To finalize a divorce, it is necessary to value and divide all assets and debts. It is also necessary to calculate each party’s income to determine child support and spousal support. When one of the parties owns a business, it is often challenging to value the business and calculate the income derived from the business.
There are multiple methods of valuing a marital business. Experts will use three accepted methods to calculate the value and then tell the court which method is most appropriate for the marital business in question. The three accepted ways of valuing a business include: the income method; the asset method; and the market value method. An expert is required because most judges will not allow the parties to testify to the value of the business because they are not qualified as experts and may be biased. Typically, each party will hire a business valuation expert. At trial, the court will determine which expert is more credible to determine the business’ value.
At the same time the business valuators are calculating the value of the business, the calculation of each party’s income is also taking place. If only one party works in the business, their income will be calculated using their K-1 and W-2 forms.
It is important to note that, when calculating the income of the party working in the business, family courts will add personal expenses paid by the business to the payee’s income. While the IRS allows certain personal expenses (car, cell phone, home office, entertainment) to be deducted as business expenses before calculating income for income tax purposes, most family law courts will include those deducted personal expenses in the income of the party working at the business.
Let’s discuss a case where the wife owns a business, the business is paying her $100,000 in W-2 income as an employee, $90,000 in K-1 income from distributions as a business owner, and paying $60,000 of car, phone, and housing expenses. The wife’s total income would be $250,000 for calculating support. In addition, the expert has determined that the business is worth $1 million and the husband makes $100,000 a year.
Now the tricky part with a business, is that if we determine it is a marital business and all of the marital assets are being divided equally, the court will not, under normal circumstances, give both parties half of the business. In a divorce, the goal is to separate the parties and reduce future interaction. It would be impractical for them to run a business together. Therefore, the court will give the business to the party who ran the business and will give the other party an asset of equal value.
So, using our prior example, we will say the wife gets the business and the husband gets the house. Both assets are worth $1 million. Now, their assets have been equalized. The question then becomes how is the income from the assets, the house, and the business calculated? The wife might be required to include the income from the business, the distributions, and expenses paid by the business in her income for purposes of calculating support. It is unlikely that the husband will be required to include the housing benefit he receives from the house, (i.e. a $1 million mortgage would cost $11,000 per month or $132,000 per year) in his income for the calculation of maintenance.
Remember, both husband and wife make $100,000 of W-2 income. That alone would mean there would be no maintenance paid by either spouse to the other. The additional $150,000 per year that the wife makes based on her investment of $1 million in a business should not be considered in the calculation of maintenance. Yet, most courts do consider the extra $150,000 per year and in practice often give the husband maintenance from the wife based on those extra earnings. The wife’s attorney needs to be ready to point out the benefit that the husband receives from the house worth $1 million and how much he is saving by not paying a mortgage. The husband also has the opportunity to sell the house and invest his $1 million in an income-producing investment or business.
When a divorce involves a business, it is extremely important for both parties to secure an attorney who is familiar with how businesses are handled in a divorce case, understands the case law and statutes that govern business income, and how to value a marital business.
Michone J. Riewer is an attorney with Strategic Divorce in Lake Bluff, 847-234-4445, strategicdivorce.com.