Tuesday, April 6, 2010

The Classification of Inter-Spousal Gifts

One of the most common misconceptions that arises in the context of equitable distribution is the belief that a divorcing spouse is entitled to retain any specific gifts which he or she was given by their partner during the course of the marriage. Clients often assume that a gift, be it jewelry, artwork or cash, which was given to them as a gift should logically remain theirs free and clear from any claim of the donor-spouse.

In fact, although perhaps antithetical to the concept of a gift; the general rule in Florida is that a gift from one spouse to another (termed an inter-spousal gift) is a marital asset subject to division and/or distribution. “Interspousal gifts during a marriage are marital assets subject to equitable distribution.” Dwyer v. Dwyer, 981 So.2d 1254, 1256 (Fla. 2nd DCA 2008). “Under well-established statutory and case law, an interspousal gifts during the marriage is a marital asset.” Maddox v. Maddox, 750 So.2d 693, 694 (Fla. 1st DCA 2000).

There is, however, a potential loophole which can be used to argue that an inter-spousal gift should be set aside to the recipient spouse as a non-marital asset. This loophole is predicated upon the fact that, unlike Florida, most states regard inter-spousal gifts as the non-marital property of the recipient spouse. At the same time, Florida law holds that the distribution of moveables (i.e. tangible and intangible personal property) is governed by the laws of the state where the property was acquired as opposed to the laws of the state where the dissolution takes place. "The interest of one spouse in moveables acquired by the other during marriage is determined by the laws of the domicile of the parties when the moveables are acquired.” Camara v. Camara, 330 So.2d 818 (Fla. 3d DCA 1976). See also Quintana v. Ordono, 195 So.2d 577 (Fla. 3d DCA 1967) holding “However, by the almost unanimous authority in America, the ‘Interests of one spouse in movables acquired by the other during the marriage are determined by the law of the domicile of the parties when the movables are acquired.” See also In Re Estate of Nicolas Santos, 648 So.2d 277 (Fla. 4th DCA 1995).

Therefore, all relevant facts concerning the acquisition of an inter-spousal gift should be determined before relying upon the general rule that the asset is marital in nature.

Monday, January 25, 2010

Primer on Business Valuation (Part One)

As I noted in my January 21, 2010 blog entry (Primer on Property Division), when parties are attempting to divide their assets and debts, disputes often arise over the proper valuation of closely held business. Unlike automobiles, real estate or stock in publicly traded corporations; the valuation of privately held companies generally cannot be performed by simply looking up an index or applying to an online database. Instead, an intensive review (typically by a forensic CPA) must be performed in order to determine the price at which a willing buyer would sell and a willing seller would pay for a given entity.

Although most experts will concede that the process of valuing a small business is often as much an art as a science; there are clear methodologies which must be followed in order for the valuation to be recognized as a by-product of generally acceptable accounting principles (and therefore admissible in a court of law).
This article (as well as the next few blog entries) will attempt to demystify the various valuation methods such that they can be understood by attorneys and clients alike.

The Capitalized Excess Earnings Method (i.e. Treasury Method)

One valuation method which may be utilized to determine a per-share value is the Capitalized Excess Earnings Method which is sometimes also referred to as the Treasury Method. This method, which is often used in the calculation of gift and estate taxes, is sometimes used because it allows the expert to distinguish between values associated with hard assets and those comprised of intangible goodwill.
NOTE: In a given dissolution of marriage case, the distinguishing between values associated with hard assets (commonly referred to as book-value) and values associated with intangible goodwill is often crucial in arriving at an accurate appraisal for equitable distribution purposes. This is because some forms of intangible goodwill is deemed a non-marital asset of the spouse who operates the company and therefore it must be deducted from the overall value of the company. (An explanation of goodwill and its implications will be described with greater detail in a later entry.)

