F I T T – October, 2014

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F I T T – October, 2014 Edition

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Forensic Forum

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FORENSIC FORUM

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F I T T – September 2014 Edition

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Marital Momentum

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“When a girl marries she exchanges the attentions of many men for the inattention of one.” – Helen Rowland

This is an underappreciated and underused angle to consider in a divorce litigation, though it has generally limited applications and, like so many other interesting ideas, needs the right case, the right financial magnitude, to justify pursuing. The concept is that on or around the time of the filing of the complaint for divorce, the business (or the earnings power of one or both of the litigants) reached a critical mass, kind of a precipice, where from this point forward it can be expected to increase dramatically, perhaps far out of proportion to what might otherwise be considered normal. That is, the marital partnership has devoted years of effort to building up something, whether that be a business or a career, and the fruits of those years of labor are now (now being defined as the filing of the divorce complaint) about to be realized. Would this not warrant some additional consideration, some additional value, payment or some other financial compensation to the spouse who will no longer share in the rewards to which they worked, in effect an investment in deferred benefits that are now coming in to pay status.

Using a career, an employee situation, as an example, let us assume we are dealing with a corporate executive type, who has worked her way up through the ranks, and is currently earning $200,000 per year. The marital lifestyle, the build-up of savings and everything else that goes along with that level of income, is consistent with same, and in a divorce context, alimony and the equitable distribution aspects can be expected to fall into place in accordance with normal procedures. However, this is not normal – this corporate executive is on the verge of being recognized, has developed a skill set that will either get her a great promotion, increase in pay, and the next stepping stone onto corporate executive stardom, or position that person to be able to jump ship for a major increase in pay, options, benefits, etc. None of these potentialities has happened, and none could have contributed to the marital lifestyle, or to a build-up in assets.

Is it fair to turn off the spigot at the DOC – or should the stay-at-home spouse be allowed to share in what the two of them were working towards all those years? Can it be seriously posited that this executive’s upcoming move with all the financial rewards that it entails just happened within the last few months or year or so? Or is it more likely that this quantum increase in financial power was the result of years of effort? If so, and if the concept of a marital partnership is relevant, wouldn’t those years of effort mean that the marital estate has a vested interest in what is about to happen? Whether the spouse would be rewarded by escalating alimony as the years go by, by some share of a dramatically increasing pension benefit, or other forms of savings – whatever and however, wouldn’t that be appropriate, wouldn’t that be equitable?

The issue is perhaps a bit more complex when it involves a business. The basic concept is the same. However when valuing the business, in theory the valuation expert took into account the potential for the business at that point (at any point) to grow, to be more valuable. Nevertheless, at least two issues arise. For one, most valuation experts would be extremely reticent to make assumptions of the magnitude of growth and increase in value that are under consideration here. The odds are that the valuation done as of the DOC, based on history and reasonable expectations of the future, will not take into account the extent of the increase that is being hypothesized here. As a result, the expert may conclude with a dramatically lower value than a valuation would conclude were it done one or two years later.

The second issue with a business, even if the valuation issue were fairly addressed, is what the increase in income will mean to the standard of living, including a build-up of savings. Not only will the business itself increase in value, but the compensation received, the pension benefit, the personal savings, and all the other accoutrements of a higher income will, in the traditional approach, inure only to the business spouse, none of it to the soon-to-be ex-spouse. Again, taking into account the premise expressed earlier in this chapter, is that fair?

One possible approach, at least in part to some of these issues, would be the determination of enhanced earnings, and a calculation as to the present value of same. In effect, this is treating enhanced earnings as a form of asset that can be valued. By way of illustration, assume that the executive spouse can anticipate an increased income stream in the magnitude of $200,000 per year above and beyond what has already been realized, that $200,000 being above and beyond what would reasonably be expected were it not for this martial momentum concept. Further assume that enhanced level of income can be expected to continue for the remainder of that person’s business/working life.

Thus, wouldn’t it be in some way fair to calculate what that enhanced earnings means on a present value basis, then possibly tax effect same, and award the other spouse an equitable share of that future income? By way of an oversimplified example, this executive spouse is expected to work another 20 years, with this $200,000 bump-up in income – an extra 4 million dollars. Do we present value same? On one hand, it seems like an obvious need; on the other hand, it may be that there is no need for a present value, because it can be expected that the $200,000 of income being considered itself will be adjusted by at least the rate of inflation, probably more, a contra (offset) to the present value discount.

