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Family Law Update

Bernier v. Bernier, 2007 (September 14, 2007), Massachusetts Supreme Judicial Court

There were two main valuation issues in this marital dissolution case that have relevance to Wisconsin divorce cases. The first was: "whether it was proper to discount the value of an S-corporation by "tax affecting" income at the rate applicable to C-corporations, where the one spouse will receive ownership of all shares of the S-corporation after the divorce and the other will be required to relinquish all ownership in the business". The second major issue dealt with: "whether the judge erred in discounting the fair market value of the S-corporation at issue here by applying "key man" and "marketability" discounts".

Summary of Case and Decision

Facts: The husband and wife in this case owned two supermarkets which were S-corporations. The Husband testified that his expertise and management skills were critical to its continued success of the business. They had agreed that he would therefore maintain total ownership and control of the supermarkets (as S-corps) after the purchase of her interest.

Both the husband and the wife’s expert used an income method of valuation in calculating the fair market value of the supermarkets. They differed in their application of taxes and discounts. The husband’s expert applied a hypothetical tax to the S-corporation income, using an "average tax rate" and thus reduced the S-corporation income by 35%. He also applied "key man" and "marketability" discounts to the value. The wife’s expert did not reduce the income of the business by corporate taxes and did not take any discounts. The trial judge adopted all aspects of the Husband’s expert’s approach to valuation of the S-corporations. The case was appealed.

Supreme Judicial Court's Ruling: With regard to the taxation of the S-corporation earnings, the SJC ruled that the judge erred in adopting the husband’s expert’s approach with regard to this issue. It was determined that is was correct to tax affect – however using an arbitrary tax rate – based on C-corporation rates was inappropriate. On remand, the judge was to use the tax affecting approach adopted in Delaware Open MRI Radiology Assocs. v. Kessler, 2006 Del. Ch. LEXIS 84 (April 26, 2006). This approach attempts to determine what the effective corporate tax rate would be for the S-corporation shareholder, although the entity itself does not pay corporate tax. It did not simply use the "average tax rate".

With regard to the issue of key man and marketability discounts, the SJC ruled that the trial judge ignored the clear evidence that the husband planned to continue to run "the whole show" and had no plans to sell the business. The SJC stated that these discounts assume the possible sale of the businesses. In this case – it was a stated fact that the supermarkets would NOT be sold, and therefore, in error to take discounts that assume the sale of the assets.

This case is instructive for several reasons.

First, in citing Massachusetts’s requirements of equitable distribution in divorce cases, the Court chose to apply a "fair value" standard for valuing the business rather than a "fair market value" standard. A fair market value standard would require the use of a "hypothetical buyer and hypothetical seller" assumption. By ignoring the hypothetical parties standard and looking to the facts regarding the actual parties, the Court determined that it would be inappropriate to assume a sale of the business to a buyer that would consider hypothetical income taxes in its analysis. The parties testified that the husband would continue to own and operate the businesses. Therefore, the Court reasoned, assuming a sale would be disregarding the facts of the case.

Secondly, based on the above rationale, the Court refused to apply a discount for the lack of marketability of the stock, as well as a discount for the loss of a key man, the husband, when the husband testified he was going to continue to own and operate the businesses.

Finally, the Court adopted the approach to dealing the tax affecting of Subchapter S corporations taken in the Delaware Open MRI case cited above, which requires the calculation of an "effective tax rate" for the shareholders of the S Corporation, even though they paid no actual tax at the S corporation level. The effective tax rate in the Delaware Open MRI case was determined to be 29.4%.

Conclusion

When valuing an S corporation for a Wisconsin divorce case, the valuator must determine whether it is appropriate to tax affect the earnings of that company when arriving at the value.

• "Fair market value is the price that property will bring when offered for sale by one who desires but is not obligated to sell and bought by one who is willing but not obligated to buy. This definition requires consideration of what factors buyers and sellers find relevant when negotiating a deal. Thus, disadvantages or liabilities of ownership may dramatically affect the fair market value of property."

The definition of fair market value as relied upon in the valuation community is defined as follows:

• "The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property."

The Wisconsin Courts have been silent to date on the issue of tax affecting S Corporations. The issue also applies to other pass through entities as well, including Partnerships and LLCs, although these entities have different legal and tax issues that need to be considered. The decision to tax affect also may depend on the size of the ownership block. The decision may be different for a controlling interest versus a non-controlling interest.

Whatever decision the valuator makes regarding the tax affecting of the earnings of the business, it must be supported.

The decision of whether to tax affect the earnings of the S corporation can dramatically impact the value of the entity. As noted above, if the Wisconsin Courts were to adopt the approach in Bernier and Delaware Open MRI, the application of discounts for lack of marketability would also come into play.

Currently the valuator has very little guidance in Wisconsin Case law from which to draw. As a result, it is necessary to look to basic valuation principals; commentary and insight from the valuation community; as well as current Tax Court or other jurisdictional Court Cases addressing the issue.

Liddle v. Liddle, 140 Wis. 2d 132; 410 N.W.2d 196; 1987 Wisc. App. LEXIS 3692
Revenue Ruling 59-60, Sec. 2.02, C.B. 1951-1.237.