Valuing the S Corporation for Divorce Purposes: A Review of Bernier v. Bernier
By: William C. Herber
Introduction
The issue of how to value S Corporations has beleaguered appraisers for many years, especially since Gross v. Commissioner (affirmed by the 6th Circuit in 2001). The decision in Bernier v. Bernier, 2007 Mass. (May, 2007) is of particular note and interest in that it generally follows and references Delaware Open MRI Radiology Associates v. Kessler in its methodology of valuing S Corporations. In the original divorce case, the judge ruled to accept the valuation of the husband's expert in its entirety; the wife's experts appealed. The appeal is framed in this manner: Is it proper to discount the value of an S Corporation by "tax affecting income at the rate applicable for a C Corporation?" In this case, the court clearly noted that the shareholders of an S Corporation enjoy the benefit of avoiding the "double taxation" of corporate dividends that are the hallmark of the C Corporation. Although the biggest issue on the table was how to measure the benefit to the shareholders of an S Corporation over a C Corporation, the appeal also focused on several items of lesser importance: the use of fair value or fair market value for the standard of value; the "key man" discount, the lack of marketability discount and the application of an appropriate rate of growth.
Brief Overview of the Case
In order to understand the significance of this case, it is useful to review the general facts, point out the areas of agreement and focus on the areas of disagreement. Stephen and Judith Bernier were married in 1967. During their marriage, the couple acquired a fair amount of real estate (commercial, residential, and undeveloped properties). In the process, they moved to the Martha's Vineyard area where their S Corporation stores (owned jointly and equally by the two of them) became quite lucrative. After 23 years of marriage they filed for divorce. The couple agreed to the majority of the court's rulings on the division of marital property. However, the wife's appraiser and the husband's appraiser concluded widely different values for the supermarket enterprises. A summary of the main points of contention follows.
Tax Consequences and Value
In Bernier, determining the tax consequences of transferring company ownership to the husband for divorce purposes is no easy task. All parties involved recognized that there are tax consequences, but there is no universally accepted formula for arriving at the value upon which those taxes are based. It is generally accepted that the income approach to value is one of the better ways to determine the value of a business enterprise. Because the Berniers established the two supermarkets as S Corporations, S Corporation rules define the tax consequences for business purposes: the burden passes through to the individual shareholders at their respective rates; there is no corporate tax at the Federal level. The Court stated that the S Corporation election provides a clear benefit to shareholders for business purposes. The relationship of that benefit to value presents a dilemma when dividing marital assets.
A brief overview of the differences between C and S Corporations is essential to understanding the Bernier case. S Corporations are pass-through entities which have specific ownership criteria and tax consequences. There can be no more than 100 shareholders in an S corporation - consisting only of individuals, estates and certain trusts. The entity does not pay taxes at the corporate level; rather, the company earnings are passed through the corporation to the individual owners and are taxed at each individual shareholder's rate. The S election is generally useful for small entities. However, larger businesses (over 100 shareholders or owned by another corporation, etc.) must elect C Corporation status. The hallmark of the C Corporation is that the earnings are taxed twice. At the Federal level, the company pays taxes on its profits. Profits are distributed to the shareholders who then pay taxes on the distributions at their individual tax rates.
For divorce purposes, it appears that valuing a company on the basis of its corporate status alone gives unfair advantage to one party while penalizing the other. Figure 1 shows the dramatic difference in value between tax-affecting and not tax-affecting. It also indicates how important it is to use more than one approach when determining value. Using a market approach would have shown that there is little, if any, premium for S corporations. A rigid application of the tax rules for an S Corporation (no tax is computed in the discounted cash flow model), results in a value that inflates the rate of return for the husband (retaining owner) and fails to account for the loss of those benefits to the involuntary seller (wife). If C Corporation tax guidelines are used, the value of the business entity is artificially lowered (corporate tax rates are used in the discounted cash flow model) - favoring the husband and reducing the value of the wife's interest and ultimately the amount of compensation she receives.
Why Tax Affect?
The husband's expert (Horvitz) valued the subject supermarkets as if they were C Corporations and concluded that they were worth $7.85 million. The wife's expert (Leicester) valued them as if they were S Corporations arriving at a value of $16.4 million. On appeal, the judge found fault with both methods, ruling that each value was extreme and neither was appropriate. He cited the Delaware Chancery Court's decision in Delaware Open MRI v. Kessler as evidence that a more reasonable value lies somewhere in the middle. Figure 1 summarizes the techniques used by the three appraisers: Horvitz, Leicester, and Kessler. Clearly, it is necessary to tax affect, but not at a rate of 35%.