The Capitalized Excess Earnings Method is applied by following steps:

1. Determining the company’s book-value by adding the fair market value of its individual assets and then deducting from that figure the total liabilities of the company in order to arrive at a net asset figure;

2. Establishing a reasonable rate of return based upon the net assets and multiplying this (theoretical) rate of return by the net asset figure in order to calculate projected earnings attributable to the tangible assets;

3. Estimating a normalized level of economic earnings by averaging the company’s earnings over the length of a business cycle;

4. Deducting the projected earnings which are theoretically attributable to the tangible assets from the total normalized earnings in order to calculate the “excess earnings” which are attributable to the intangible assets;

5. Estimating a capitalization rate and multiplying this figure by the “excess earnings” to calculate the company’s intangible value;

6. Adding the net asset figure to the intangible value figure in order to get a total value;

7. The final step is to deduct a minority or marketability discount from the total value (where applicable) with the result being the fair market value of the entity.

In order to fully illustrate this method in action we will use a fictional company (JOSH ENTERPRISES) which, for purposes of this explanation, is in the business of manufacturing candy bars. JOSH ENTERPRISES has hard assets (machines, office supplies, inventory and computer software) which are collectively valued at two million dollars ($ 2,000,000.00) and total liabilities (mortgages and loans) of one point two million dollars ($ 1,200,000.00). Also, for purposes of this exercise assume that over the past five (5) years the company’s net income (revenues less expenses) was:
2009: $ 300,000.00
2008 $ 280,000.00
2007: $ 310,000.00
2006: $ 290,000.00
2005: $ 265,000.00

With these figures in mind, we are ready to start our analysis under the Capitalized Excess Earnings Method.

Step One: Determine NET ASSETT VALUE

In this case, determining the NET ASSET VALUE is relatively simple. The collective book value of the various assets is two million dollars ($ 2,000,000.00) and the total liabilities are one point two million dollars ($ 1,200,000.00). Therefore the NET ASSET VALUE (assets less debt) is eight hundred thousand dollars ($ 800,000.00).

Step Two: Apply a Reasonable Rate of Return to the NET ASSET VALUE

The second step is to apply a reasonable rate of return to the NET ASSET VALUE (NEA). This is done by assuming that rather than investing in this entity, the owner had taken the amount of the NEA and invested it into another venture in which he or she had no control or operating interest. In this case, if the owner of JE was not operating a company then the NEA would have been invested in stocks and equities in which the average rate of return was seven percent (7%). Therefore, we will multiply this percentage by the NEA ($ 800,000.00 x .07) to obtain a “reasonable rate of return” of fifty-six thousand dollars ($ 56,000.00).

Step Three: Estimate Normalized Earnings

There are very few industries where a company’s earnings will remain constant and therefore a business valuator needs to “normalize” past earnings in order to accurately predict future income potential. The simplest way of calculating an average (i.e. normalized) income stream is to simply add the past five years net income together and divide by five. (Your forensic accountant may give more weight to recent earnings in his or her calculation, however; for purposes of this example that is not necessary.)

NOTE: In most cases, the business valuator will make adjustments to the net income figures before factoring them into the normalization calculation. For example, any personal expenses which were run through the business will be re-classified as a distribution which will have the effect of increasing the normalized income. On the other end of the spectrum the CPA may determine that the owner/manager was taking less in salary then an average manager would and therefore he will make an adjustment by reducing income by the amount of the difference. These adjusted figures, and not necessarily the ones set forth in the company’s tax returns, will be factored into the calculation of normalized earnings.

In this example, the average of the net incomes over the previous five years (set forth above) is $ 289,000.00.

Step Four: Deduct Return on Assets from Normalized Earnings

In order to ascribe the value of intangible goodwill (i.e. value above that attributable to the hard assets) we will need to deduct the rate of return which is attributable solely to the hard assets from the total (normalized) earnings. In this example, our total normalized earnings are $ 289,000.00 and our rate of return on NEA is $ 56,000.00. Therefore, our normalized earnings attributable to factors other than hard-assets are $ 233,000.00. This figure is referred to as our excess earnings.