Let’s go now to the next step – we have determined there’s a 4 million dollar asset, and the spouse is entitled to a fair share. For discussion purposes, let’s assume that a fair share here is less than what might otherwise be an equitable distribution percentage, say 20% – which equals $800,000. Putting aside whether or not this should be tax effected, it is probably a certainty that the marital estate that exists currently doesn’t have that extent of additional funds to carve out to the non-business spouse. It would require some form of a future payout. Besides the inherent difficulty in getting this concept across to the spouse who will be paying it, you can readily see how – despite some possibly clear issues as to equity – this broad concept is fraught with complexities.

Human Capital

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“Do not be fooled into believing that because a man is rich he is necessarily smart. There is ample proof to the contrary.” – Julius Rosenwald

 

The concept here is the anticipated post-marital disparate economic relative positions between the now former spouses – and to what extent, if any, should that be taken into account in the divorce process, whether through alimony, equitable distribution or both. For ease of illustration, we will assume the stereotypical situation of the husband being the major breadwinner/business owner, and the wife the classic “dependant” (even if only semi-dependent) spouse. Deepest apologies to all of our female readers – feel free to reverse the spousal identifications.

At least in theory, the financial results of a divorce are supposed to put the wife (often with the children) on some roughly equivalent financial footing, both as to income and assets, as the husband. As to income, that means that the alimony the husband is paying to the wife (along with the child support) – and typically also with what the wife will be earning in the job market, or is imputed to earn – will make them, if not equal, at least relatively close, or in some way that is considered equitable. A problem with this concept is that the marriage was an economic partnership, with each spouse contributing to that partnership in some roughly equivalent fashion (the husband with money from the outside world, the wife with household and child rearing services, and possibly also some level of outside employment). As a result, the marital unit grew and prospered. Each party – though generally this is much more so as to the wife – sacrificed something in terms of future employability, employment rewards and the like, by working for that marital partnership within the context of what was agreed to (whether that agreement was implicit, explicit, or just generally assumed through the traditional gender roles).

However, after a 20 year marriage, where the husband has established himself in the corporate world or in some similar fashion, and the wife has not, no matter what one does through alimony, outside employment, rehabilitative alimony, etc., the wife will never achieve the level of financial success that the husband has. Further, she will likely continue to have – and this is perhaps key to this concept – a relative disparity which will not only continue (which is not necessarily bad economically because the alimony in theory compensates for that), but will actually widen. This is so because in general that is the way careers go. But it is also because if we assume some ongoing percentage increase in income, the husband, having a larger base to start with, will get, even with the same percentage increases, a greater dollar increase than will the wife.

To compound the matter, this directly translates to discretionary income. It is far more likely that the husband will have more money than he needs to live on (discretionary income) than will the wife. Thus, growing the overall income by greater dollars (even if by the same percentage) will give the husband proportionately more discretionary income, more savings, more comfort level, etc. than will have the wife. Compounding same, the alimony typically is at a fixed amount. Therefore, the wife will only see an increase on the portion of her income generated by outside employment – leaving what can be a relative substantial base (the alimony) fixed, without growth.

In a similar sense, is the matter of the pension element of equitable distribution. Of course, not every case is blessed with a retirement benefit to be allocated between the spouses, and some of them are very modest IRA or other type of retirement plan accounts where the employment, per se, will not make a difference as to the rate by which they will increase. However, for some people, especially those who are with a company having a defined benefit type retirement plan, the likely future rate of increase will be far greater than what the wife, now employed, will be able to experience, assuming she will experience any kind of retirement benefit.   The husband, having already established his career and with a solid employment base, has a much greater chance of not only general raises and inflationary adjustments, but more substantial merit type raises – which will in turn provide greater increases and retirement plan benefits, in greater dollar amounts, and in greater percentages than the wife could possibly hope to experience. Thus, even after allowing for a QDRO’d allocation of pension benefits, and even assuming equivalent investing, the husband will in all likelihood experience a (maybe significantly) greater increase in retirement plan benefits.

Now that we know there is a future disparity in the offing (go along with me on this one – it is the premise for this article), the next issue is how to address same, if at all.   Addressing it can mean very different things to different people. From an income perspective, one suggestion might be a disproportionate alimony carve-out – whether for a short limited term, a longer limited term, or perhaps an indefinite term. It might even mean continuing same past a point of remarriage, or past a retirement of the husband. Perhaps doing a standard alimony determination based on the husband’s current income situation, but providing for a carving-out of future increases. Obviously, none of this is going to sit well with the husband – but the concept here is to consider the economic realities of the future.   In a similar sense as to the future retirement plan benefits.   Should consideration be given to some carve-out of future pension increases. Perhaps, a future revisit to the QDRO situation – providing the wife with a supplemental QDRO of sorts some years down the road.

