Valuing Professional Practices in Divorce

Custody, parenting, child support and property and debt division issues are typical in a divorce. However, dentists, doctors, accountants, architects, lawyers and other professionals with independent practices – and their spouses – often encounter additional complexities as they value and sometimes divide their business and professional assets. The methods used to value a professional practice are complex and, as a result, most professionals (and sometimes, their spouses) hire expert business valuators (usually, business appraisers, accountants or business brokers). This article outlines the most common issues that arise during the valuation process and how they can affect a divorce settlement.

Community Property

The first step in valuing a practice for purposes of a divorce is establishing whether the business is considered community property and, thus, is divisible under Washington State law. Washington is one of fourteen community property states. In Washington, property acquired during a marriage is presumed to be community property. Whether an asset is considered community property or property of only one party depends upon the date of its purchase or acquisition. That status can only be changed by agreement or by operation of law. The community property presumption can only be overcome with clear and convincing proof that the transaction through which the property was acquired falls within the definition of separate property. A party asserting the separate character in an asset must be able to trace “with some degree of particularity” the separate source of the funds or the separate properties used to purchase or acquire the asset.

To make matters more complex, a professional practice may encompass competing principles of community property. For instance, if a professional practice were established prior to the marriage, it would be considered separate property. But, how should it be handled if the practice grows during the marriage, increasing the value substantially? Case law has established rules on balancing these competing interests, but each case must be evaluated based upon its own unique circumstances.

(For purposes of this article, assume the professional practices were started or acquired during the marriage, making them community property.)

Apportioning Property

The standard used by the courts to divide community property is “a just and equitable” standard. Usually in the case of a closely held business or professional practice, the business is not divided between the spouses. Instead, one spouse keeps the business and the other receives different assets of equal value or a cash transfer payment equivalent to their interest in the business.

In many divorce cases, the business can be the most complex and valuable asset of the marital estate, so valuing the business is critical to the divorce settlement. The parties can agree to conduct a joint business valuation or each can retain their own business valuator.

Valuing a Professional Practice

In a typical business valuation, the professional will be asked for an extensive list of financial information, including financial statements, balance sheets, federal income tax returns, aged accounts receivable reports, accounts payable reports, a fixed-asset registry, lists of items comprising significant other asset balances and accrued liabilities reports. For dental or medical practices, existing and new patient count reports, practice demographic reports, capital equipment lists (which include a fixed asset registry) and previous practice appraisals are also needed to value a practice.

Goodwill

Unlike some states, Washington includes “goodwill” when valuing a business. Goodwill is the expectation of continued public patronage and is considered an intangible asset. It can exist for a number of reasons including the location of the business, the amount of patronage, the personalities and skill level of the parties engaged in the business, how long the business has been in operation, and the likelihood of repeat business. Profitability of the business is an important factor in determining goodwill. Goodwill does not exist in every business. When considering an asset division, the court must determine first whether goodwill exists and then determine the reasonable value of the goodwill.

Goodwill should not be confused with the earning capacity of a spouse. A salaried professional such as an associate in a practice with no ownership interest in a business has earning capacity, but no goodwill.

Goodwill can exist in the business or in the person that owns the business. An example of goodwill in a business would be a franchised business with notoriety, such as Starbucks or McDonalds. The personality of the owner does not make the business profitable. An example of goodwill in the owner of a business would be a dental practice. The dentist’s personality and skill determines the success of the business.

To determine the value of a professional’s goodwill, the court will take into account a person’s age, health, demonstrated earning power, reputation in the community as to judgment, skill, knowledge and comparative professional success. These factors are known as the Fleege factors because they were first set forth In re the Marriage of Fleege in 1979.

Next, the court must determine the reasonable value of goodwill. There are different recognized methods of evaluating goodwill which supplement the Fleege factors which include:

1. The Straight Capitalization Accounting Method
2. The Capitalization of Excess Earnings Method
3. The IRS Capitalization of Excess Earnings Method
4. The Market Value Method
5. The Buy/Sell Agreement Method

The court may use one or a combination of these methods to determine the value. The court has full discretion as to which method to use.

Several months may pass from the beginning of a business valuation until its completion. The valuation often begins the process of negotiation during a divorce. For many, it creates momentum because the parties have a sum certain value to one of the most important assets in the marital estate. In making a “just and equitable” division of the property the court’s decision may result in a 50/50 division of the assets, but this is not always the case.

Professional Degrees & Licenses

In some cases, allocating a disproportionate share of the assets to one spouse is justified. For example, a professional license or degree obtained during a marriage is not considered community property. However, the spouse who contributed to the acquisition of the degree may be entitled to compensation in the form of spousal maintenance and/or a disproportionate share of the assets. The theory behind compensation is to replace the benefit of the professional degree or license lost as a result of the divorce (based on the assumption that the non-professional or lower earning spouse will be “left behind”). Generally, courts give more weight to the non-professional spouse when he or she has made significant contributions that have helped the other obtain the degree or license. The perception is that the non-professional or lower earning spouse will be “left behind,” or otherwise that failure to compensate for the value provided by the non-professional spouse would be unjust and inequitable. It is in the court’s discretion to permit compensation.

When determining the allocation, the court will also take into account:

1. the amount of community funds spent on educational costs
2. the amount which the community would have earned had the efforts of the student spouse not been directed toward studies
3. any educational or career opportunities which the supporting spouse forewent to assist the student spouse obtain their education or to move to the location of the school
4. the future earning prospects of each spouse

Every case is considered based upon its own unique circumstances. This same theory applies in other situations in which the full value of a community interest has not or may not have been realized until after the divorce. This includes real estate licenses or broker’s licenses.

Conclusion

A professional practice is a unique creature in a divorce matter. Not only is it the most valuable asset in a many marital estates, but its value can be highly dependent on one spouse’s own personality, skill and reputation. A spouse has an interest in the professional spouse’s goodwill. Keep in mind that obtaining the necessary information needed for a business valuation is not always easy, especially for the non-professional spouse who may have had little to do with the professional practice. If you are considering divorce, consult an attorney early on so that you can put safeguards in place to prevent one spouse from transferring, concealing or wasting valuable documents or assets. The attorneys at McKinley Irvin have represented many clients whose cases involved the valuation and distribution of businesses and professional practices.