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Small Business Capital to S Corp

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					small_business_and_divorce                                                                                                        11/02/2007 03:20 PM




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           Closely Held Coprporations

           For most small business owners, the business is their greatest, or only, source of income and also their largest asset.
           Closely held corporations are formed under either Subchapter S (an “S corp.”), or Subchapter C (a “C corp.”) of the
           IRS code (26 U.S.C. §1361(a) and (b)). The primary distinction is that an S corp. passes its income straight through
           to the shareholder’ 1040 and the shareholder is taxed on that income. A C corp., on the other hand, pays tax on its
           income and then may pay profits to the shareholders in the form of dividends. The marital character (marital or non-
           marital) of any business interest is determined as with any other asset: if acquired during the marriage, the shares
           are presumed to be marital but the presumption may be overcome by evidence that it is really, non-marital in
           character.

           When a divorce impacts a shareholding spouse, the three biggest issues to be resolved are: the business valuation,
           the treatment of any retained earnings, and the treatment of personal goodwill. Each of these concerns is discussed
           below.

           Valuation of Closely Held Business Interests: It has been said that the most factually and legally complex area
           of divorce law is business valuation.1 The field and the cases are all relatively new – stemming mostly from the
           advent of the personal computer which allowed business appraisers and expert witnesses to create ever more
           detailed spreadsheets and thereby value small businesses with ever greater detail and accuracy.

           Today, divorce courts have several methods by which to value the interest of a shareholding spouse. Using the
           wrong method can financially destroy a shareholding spouse and, where the business owning-spouse may have to
           borrow against business assets to buy out the non-owning spouse, may even present a death sentence to the
           business itself. Countless businesses have been destroyed by poor divorce planning and strategy. Consider one
           recent case 2 where an insurance agency was valued at $243,000 using a flawed valuation method. Not only was the
           valuation flawed in several ways, the court also considered the agency’s expected future earnings as part of a the
           valuation. On appeal, the the valuation was reduced – from $243,000 to a mere $32,000. The result after the appeal
           was a whopping a $211,000 savings; or roughly 87%.

           Finding The Right Expert Valuator: In any divorce case involving ownership of a closely held corporation (where
           the business has any value other than the services provided by the business owner) a qualified business appraiser
           should be brought in to value the corporation. Although ordinary CPAs possess many of the tools needed to conduct
           a business appraisal, they are NOT necessarily qualified business valuators. The American Institute for Certified Public
           Accountants (AICPA)3 requires a CPA to receive specialized training before being certified as an Accredited Business
           Valuator. An apprenticeship program (10 business valuations) must be completed, the CPA must pass an exam and
           must maintain annual, continuing professional educational requirements. In additional to the AICPA, our divorce
           lawyers have worked with business appraisers certified by the American Society of Appraisers, 4 the Institute for
           Business Appraisers, 5 and the National Association of Certified Appraisers. 6 If you need help finding a qualified,
           experienced business valuator, call our office to talk with an attorney who has the contacts to get the job done.

           Revenue Ruling 59 – 60: The IRS publishes “Revenue Rulings” to help valuators, tax lawyers, and divorce lawyers
           (among others) know the government’s position on how certain assets and liabilities should be treated for tax
           purposes. Rev. Rul. 59-60 is the granddaddy of Revenue Rulings for business valuations for three significant reasons.
           First, it defines “fair market value” for transactions involving assets like closely held businesses.7 Second, Rev. Rul.
           59-60 sets out 8 factors that should considered in any valuation of a closely held business.8 Third, Rev. Rul. 59-60
           addresses the impact of the loss of a “key person” on the valuation of a closely held. Illinois divorce cases address
           this concern in the comparison of “personal goodwill” versus “enterprise goodwill;” but the foundation for all such
           analyses is found in Rev. Rul 59-60. On this last point, Rev. Rul 59-60 says:

                    The loss of the manager of a so-called “one-man” business may have a depressing effect upon the
                    value of the stock of such business, particularly if there is a lack of trained personnel capable of
                    succeeding to the management of the enterprise. In valuing the stock of this type of business,
                    therefore, the effect of the loss of the manager on the future expectancy of the business, and the


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                    absence of management-succession potentialities are pertinent factors to be taken into consideration.
                    On the other hand, there may be factors which offset, in whole or in part, the loss of the manager’s
                    services. For instance, the nature of the business and of its assets may be such that they will not be
                    impaired by the loss of the manager. Furthermore, the loss may be adequately covered by life
                    insurance, or competent management might be employed on the basis of the consideration paid for the
                    former manager’s services. These, or other offsetting factors, if found to exist, should be carefully
                    weighed against the loss of the manager’s services in valuing the stock of the enterprise.

