Family lawyers want a fair distribution of marital property for their divorce clients. Valuation of a spouse’s small business poses a challenge to achieve that goal.
This post addresses how forensic accountants put a price tag on a small business for marital property allocation purposes. Also, the post examines the methodology employed in small business divorce forensics. Delving into clues that help assign a value to small business will be reviewed.
Both spouses may retain a separate divorce accounting expert to perform an appraisal. Small business valuations by their very nature are subjective. Operating a business involves tangible assets, such as:
- Product inventory.
- Real estate, including the brick and mortar business location..
A business also has intangible assets, such as goodwill, rights assigned by contracts and intellectual property (patents, trademarks, copyrights). Stock options, deferred compensation, and retirement funds are just some of the divisible assets forensic accounting specialists will assess.
Like crime scene detectives, forensic accountants doing a small business valuation search for clues. They review tax returns, bank accounts, and the like. Accountants pore over insurance policy statements, credit card statements and loan applications. Searching business records filed with municipal and state offices and tracking a company’s cash flow could uncover inconsistencies. For example, disparities in figures on loan applications and tax filings may emerge. Offshore accounts and business property in other states and countries are evaluated.
Valuation of a business is a question of fact. When valuation experts differ in their opinions about worth, Probate Court judges have several options. Judges can accept one reasonable assessment over another. Judges also can reject expert opinion entirely and determine a valuation on other evidence. Appellate courts generally are deferential to the probate judge. Reviewing lower court opinions depends largely on whether the judge’s findings were clearly erroneous.
Loosening a Closely Held Business
Assigning a value to a business can be done using different techniques, namely,
- Income approach.
- Asset approach.
- Market approach.
Some methods better lend themselves to particular types of business entities. Whether the small business at issue is a sole proprietorship, partnership or corporation does not affect the valuation method adopted by a probate court. A business may employ whichever accounting methods it deems suitable, provided it satisfies Internal Revenue Service requirements.
An income approach attempts to evaluate the entity’s expected economic benefits. At the same time, the approach discounts for the risk that the prospective benefits might not be realized. Forensics pros accomplish this by speculating and making adjustments for future performance based on studying the business’s previous financial information. The theory underlying the income approach is that a business’ value or a business interest relies on future economic benefits accruing to that business. These future benefits are then discounted to present value at an appropriate discount rate.
Predominant Income Method
Private, small businesses are most often valued using the income method. A direct capitalization of income approach initially finds the average normalized pretax income of a business. That figure reflects deductions for nonrecurring income, salary and expenses. Also, this reflects other adjustments to account for risk and other economic factors. The normalized average income then is divided by an appropriate capitalization rate to discount to present value.
Alternatively, another methodology within the income approach is the discounted cash flow approach. This method is useful to appraise a spouse’s partnership interest. Instead of the direct capitalization’s constant income stream, the discounted cash flow approach applies an equation that reduces a finite future income period to present valuation.
Another methodology used is the asset approach. This approach involves setting a value for the entity’s tangible and intangible assets, and assigning a value to the company’s liabilities. Subtracting liabilities from assets yields the business valuation. Easier said than done, because intangible assets are difficult to value. Sometimes, intangible assets are even hard to discover.
Lastly, a market approach compares the spouse’s business to like businesses that have been sold to determine a value. This is similar to a real estate agent who performs a comparative market analysis of similarly priced homes sold in a neighborhood before recommending a purchase price. Basing an appraisal on recent transactions arguably enables the forensics expert to gauge the current market value of the small business.
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