Of course, there are those who do not accept this concept of a marital investment in the human capital, and that the divorce creates a loss of the sharing of the investment in each other that each made. If both walked away completely equal (which is not normally the case), then likely this would not be a problem. Certainly, none of this is easy – the concept itself will rankle many. Besides, there is the practical issue of the economics, and the difficulty in even considering carving-out greater alimony than would normally be the case, disproportionate sharing of assets currently, a revisit in the future. All of these would typically be distasteful to the husband, and in many cases keeping this type of connection would also be distasteful to the wife.

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Double Dip

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“Whatever their other contributions to our society, lawyers could be an important source of protein.” – Guindon cartoon caption

A particularly sensitive issue with attorneys (we all know that law practices are not worth anything), is the concern over a possible double dip. This is a practical matter in addressing the interconnected issues of alimony and equitable distribution of the business value. The essential concern that creates the double dip is that in the classic approach to business valuation, the valuation expert determines what is reasonable compensation (for simplicity we’ll call that the compensation necessary to go out in the open market and hire somebody to replace the business owner in a truly arm’s length arrangement) in order to determine the economic income of the business. The economic income, typically through a capitalization of income approach, is used to determine value.

The income actually taken out of a business often exceeds the determined reasonable compensation. By one line of thinking, that means the lifestyle enjoyed by the family was made possible by some (or even all) of the same economic income of the business that is being used to determine its value. Thus, this spread (the excess of what was actually taken as income as contrasted with the reasonable compensation), is being used both to establish a lifestyle and therefore support, and as part of the calculation that determines value, from which the non-business spouse will be receiving his/her share in equitable distribution. Thus the double dip conundrum.

One of the arguments that a double dip does exist is that it is overtly obvious from an economic point of view, based on the scenario described above, that part of the income generated by the business is being used both for support and valuation purposes. This would not be the case if the business were being sold at arm’s length, because the buyer in a commercial transaction would not have the responsibility to also pay support payments to the seller. Based on the preceding, is there in fact a double dip, and even if there is, is it a problem? There are a number of responses/counters to the concern of a double dip.

  •  The double dip referenced above was “created” because the illustration of the value included a determination of reasonable compensation. Every financial expert knows it is possible (sometimes) to value a business without determining its economic income, without determining reasonable compensation. We might use total net income before compensation to the owners as the benchmark, or perhaps the sales or the top line is the benchmark, with no need to go through a determination of economic income. In that case, no foundation would be evident for assuming a double dip.
  •  The argument in favor of the double dip would probably be stronger if we were looking at a 50% allocation of the value of the business to the non-business spouse. The non-business spouse (typically the wife) rarely gets 50% of the value of the business. Commonly, we see something in the range of 30 to 40%. Arguably, a percentage that low takes into account a number of factors – such as an assumption of a built-in tax (which sometimes does and sometimes does not exist), perhaps the double dip, perhaps a built-in bias in favor of the business owner, perhaps a recognition that the business owner will continue with the business which carries a much higher degree of risk than the cash buy-out that is likely going to the non-business spouse.
  •  Studies have been done showing that the aftermath of divorce tends to leave the major earner/breadwinning spouse (typically the husband) in a considerably better financial position as the years go by than the “dependent” spouse (as we know, usually the wife – often with the children). Assuming that these studies extend beyond merely the W-2 earner to include business owners, even if you were to successfully argue the concept of a double dip, where is the financial harm in that double dip; as contrasted to what would certainly be the more likely financial harm if that double dip were given the financial respect its advocates posit.

The preceding notwithstanding, let us assume that the issue of a double dip gets a favorable reception, and thus it has been agreed it needs to be compensated for in some financial manner. There are several ways to do this, all having shortcomings. For instance:

  •  You simply cut back on the percentage of the business allocated to the dependent spouse. In that fashion, an economic trade-off has been made, taking away some part of an asset (through the equitable distribution process) in compensation for the double dip. Referencing a comment made above, perhaps that wouldn’t be terribly unreasonable if we were starting with a 50% carve-out factor. Since typically we see property distribution shares on a business in the 30 to 40% range, this alternative might reduce the carve-out to the 20 to 30% range. At what point do we start having a social policy problem – how unfair is this to the dependent spouse? Further, not that this is etched in stone, but often what is unfair to the dependent spouse invariably becomes, intentionally or not, unfair to the children. The logic for this trade-off is clearly that the alimony is at such a level that there is a double dip, therefore a rationale for “balancing” the economics by taking something away from the equitable distribution. What happens when that former spouse remarries, and the alimony stops? That spouse now has not only lost the income flow of the alimony, but never got his/her “fair share” of the equitable distribution. The concern over the double dip has proven to be ephemeral.
  •  An alternative is to compensate for the double dip by taking it out against the alimony. Instead of giving the dependent spouse a smaller share of the business, simply pay less alimony. It is not too difficult to figure out this approach comes with its own set of problems, including potentially pauperizing the former spouse (and, need it be said again, that also typically negatively impacts the children), and creating another form of a social policy problem.
  •  Another possible approach may be to do some kind of a blend, under the concept that, as an example (and this won’t work all the time), if the business were capitalized at a 20% cap rate, the inherent economic assumption is a 5 multiple – 5 years of income of that business constitutes value. In this simplistic sense, perhaps the alimony will be reduced for only 5 years, representing that time frame for which one might argue the double dip existed. Or, perhaps the business owner gets 5 years free ride of no payments for the buy-out of the share of the business (or some economic equivalent). These approaches present their own problems, including insufficient funds to the dependent spouse for reasonable support, forcing the dependent spouse to wait years to receive his/her fair share of the business, the risk of that business in some way being sold, destroyed, whatever, and that money not being there…

