation process.

Essentially the business valuation expert performs a sufficient level of analysis to enable him/her to provide a reliable estimate of value–or range of values–for settlement purposes. The expert will provide well-footnoted valuation schedules and a summary report if requested.

The expert will generally be available for mediation to explain the valuation analysis.

The expert could be a “neutral” working on behalf of both parties; or, each party may hire an expert to perform an abbreviated valuation analysis. If the case is not resolved at mediation, the expert(s) can perform a more comprehensive analysis and report letter for trial or arbitration – generally with no duplication of effort.

Not all businesses are suitable for this approach. Some have too much uncertainty about the future such that an in depth analysis is required. However, based on the author’s experience, the abbreviated valuation approach applies to the vast majority of companies and professional practices.

If effective, this approach saves time and fees. The cost is generally about half the fee for a comprehensive valuation analysis and report.

Use of a neutral appraiser working on behalf of both parties is often an effective method for resolving the valuation issue on an expeditious, cost-effective manner.

It is common for each party to retain a business valuation expert. But, it is not uncommon that the values calculated by such experts are meaningfully different. If they cannot resolve the disparity in values, often a third expert is engaged to opine on value–causing considerable delay and additional fees.

However, if the parties can agree on one business appraiser at the outset, they can avoid the possible “battle of experts”. They can also save time, fees and emotion. Experienced family law practitioners know and can usually agree on a business appraiser with a reputation for competence and integrity.

When using a neutral, it is often advisable to reserve the right to have his/her valuation analysis reviewed for reasonableness by another expert. This offers some protection against a valuation analysis performed erroneously by the neutral. But, to preserve the benefits of using a neutral, the review should be limited to a “reasonableness check,” not a full-blown valuation analysis.

Example

(see PDF below for example details)
……

Continued in PDF file below… “Expediting the Business/Professional Practice Valuation Process”
View / Download June 2017 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “June / July 2017 : Expediting the Business/Professional Practice Valuation Process”

May 2017 : Valuing a Small Minority Interest in a Large Personal Services Firm

Posted by Joseph W. Cunningham, JD, CPA
Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

In recent columns (October 2016 and March 2017), various aspects of using “value to the owner,” sometimes referred to as “Holder’s Interest” value, were presented.

Background

As noted in the October column, the Michigan Court of Appeals has ruled in a number of cases that if a business providing personal services is worth more to the owner than the price at which it could be sold, the value for divorce purposes is value to the owner, unless there is reason to believe the enterprise will be sold. Kowalesky v. Kowalesky, 148 Mich App 151; 384 NW2d 112 (1986), and several other Court of Appeals (COA) cases cited in the column.

As noted in the March column, the underlying logic is as follows:

If there is no intent to sell or discontinue a business or professional practice, it should be valued for divorce based on its intrinsic value to the owner on a going concern basis. The financial benefits from that value are what have been conferred on the family while intact and will be conferred solely on the owner post-divorce.

If there is no intent to sell, under what rationale should any value other than the value based on current financial benefits provided by the enterprise be used in a divorce settlement?

No other value is relevant to this family or, hence, to this divorce.

Application to Small Minority Interest in a Large Firm

There are many large law firms, accounting firms, engineering firms, medical practices, etc. operating in Michigan. How is the “value to the owner” determined for a member holding a minority interest in such an enterprise?

Binding “Buy/Sell” Agreements Generally Not Applicable

Most large personal service firms require individual members to sign binding agreements providing (1) restrictions on transfer and (2) a set price or formula to determine the price of a member’s interest on termination. Quite often such prices include no goodwill value.

It is well established that such agreements are not determinative of value for divorce because none of the events to which they apply–death, disability, or termination of interest for other reasons–are occurring.

Valuing Entire Firm and Applying Member’s Ownership Percentage Is Generally Not Representative of Value

For example, assume two partners—A and B—work at a large accounting rm. Both own 1% of the practice. But, A makes $500,000 annually while B makes $300,000. This disparity is due to different performance levels which may ultimately result in A being awarded a higher ownership interest than B, but currently they both own 1%.
……

Continued in PDF file below… “Valuing a Small Minority Interest in a Large Personal Services Firm”
View / Download May 2017 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “May 2017 : Valuing a Small Minority Interest in a Large Personal Services Firm”