           Minority Interest vs. Controlling Interest: A good business valuation must account for any “minority discount” or
           “controlling premium.” Small businesses, with only a few shareholders, usually have a controlling shareholder and
           minority shareholders. Imagine a business where one partner owns 51% of the shares and the remaining 49% are
           equally divided between seven others. On paper, the majority shareholder’s interest is worth 51% of the business’s
           value and the minority shareholders each hold an interest worth 7% of the business’s value. In reality, the majority
           shareholder’s interest is worth much more than 51%: he determines policy, makes the decisions, determines
           compensation, he determines the fate of the business. Conversely, the value of the minority interests each probably
           are worth less than 7% of the business because (even if they banded together as a bloc) they have no control over
           the fate of the business. Because the majority shareholder wields such power, his shares may be valued with a
           “controlling premium” and the minority shares may be valued with a “minority discount.” The premium and discount
           reflect the added value (or loss) to shares that allow the shareholder to control (or limit the shareholder’s control of)
           the business. One court succinctly expressed the idea in a case involving a business valued at $250,000 with a
           controlling interest shareholder: “There are 51 shares . . . that are worth $250,000. There are 49 shares that are not
           worth a damn.” 9

           Another majority/minority problem presented by small, family-owned businesses usually have several shareholders
           spread over a few generations. It’s not unusual, for example, for a parent to hold a controlling interest (say, 52%)
           and a few members of the next generation to hold the balance (say, two brothers, each holding 24%). Often, as the
           parent ages and the brothers assume more of the business’s operations, one brother begins to assume more
           responsibility in the management and operation of the business and, quite naturally soon finds the parent acquiescing
           to his decisions. On paper, that brother owns only 24% of the business. In reality, that brother controls 76%. The
           question then arises: if that brother suffers a divorce, how is his interest in the business valued?

           Another problem arises when a husband and wife each hold shares in a family business. Illinois courts prefer to
           allocate all of the shares to only one spouse rather than have the spouses continue in the business relationship after
           the divorce. Imagine a three-person business where the husband and wife each hold 25% and a third party holds the
           remaining 50%. When the husband and wife divorce, should the court consider the separate values of the two 25%
           interests, or should it consider the value of a 50% interest (since either the husband or the wife will leave the
           divorce with both blocs)?

           Other Discounts and Premiums: In addition to the minority interest discount and the controlling interest premium,
           your business valuation may reference a number of other discounts or premiums, including: a marketability discount,
           a trapped capital gains discount, a voting vs. non-voting shares discount, a litigation risk discount, an environmental
           risk discount, a portfolio discount, and a key-person discount, among others. Be sure to work with an attorney who
           can coordinate with the business valuator to optimize your case presentation. Call our office to learn more.

           (Un)Reasonable Compensation: Controlling shareholders hold a significant benefit in privately held companies:
           they may set their own compensation. A divorcing spouse holding a controlling interest in a small business may want
           to try to use that benefit to advantage in the divorce. For example, a divorcing parent may want to reduce his or her
           compensation to show an inability to pay an otherwise reasonable amount in the way of maintenance (alimony) or
           child support. Conversely, a divorcing spouse may want to take too much in the way of compensation to deplete the
           business of funds, thereby decreasing the business’s value. A business appraiser will seek to normalize the
           compensation of a controlling shareholder by establishing a fair compensation and a reasonable return on capital. 10

           Valuation Approaches and Methods: There are three basic “approaches” to business valuations. The particular
           facts of the case will determine which approach is used by the business valuator.

