In a divorce case, double-dipping refers to a practice that counts an asset for two different purposes, so that one spouse receives two payments from a single asset.
For a relatively simple example of double-dipping, consider a divorce in which one spouse will receive a pension that was earned during the marriage. The other spouse may be able to choose to receive marital assets equivalent to half of the value of the marriage, or to receive half of the pension benefit earned during the marriage when the pension starts paying benefits. It would be double-dipping for the spouse to receive both a payment based upon the present cash value of the pension, and also to receive the future pension benefit.
The issue of double-dipping is more complicated in the context of a marital estate that includes the business or professional practice of one spouse.
The goal of business valuation is to determine the present value of the business or, more specifically, the present value of the future benefits of owning the business.
Courts hearing divorce cases may be of the impression that business valuation is based upon the past income of the business. In fact, while past income may be an indication of what is likely to happen in the future, a business is valued based upon the value of its assets and anticipated future returns.
There are several methodologies for business valuation, including:
- Income approach: basing the value of a business upon its intended future stream of income;
- Capitalization of earnings: calculating the value of the business by dividing its normalized income by an appropriate capitalization rate. This form of valuation is most appropriate when the earnings of a business are expected to be stable.
- Discounted cash flow: Calculating the value of the business by calculating the present value of expected future returns. This form of valuation may be useful when the cash flow of a business is expected to fluctuate, and may be complex. Market approach: Valuing a business based upon the stock value or sale value of similar business operations.
- Asset approach: Basing the value of a business on what it would cost to purchase the assets of the business at their current market value. The value of the business’s goodwill, intellectual property, and other intangible assets is included in this calculation, as are the value of liabilities and contingent liabilities of the business.
- Hybrid approach: Using aspects of both the income and asset approaches to determine a value based upon the value of the assets of the business plus the value of any intangible assets and goodwill.
The issue of double-dipping arises only when the value of the owning spouse’s future income is considered in the valuation of the business.
With some businesses, particularly professional practices, consideration of future income may be unavoidable. Consider, for example, a law firm with three partners and $3 million in revenues. The value of the physical assets of the law firm may be modest, for example, $150,000, but it would be patently unreasonable to value each partner’s equity share at only $50,000.
Goodwill represents the value of a business beyond the value of its assets as reduced by its liabilities. When valuing a business, it is possible to divide goodwill into two categories:
- Enterprise goodwill: Goodwill that relates to the business itself, and that would transfer from one owner to another. This is the value of the reputation of the business, which transfers to the new owner through the acquisition of the business name and operations.
- Personal goodwill: Goodwill that is produced by the owner’s presence in the business and the work that the owner performs for the business.
The double-dip issue for the division of goodwill occurs in states that allow personal goodwill to be considered to be part of the marital estate, when the non-owning spouse seeks both compensation for a share of the business and future spousal support based upon the owning spouse’s compensation.
Personal Goodwill and Small Business Valuation
For many small businesses, the value of the business comes from primarily from the labor of the owner. Many small businesses that pay the owner a healthy salary have little value to a buyer, who would have to hire and pay a salary to the person who takes the role of the owner.
When the value of a small business is calculated based upon its revenues, the owner’s compensation is included in those revenues when the business is appraised. The double-dip argument is that it is unfair to then again consider the owner’s compensation when calculating spousal support, as the spouse seeking support has already benefited from the value of that compensation by receiving their share of the value of the business.
For example, if a business that is part of the marital estate is valued at $500,000 due to its cash flow, with $150,000 of that cash flow available to the owning spouse as compensation, the non-owning spouse would receive $250,000 for that spouse’s share of the business. The double-dip argument is that, having received compensation based upon the entire cash flow of the business, it is inappropriate for the non-owning spouse to be awarded spousal support out of the $150,000 that is available as income to the owner.
Risk of Continued Ownership
Another consideration is that, in receiving half of the value of the business, the non-owning spouse is insulated from future risk. The owning spouse continues to bear the risk of market changes or other business issues that cause a sharp reduction in income, and those changes will carry over to the value of the business.
While it may be possible to modify spousal support based upon a loss of earnings, assuming that modification is not barred by the divorce judgment, it is not possible to revisit the valuation of the business.
States have responded to arguments about the double-dip, with most states having made an effort to define rules for the consideration of business goodwill during divorce. A few states have yet to clearly state a position.
Separating Enterprise Goodwill from Personal Goodwill
Most U.S. jurisdictions now separate enterprise goodwill from personal goodwill, and base the value of the business only on enterprise goodwill. When that occurs, the court may consider the excess earnings that may come from personal goodwill when setting spousal support, without causing a double-dip.
States that follow this majority rule include Alaska, Arkansas, Connecticut, Delaware, the District of Columbia, Florida, Hawaii, Illinois, Indiana, Maryland, Massachusetts, Minnesota, Missouri, Nebraska, New Hampshire, Oklahoma, Oregon, Pennsylvania, Rhode Island, Texas, Utah, Vermont, West Virginia, Wisconsin and Wyoming. Florida goes a step further, and treats most enterprise goodwill as if it is personal goodwill.
Classifying Both Personal and Enterprise Goodwill as Marital Property
Many states make no distinction between enterprise goodwill and personal goodwill. The reasons for this position are varied.
- Some states take the position that double-dipping is not an issue, under the theory that the business owning spouse will actually receive any excess earnings, the value of earnings in excess of the fair market value of their labor, indefinitely.
- Some courts have taken the position that if the choice of business valuation method should not dictate whether or not there is an unfair double-dip, and thus that the owning spouse’s future income should be treated in the same manner no matter what valuation model is used to value the business.
States that follow this approach create the greatest risk of a double-dip in divorce. These states are Arizona, California, Colorado, Kentucky, Michigan, Montana, Nevada, New Jersey, New York, North Carolina, New Mexico, North Dakota, and Washington .
Excluding Goodwill from Business Valuation
Some states exclude the consideration of goodwill when dividing a marital estate. This approach completely avoids the double-dip, but may significantly undercompensate the non-owning spouse for that spouse’s share of the business.
States that exclude goodwill from business valuation include Kansas, Louisiana, Mississippi, South Carolina and Tennessee.
Some states either have not yet published case law that clearly defines how goodwill is to be divided in divorce, or have conflicting appellate court opinions on the subject.
These states include Alabama, Georgia, Idaho, Iowa, Maine, Ohio, South Dakota, and Vermont.
Where it is not feasible to avoid considering personal goodwill in the value of a business, a court may mitigate the effect of that inclusion when later setting spousal support.
For example, instead of considering what portion of the cash flow might be available to the owning spouse as income, the court could evaluate the spousal support petition based upon the fair market value of the owning spouse’s position — the amount that the owning spouse would be paid as reasonable compensation if employed by another business in which that spouse had no ownership interest. By doing so, the court would separate the amount that the owning spouse receives from managing the business from the additional income that the owning spouse receives by virtue of owning the business.
Whether or not such an approach is possible will depend upon the statutes and case law of the state in which the divorce is proceeding.