Even if you believe there is an economic double dip, when all factors are taken into account, does it matter, does it truly present a financial burden to the business owner? Does the system as it is currently constructed implicitly take all of that into account (i.e. by the typically less than 50% share to the dependent spouse and by the typically less than 50% share of the family income that goes to the dependent spouse), and thus therefore, is there really no problem or, as it has been phrased, is it a “permissible” double dip?

 

F I T T – Financial Information & Tax Tips – August, 2014

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F I T T – August 2014 Edition

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Build-Up of Retained Earnings as Marital Savings

 

“Money frees you from doing things you dislike. Since I dislike nearly everything, money is handy.” – Groucho Marx

 

Sometimes a business, over the years, builds up a very substantial investment or cash position, far and away above what is needed for operations. If so, that might be a situation where there has been a build-up in retained earnings (that is an increase in equity), meaning that the company retained a (substantial?) portion of its income above and beyond what would appear to be its operating needs, rather than distributing it to the owners in the form of increased compensation or dividend distributions. Depending on various factors, that may mean there were disguised marital savings. The company kept it rather than giving it directly to the marital estate.

While a first blush reaction might be to the effect of “so what?”, when we recognize that marital savings is considered a component of lifestyle, you can see where “hiding” some of that lifestyle by not giving the family unit a chance to spend it, might effectively distort that family’s lifestyle. In addition, as a practical matter, since the non-business spouse generally gets less than 50% of the business, but generally 50% of the family savings, this is not only a lifestyle (and therefore support) issue, but also one that might have a significant bearing on equitable distribution.

Before assuming that every build-up in retained earnings/equity is a proxy for marital savings, recognize that this is generally a subjective area, and there can be solid business explanations for a build-up. Among the concerns we need to address before we can conclude a build-up was marital savings, are:

  •  Liquidity – a build-up in equity is not necessarily synonymous with a build-up in cash or investments. This argument generally doesn’t go very far when the build-up is not in liquid form, but rather for instance invested in plant and equipment;
  •  Ownership interest – this is kind of an easy one if the interest at issue is a 100% ownership interest, or at least greater than 50%. However, if it were a 10% interest, the argument would likely be much weaker. It is unlikely 10% had the ability to dictate whether the company was going to retain those earnings and when and if it was going to distribute them;
  •  Size of the company – as a general comment, a small company tends not to need much in terms of a build-up of funds; whereas a medium or large company may have need for same;
  •  History – not that this is determinative, but it might be relevant if the company has a history of distributing (whether by compensation or dividends) substantially all of its income and then changes that in the last few years;
  •  Growth – in general, all other things being equal, a growing company has a greater need to retain income to fuel that growth, than does a stagnant or shrinking company.

Kind of as a bonus, if the financial expert can make the case for such a build-up, that there is excess liquidity, non-operational assets, then in the typical income or even market driven approach to value, there will likely be additional value. Thus, not only is there a bump up in the martial standard of living, but also something extra on the value end, and an argument for a better carve-out for the non-business spouse.

F I T T – Financial Information & Tax Tips – July 2014

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Click on the link below for this month’s discussion – Tax Indemnification Agreements and Gifting.  Also, be sure to check in regularly for upcoming postings of F I T T!

F I T T – July 2014 Edition

Our Story

The Barson Group was founded in January, 2002 by Kal and Janet Barson. Prior to that, Kal was a partner at another local accounting firm, and for the several years before leaving, was managing partner. During Kal’s tenure with that firm, with considerable contribution from him, it grew from about 10 people to in excess of 55 personnel. During those years, Kal developed an expertise (nationally recognized) in investigative accounting and business valuation. Janet was an administrative assistant at the same firm. Read more.

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