           The “Market Approach” determines a business’s value by looking at various transactions involving the subject
           business or similar businesses. For example, the valuator may consider similar businesses that are publicly traded
           and for which financial data are available. The valuator may also be able to consider recent buy/sell transactions for
           similar privately-held businesses. Like “comparables” in real estate appraisals, recent buy/sell transactions for similar
           businesses offer one way to estimate a business’s value. Finally, under the Market Approach, a valuator may look to
           past stock transactions between shareholders within the subject business. This last issue comes up a lot in divorce
           cases and must be considered with great care and skepticism. A spouse seeing a divorce on the horizon may collude
           with another shareholder to transfer shares for safekeeping until the divorce is over. Such a transaction, however,


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small_business_and_divorce                                                                                                  11/02/2007 03:20 PM


           can only be effective if the stock is sold for far less than its actual value. The divorce lawyer and valuator must work
           closely together to thwart the attempted fraudulent transfer. In particularly egregious cases, the non-shareholding
           spouse may consider an action for money damagers against the conspiring spouse and the co-conspirators under the
           RICO law.

           The “Income Approach” – the most common business valuation approach used in divorce cases – looks to the
           business’s cash flow as the primary consideration in determining the business’s present value. The business valuator
           may look at the business’s income stream from either of two perspectives, or “methods.” The “capitalized return”
           method calculates the business’s value by looking at a specific period of normalized income. The valuator considers
           the company’s historical returns and, where a business has been operating smoothly, profitably, and predictably, the
           valuator will project that performance into the future to determine the business’s present value.

           Alternatively, the valuator may employ the “discounted income” (or discounted future cash flows) method and
           consider cash flow in several future time frames (the business must provide earnings projections) to determine the
           business’s present value. The valuator determines a “discount rate” by considering the risks that would be faced by
           an investor in the business. The greater the risk, the greater rate of return an investor would demand before
           investing in the business. The cash flow projections are divided by the determined discount rate. This function
           determines the present value of the “discounted cash flows.” Obviously, a little change in the discount rate (the
           denominator) can make a big difference in the final business value. Finally, the sum of the discounted cash flows is
           added to a “current value;” that is, the value of the business’s current cash flow assumed to run forever. The sum of
           the discounted cash flows and the current value defines the present value of the business.

           The “Asset Approach” looks at a business not as a whole, but rather as the sum of its parts. The asset approach
           ignores the cash-flow of the business and instead values each asset of the subject business and looks to the sum of
           the value of those assets, less its liabilities, to determine the overall value of the business. The reasoning is that a
           hypothetical investor could purchase similar assets of equal utility and, essentially, supplant the subject business.

           Nearly all businesses, however, are valuable to their investors for their cash-flow, not for the assets they hold. For
           this reason, the “asset approach” – which ignores cash-flow – is flawed for most applications. It may be of some
           utility when valuing those few businesses with substantial assets but little or no cash-flow: holding companies, real
           estate partnerships, start-up businesses, etc.

           Treatment of Specific Business Assets: A good valuation will properly treat accounts receivable (they should be
           considered an asset and properly discounted) and outstanding contingency fees (they are not to be considered assets
           as they are too speculative), cash on hand (asset), cash surrender value of life insurance (asset) and loans due from
           officers. 11

           Work with one of our attorneys to help ensure the best outcome for your business.

           Intangible assets: There are several ways to measure intangible assets. Illinois courts have done a very good job
           in laying out valuation methods for many intangibles. Where there appears to be no appropriate method, divorce
           lawyers and business appraisers fall back on the “formula” method. Originally defined in 1920 by the Treasury
           Department (to determine the declines in value suffered by breweries due to Prohibition), the “formula” method was
           adopted by the IRS in 1968 in Revenue Ruling 68-609. The formula method treats valuation of intangible assets in a
           rather ham-fisted way. For that reason, Rev. Rul. 68-609 specifically warns “ . . . the “formula” approach may be
           used for determining the fair market value of intangible assets of a business only if there is no better basis therefore
           available..”

