“Whatever their other contributions to our society, lawyers could be an important source of protein.” – Guindon cartoon caption
A particularly sensitive issue with attorneys (we all know that law practices are not worth anything), is the concern over a possible double dip. This is a practical matter in addressing the interconnected issues of alimony and equitable distribution of the business value. The essential concern that creates the double dip is that in the classic approach to business valuation, the valuation expert determines what is reasonable compensation (for simplicity we’ll call that the compensation necessary to go out in the open market and hire somebody to replace the business owner in a truly arm’s length arrangement) in order to determine the economic income of the business. The economic income, typically through a capitalization of income approach, is used to determine value.
The income actually taken out of a business often exceeds the determined reasonable compensation. By one line of thinking, that means the lifestyle enjoyed by the family was made possible by some (or even all) of the same economic income of the business that is being used to determine its value. Thus, this spread (the excess of what was actually taken as income as contrasted with the reasonable compensation), is being used both to establish a lifestyle and therefore support, and as part of the calculation that determines value, from which the non-business spouse will be receiving his/her share in equitable distribution. Thus the double dip conundrum.
One of the arguments that a double dip does exist is that it is overtly obvious from an economic point of view, based on the scenario described above, that part of the income generated by the business is being used both for support and valuation purposes. This would not be the case if the business were being sold at arm’s length, because the buyer in a commercial transaction would not have the responsibility to also pay support payments to the seller. Based on the preceding, is there in fact a double dip, and even if there is, is it a problem? There are a number of responses/counters to the concern of a double dip.
- The double dip referenced above was “created” because the illustration of the value included a determination of reasonable compensation. Every financial expert knows it is possible (sometimes) to value a business without determining its economic income, without determining reasonable compensation. We might use total net income before compensation to the owners as the benchmark, or perhaps the sales or the top line is the benchmark, with no need to go through a determination of economic income. In that case, no foundation would be evident for assuming a double dip.
- The argument in favor of the double dip would probably be stronger if we were looking at a 50% allocation of the value of the business to the non-business spouse. The non-business spouse (typically the wife) rarely gets 50% of the value of the business. Commonly, we see something in the range of 30 to 40%. Arguably, a percentage that low takes into account a number of factors – such as an assumption of a built-in tax (which sometimes does and sometimes does not exist), perhaps the double dip, perhaps a built-in bias in favor of the business owner, perhaps a recognition that the business owner will continue with the business which carries a much higher degree of risk than the cash buy-out that is likely going to the non-business spouse.
- Studies have been done showing that the aftermath of divorce tends to leave the major earner/breadwinning spouse (typically the husband) in a considerably better financial position as the years go by than the “dependent” spouse (as we know, usually the wife – often with the children). Assuming that these studies extend beyond merely the W-2 earner to include business owners, even if you were to successfully argue the concept of a double dip, where is the financial harm in that double dip; as contrasted to what would certainly be the more likely financial harm if that double dip were given the financial respect its advocates posit.
The preceding notwithstanding, let us assume that the issue of a double dip gets a favorable reception, and thus it has been agreed it needs to be compensated for in some financial manner. There are several ways to do this, all having shortcomings. For instance:
- You simply cut back on the percentage of the business allocated to the dependent spouse. In that fashion, an economic trade-off has been made, taking away some part of an asset (through the equitable distribution process) in compensation for the double dip. Referencing a comment made above, perhaps that wouldn’t be terribly unreasonable if we were starting with a 50% carve-out factor. Since typically we see property distribution shares on a business in the 30 to 40% range, this alternative might reduce the carve-out to the 20 to 30% range. At what point do we start having a social policy problem – how unfair is this to the dependent spouse? Further, not that this is etched in stone, but often what is unfair to the dependent spouse invariably becomes, intentionally or not, unfair to the children. The logic for this trade-off is clearly that the alimony is at such a level that there is a double dip, therefore a rationale for “balancing” the economics by taking something away from the equitable distribution. What happens when that former spouse remarries, and the alimony stops? That spouse now has not only lost the income flow of the alimony, but never got his/her “fair share” of the equitable distribution. The concern over the double dip has proven to be ephemeral.
- An alternative is to compensate for the double dip by taking it out against the alimony. Instead of giving the dependent spouse a smaller share of the business, simply pay less alimony. It is not too difficult to figure out this approach comes with its own set of problems, including potentially pauperizing the former spouse (and, need it be said again, that also typically negatively impacts the children), and creating another form of a social policy problem.
- Another possible approach may be to do some kind of a blend, under the concept that, as an example (and this won’t work all the time), if the business were capitalized at a 20% cap rate, the inherent economic assumption is a 5 multiple – 5 years of income of that business constitutes value. In this simplistic sense, perhaps the alimony will be reduced for only 5 years, representing that time frame for which one might argue the double dip existed. Or, perhaps the business owner gets 5 years free ride of no payments for the buy-out of the share of the business (or some economic equivalent). These approaches present their own problems, including insufficient funds to the dependent spouse for reasonable support, forcing the dependent spouse to wait years to receive his/her fair share of the business, the risk of that business in some way being sold, destroyed, whatever, and that money not being there…
Even if you believe there is an economic double dip, when all factors are taken into account, does it matter, does it truly present a financial burden to the business owner? Does the system as it is currently constructed implicitly take all of that into account (i.e. by the typically less than 50% share to the dependent spouse and by the typically less than 50% share of the family income that goes to the dependent spouse), and thus therefore, is there really no problem or, as it has been phrased, is it a “permissible” double dip?