Who says there’s no goodwill in a divorce?
Intangibles often play a key role in marital assets

Determining equitable distributions of marital assets in a divorce can be challenging — especially when the estate includes an interest in a privately held business. Business appraisals require subjective interpretations, and there is little consensus from state to state regarding which company assets to include in the marital estate.

Plying the murky waters - When a spouse owns his or her own business, it often represents a significant portion of the marital estate. Each side has a vested interest in maximizing its share of the company’s value. When business values are based on hard assets — such as cash, securities, real estate or equipment — the value is fairly clear-cut. Thus, the parties are less likely to disagree.

When a company’s value resides in intangible assets, however, the waters become murkier. Intangible value can be difficult to quantify and categorize. Moreover, depending on a case’s venue and proposed support payments, assets might be counted twice, leading to inequitable allocations.

This practice, known as “double dipping,” occurs when a nonmonied spouse is credited for the monied spouse’s contribution to a business twice: once in the form of support payments and again with half of the company’s intangible value (or goodwill).

Understanding the terminology - In a divorce context, the term “goodwill” is a catchall phrase that refers to all intangible value. Valuators customarily quantify goodwill as the difference between the fair market value of a business and its net tangible value.

Although many states are undecided on how to handle goodwill, approximately half recognize the double-dipping argument by excluding personal goodwill (intangible value attributable specifically to the business owner) from the marital estate. In lieu of divvying up personal goodwill, courts in these states allocate the value of the monied spouse’s personal efforts via support payments, which are based on the owner’s salary, bonuses, business perks, dividends and distributions.

But the appropriate treatment of intangible assets varies substantially across state borders. Some states exclude all goodwill from the marital estate. Others include the company’s entire value in the marital estate, regardless of maintenance payments.

Family courts sometimes transcend state boundaries when deciding on the appropriate treatment of goodwill and other intangibles. The inconsistent, unpredictable treatment of intangible value requires attorneys and appraisers to understand how other jurisdictions deal with goodwill and discuss the appropriate course of action before jumping head first into the valuation assignment or settlement talks.

Identifying the likely candidates - Professional practices, startups, technology firms and single-owner businesses tend to rely more on intangibles than manufacturers or retailers. Balance sheets seldom identify intangible assets. When goodwill and other intangibles do show up, their values may be understated.

A formal business appraisal is the most accurate way to quantify a company’s intangible value. In most jurisdictions, divorce cases require valuators to go beyond simply appraising the business. They must also bifurcate goodwill into two components: business and professional goodwill.

Determining reasonable compensation - To accurately value the company or award fair support payments, the owner’s compensation must also be reasonable. And though valuations and equitable support payments generally assume the monied spouse’s compensation is reasonable, some monied spouses cut back their salaries or hide business perks in anticipation of an impending divorce. By understating personal income, they hope to lower alimony and child support payments.

On the other hand, some owners overpay themselves to avoid the double taxation of C corporation dividends or because they overestimate the cost of finding a replacement. If a monied spouse’s compensation is too high, the company’s income stream will be understated and, if unadjusted, the business will be undervalued.

Of course, what’s fair or reasonable is in the eye of the beholder. Few business owners would admit under oath that their compensation was unreasonable. A less emotionally charged way of broaching the subject is to call it “replacement” compensation, which is the amount it would cost to find an unrelated party to perform the owner’s current duties. Doing so is also less likely to raise a red flag with the IRS.

Recognizing the difference - At face value, the difference between business values and support payments may seem like a wash. But the mechanics behind these calculations can have unexpected valuation outcomes and tax consequences.

To ensure an equitable split, the valuator needs to estimate reasonable (or replacement) compensation and adjust the company’s income stream and the owner’s salary accordingly.

Sidebar: Owner compensation: More than just a salary

A business owner’s compensation includes more than just his or her salary. When quantifying how much the owner truly takes away from the company, a valuator typically includes bonuses, benefits and quasi-business expenses — such as lavish automobiles, country club dues or travel expenses. He or she also adjusts for payroll tax and income tax deductions.

In addition to considering the monied spouse’s compensation, the appraiser looks at salaries paid to other related parties. Sometimes, the business owner may drain the company’s cash flow by overcompensating salaried relatives or others.