           S Corp. Retained Earnings: Profits of an S corp. may be passed on to the shareholders, or may be retained by the
           business as an asset, called “retained earnings.” Each shareholder has an interest in any retained earnings. For
           shares characterized as “marital,” the treatment of retained earnings is easy: the shareholding spouse must
           compensate the non-shareholding spouse for his or her portion as allocated by the court or settlement agreement. In
           a case where marital property is divided 50/50, for example, the shareholding spouse must compensate the non-
           shareholding spouse for 50% of the shareholder’s interest in the retained earnings.

           Things get complicated, however, for shares characterized as “non-marital” property. The problems arises from the
           Illinois divorce law that says that when a spouse contributes personal effort to non-marital property, the marriage
           has a right to be reimbursed for the spouse’s effort.12 For example, consider a marriage where one spouse owns
           non-marital shares in a closely-held business. During the marriage, the spouse is compensated for the work
           performed at the business. The effort expended is a kind of marital asset. The compensation for the effort is,
           likewise, a marital asset. Another product resulting from the effort, however, may be an increase in the business’s
           retained earnings. Those retained earnings can increase the value of the spouse’s shares, or may be passed on
           directly to the spouse.



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           Does the marriage have a claim to a portion (or all) of the in increase in value of the non-marital shares? Does the
           marriage have a claim to a portion (or all) of the retained earnings – even though the marriage owns no shares in
           the company and the only connection is through the spouse’s non-marital shares?

           The retained earnings themselves may not be divided between the spouses. They are non-marital property and
           belong solely to the shareholding spouse. The effort that went in to producing those retained earnings, however, may
           trigger the kind of analysis above, and may require the shareholding spouse to reimburse the marriage for the effort
           that resulted in the retained earnings. Illinois law provides a test to determine when a reimbursement will be
           required and when the shareholding spouse’s other compensation is deemed sufficient compensation for the effort
           given.13

           Goodwill: Enterprise, Personal, and Professional Practice: A spouse's interest in a business that is acquired
           after the marriage is, of course, presumed to be marital property. The "goodwill" of a business is, essentially, its
           good reputation. When you need a pen you can count on, you probably think "Bic." Thinking of renting a car? Hertz
           probably comes to mind. If it "absolutely, positively, has to be there overnight," you probably think of Federal
           Express. Those are examples of "enterprise goodwill."

           When a business is known primarily for the person or persons behind it, however, that is referred to as the
           individual's "personal goodwill" – sometimes called "professional goodwill." Medical practices, car dealerships,
           law practices, and finer restaurants with a particular chef, are all good examples. The difference between a business'
           value when a person is – and is not – affiliated with a company is the "personal goodwill" brought to the organization
           by that individual.

           When a marriage is dissolved the value of a marital business (or the marital portion of a business interest) or
           professional practice must be considered. Enterprise goodwill usually is considered when dividing assets, and
           personal goodwill usually is considered when awarding maintenance.14 Generally speaking, enterprise goodwill is part
           of the value of a business – that’s an asset and should be divided in the property settlement or by the court at
           trial. 15 Personal goodwill on the other hand, is more often thought of as inhering to the individual – creating a
           continuing stream of income – and should be considered as either part of the value of the business (for property
           division purposes) or as part of the individual future income-earning ability (a factor in determining maintenance
           awards) but not both. 16 The trick for Illinois divorce lawyers is to distinguish between the two so as to prevent
           double-dipping. Double-dipping can occur even where there has been a waiver of maintenance.17 When it comes to
           divorce and professional practices or closely-held family businesses, be careful and work closely with your attorney.
           Knowledgeable lawyers may be able to keep "personal goodwill" out of the picture altogether, or may employ certain
           strategies involving maintenance to keep a spouse's personal goodwill in the marital estate and require the
           professional spouse to, essentially, buy back the right to his own name.18 You will need to work with a
           knowledgeable attorney and a reputable expert to value both the personal goodwill of the individual and the
           enterprise goodwill or the business. Special rules of evidence must be reckoned with to ensure the court will consider
           all proper evidence and expert testimony.19




           This article was written by the law office of Cowell Taradash, P.C., whose attorneys are familiar with the latest court decisions,
           recent changes in the law and even the tendencies of many judges. We can help. Contact us at 866.987.6723 or
           info@illinoisdivorce.com.




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