If you are a small business owner with no or few employees and you are about to go through a divorce, get prepared for pain. If you have a long-term marriage and you earn significantly more than your spouse, get prepared for a double dose.
In the absence of a premarital agreement, a business formed during a marriage is community property. The business will usually be awarded in the divorce to the spouse who runs the business. The other spouse is usually awarded other marital assets of comparable value to the business. If there are insufficient other assets available, the spouse awarded the business will have to “buy out” the other spouse, usually by borrowing the buy-out funds or by making installment payments to the other spouse.
On the surface this seems fair and just. However, many small business owners who have few or no employees are at serious risk of getting an unfair divorce trial ruling as to the division of their businesses. Problems arise when business appraisers value a small business based on its anticipated future stream of profits without removing the business owner/operator from the equation.
Consider Joe’s Painting as an example. Joe is a self-employed painter doing business as “Joe’s Painting.” Joe has no employees. Joe paints houses eight hours a day, five days per week. Joe nets $90,000 per year from his painting work. Joe is happy to be self-employed. If he were working for another painting company eight hours a day, five days per week, he would be earning only $50,000 per year. Joe and his wife decide to divorce. The business appraiser values Joe’s business at three times his annual profit, or $270,000 ($90,000 times three).
Assuming for purposes of this discussion that the valuation method and .333 capitalization rate (i.e. one year’s profits represents one-third of the value of the business) were correct, the appraisal is seriously flawed because it fails to remove the value of Joe’s labor. If Joe were working somewhere else, he would be earning $50,000 per year. The value of the business is the profit it brings to Joe IN EXCESS of the $50,000 he could earn working somewhere else or the $50,000 Joe would have to pay someone else to paint the houses Joe is now painting. The value of the business, then, is $120,000 ($40,000 excess profit times three).
If the court uses $270,000 as the value of Joe’s Painting, Joe will have to pay his wife $135,000 to buy out her interest. The amount Joe SHOULD pay to buy out his wife is $60,000, which is half of the correct value of the business. If the divorce judge uses the incorrect business value, Joe will overpay his wife by $75,000. Ouch.
Joe gets “double-dipped” when the trial judge also orders Joe to pay spousal maintenance based on Joe’s earning $90,000 per year. Joe’s earning ability working for another painting company is $50,000 per year. With the business buy-out, Joe’s wife is already being compensated for the $40,000 per year in excess profits Joe earns from his painting business. If spousal maintenance is based on the full $90,000 per year business profit, Joe’s wife is getting compensated TWICE for the $40,000 excess profits. That’s double dipping!
In my opinion, the fair way to handle this example is for Joe’s wife to be compensated $60,000 for her interest in the business (half of the correct appraised value derived by excluding Joe’s fair compensation from the equation) and for the judge to base her spousal maintenance orders on Joe’s earning $50,000 per year. Alternatively, the trial judge could order no business buyout and base spousal maintenance orders on Joe’s full $90,000 per year earnings.