Step Five: Choosing a Capitalization Rate

The fifth step of valuing a business is the choice of a CAPITILZATION RATE. A Cap Rate is a ratio which divides the expected EXCESS EARNINGS by the TOTAL COST in order to determine how long it will take for the asset (or company) to pay for itself. This is used to value the intangible value of the company (i.e. the value of likely continued earnings separate and apart from the hard-assets).

Essentially the Cap Rate is a measurement of how risky the business venture is to a prospective purchaser. Therefore, a high-risk venture will have a higher capitalization rate then a lower risk venture (in which a purchaser would likely wait longer to recoup their money in return for security and stability). In order to determine an appropriate Capitalization Rate most experts will start with a database containing sales/valuation figures for comparable businesses. From here, the expert can increase or decrease their suggested Cap Rate based upon the individual circumstances of your business. For example, if the average Cap Rate for a drycleaner in Florida is twenty-five percent (25%) then the expert will start with that number and either increase based upon the presence of extraordinary risk factors (high debt/new regulations etc…) or decrease it based upon extraordinary stability factors (long history/experienced management under contract/ etc..).

NOTE: These may seem like arbitrary reductions/increases but your CPA will be able to back them up with data from comparable sales and/or based upon their experience in the business fields.

In our example, we will assume that businesses in the food-manufacturing industry have an average Capitalization Rate of twenty percent (20%) so this will be our starting point. We will increase this number by five percent (5%) based upon the loss of experienced management (as it will be owner operated until the sale) and another five percent (5%) because the government seriously considering (hypothetically) banning the sale of sugar products in schools (which makes up 1/8 of our revenues). We will then decrease the resulting number by three percent (3%) because of the longevity of the business (30 years). This leaves us with a Capitalization Rate of twenty-seven percent (27%). In other words, the net operating income divided by the total value will equal twenty-seven percent (27%).

Therefore, we will divide our EXCESS EARNINGS ($ 233,000.00) by our CAP RATE (27%) which gives us an Intangible Value of $ 862,962.96.


We now have a NET ASSET VALUE for our business (i.e. book value) as well as a value for our intangible assets (i.e. goodwill). We must add these figures together to come to a TOTAL VALUE. In the case of JOSH ENTERPRISES the NET ASSET VALUE equals $ 800,000.00 and an Intangible Value of $ 862,962.96. Therefore the TOTAL VALUE of JE equals $ 1,662,962.90.

Step Seven: Apply Discounts

The final step in valuing your company for purposes of dissolution of marriage is the application of appropriate discounts to the company. If sold in a vacuum the TOTAL VALUE of the company would also be its fair market value for sale purposes. In the real world, however, the TOTAL VALUE is affected by two (2) factors which may reduce its allure to prospective purchasers. The first factor is a lack of control on the part of the owner-spouse. If the spouse will own less than one hundred percent (100%) of the company then the prospective purchaser will have to take into account other shareholders in making future decisions (this lowers the value of the company). If the spouse will own less than fifty percent (50%) of the company then a prospective purchaser will have no control and likely will not pay full value for the company. The second factor is lack of marketability. If a company stock is not readily salable due to the industry it’s in, the lack of control, or even liability issues; then this will reduce the price a willing buyer is willing to pay (thereby decreasing its fair market value).

Generally, lack of control/marketability discount will reduce TOTAL VALUE by 25%-40.Therefore, you would take the TOTAL VALUE calculated in Step Six and multiply it by the combined discount to arrive at the FAIR MARKET VALUE.

Thursday, January 21, 2010

Primer on Property Division

The issue of property division, or equitable distribution, is often the first and foremost concern among dissolution of marriage litigants. While your circumstances may or may not weigh in favor of alimony, child-issues or attorney’s fees; very few divorces can proceed without the identification and division of the marital estate.

Dividing up a marital estate is a four (4) step process which requires: (1.) the identification of assets and debts; (2.) the classification of assets and debts; (3.) the valuation of assets and debts and; (4.) the distribution of assets and debts.

Identification: In order to identify assets and debts you should make a list of each and every piece of property which you would value at more than one hundred dollars ($ 100.00) regardless of when you obtained it, how you obtained it, or whether you consider it to be you (or your spouse’s) separate property. Specifically, you should list all: (a.) real estate; (b.) automobiles; (c.) cash; (d.) bank accounts; (e.) retirement accounts; (f.) boats and recreational vehicles; (g.) jewelry; (h.) stocks; (i.) bonds; (j.) pensions; (k.) Individual Retirement Accounts IRAs and; l) 401-k plans. With respect to debts you should list all mortgages, credit card bills, promissory notes, student loans or other current obligations.

Classification: Once you have identified all of your assets and liabilities the next step is to classify them as marital or non-marital in nature. Florida Statute § 61.075 generally defines marital assets as: (a.) assets acquired during the marriage; (b.) the appreciation of non-marital assets to the extent that appreciation resulted from the expenditure of labor or marital funds and; (c.) gifts between spouses which occurred during the marriage. Non-marital assets on the other hand generally include: (a.) pre-marital assets acquired prior to the marriage or exchanged during the marriage for pre-marital assets; (b.) income obtained from non-marital asses and; (c.) gifts given to one, but not both, spouses.

Valuation: Now that you have identified and classified your marital assets, the third step is to value them. Generally, you will use the date that the petition was filed as your valuation date (although assets that passively appreciate or depreciate such as stocks and real estate will be valued as of the date of trial). There are many ways to value property but the standard must be what the fair market value is (i.e. what a willing buyer would pay and what a willing seller would sell for if neither were acting under any compulsion or pressure). In order to determine this information you will generally look to third-party sources. For example, real estate will generally be valued by a certified real estate appraiser; vehicles can be valued with the Kelly Blue Book; and pensions can often be valued in conjunction with the plan administrator. If you have a privately owned business it you may need to retain a forensic accountant to assist you in the valuation of that asset.

Distribution: The final step in the process is the actual distribution of the assets and debts. The guiding principle in this regard is that in almost every case each spouse will retain fifty percent (50%) of the assets and fifty percent (50%) of the debts. This is not to say that each asset must be divided or sold, instead; you will use the values obtained in step three (3) in order to ensure that both parties end up with roughly the same net worth (excluding non-marital assets/debts).

Tuesday, January 19, 2010

Is an engagement ring a marital asset

From time to time I come across a client who asks whether an engagement ring is considered a marital asset and, if so, whether it will be subject to the equitable distribution/property division performed at the end of the case. The simple answer is that an engagement ring is considered a pre-marital gift and therefore it is the non-marital property of the recipient (generally the Wife). "It was error for the trial court to consider the wife's premarital property, such as her engagement and wedding rings which were found to be gifts to the wife, in the equitable distribution scheme." Melvik v. Melvik, 669 So.2d 328 (Fla. 4th DCA 1996).

A wedding ring, on the other hand, is considered an inter-spousal gift (i.e. a gift between spouses during the marriage) and the equitable distribution statute (Fla. Stat. 61.075) deems inter-spousal gifts to be marital assets subject to division.

On a related note, if the parties fail to marry in the first place (such as when an engagement is broken off) then the ring must be returned. Although an engagement ring is considered a gift---see above--it is deemed a conditional gift premised upon the occurence of a marriage. "However, the decided weight of authority in other jurisdictions allows recovery by the donor if the engagement is terminated by the donee or by mutual consent of the parties. The rationale of those cases is that such presents are not absolute but are made upon the implied condition that a marriage ensue." Gill v. Shively, 320 So.2d 415 (Fla. 4th DCA 1975).