For sale purposes, appraisers rely on the standard of fair market value to determine the value of a business. All other things being equal, it is the price a willing buyer would pay a willing seller when each has a basic knowledge of the market as well as the expectation of a reasonable return on his/her investment. However, in valuations for divorce purposes, where the issue is the equitable division of marital assets, the standard of fair value may be more appropriate because the husband and wife are not in the same position as willing buyers and sellers. Marriage dissolutions are essentially "forced" sale situations. Therefore, the parties do not meet the "arm's length" requirement for a fair market value transaction.
Stephen Bernier had no intention of selling the supermarkets; retained his position as CEO; expected the business to remain profitable and planned to distribute earnings to cover expenses and taxes in the same manner as he and his wife had done in the past. The only difference in the business entity on the date of valuation and the date of the divorce agreement is that the husband would become sole owner and shareholder while the wife would receive, as compensation for her ownership rights, one half of the value of the business. The appraiser and the lawyer must verify the standard of value used for marriage dissolutions within that jurisdiction; the applicable standard of value varies from jurisdiction to jurisdiction.
Discounts and Adjustments
Value is dependent upon the continuation of the business as a going concern. Sales and transfers of business assets are frequently affected by changes in management, loss or gain of a client data base, limitations on control of decisions, and the market itself. The use of discounts or premiums in the valuation process allows the appraiser to address these factors. In this case, the disagreements regarding discounts revolve around the use of a "key man" discount; a marketability discount and the growth rate.
Key Man Discount
The "key man" is someone who is deemed crucial to the continued success and profitability of the business enterprise. His or her loss would likely result in significant losses to the company. The judge allowed a "key man" discount of 10% even though the husband stated not only that he intended to maintain his position as CEO and run the business in the same manner as before, but also that he had recently declined an offer to sell his stores to a national chain of supermarkets. On appeal, the court notes that applying a "key man" discount is not appropriate in this case and doing so arbitrarily reduces the apparent value of the business. The husband's role, while critical, is not unique nor is he "irreplaceable".
Marketability Discount
Marketability discounts serve to account for the fact that control, in partnerships, is based on the percentage of ownership. The business lacks liquidity - no one owner has the right to sell the company as a whole, thus the marketability of a company is hampered by the willingness of the various shareholders to sell. In this case, there was no anticipated sale; the wife was willing (as well as financially positioned) to purchase her husband's share in the business; and there was public knowledge of at least one comparable sale in which a smaller supermarket, in the same area, sold for a higher price than that determined by the opposition's appraiser for the subject business. The application of a marketability discount, despite the owner's intent to continue business as usual, unfairly deflated the value of the asset.
Growth Rate Adjustment
These upscale supermarkets were very profitable businesses. Although revenues had declined somewhat, there was no indication that they would fail to keep pace, at the minimum, with inflation. In this case, the 2.5% growth rate premium suggested by the wife's expert was more than justified. If one uses a zero growth rate when calculating the value of the subject business, the resulting value does not accurately reflect the historical financial status of the company and artificially reduces the amount of compensation due to the wife.
Discount and Adjustment Summary
On appeal, the court concluded that the business shareholders (husband and wife) should not be viewed as participants in a theoretical open market transaction, but rather as fiduciaries entitled to an equitable distribution of the 50% interest. Discounts for marketability or costs of a sale were not allowed because no sale was imminent, or even anticipated. Thus, it is inappropriate to take any of the above discounts in the Bernier case. An upward adjustment to value is indicated due to the continued profitability of the two supermarkets. At the minimum, a 2.5% growth rate based on inflation is warranted because historical earnings indicate that the business made money each year - even though the rate of growth was variable.
Trial Judge's Ruling
The trial judge has the latitude to accept one expert's reasonable method over another's or disallow both, relying on an alternate method of determining value. As long as the facts of the case are supported and the requirements of the matter at hand are recognized, any reasonable opinion on the judge's part is allowed. It is interesting to note that the appeal judge disagreed with the original decision on all counts and remanded the case to the lower Court for review.
Conclusion
Valuing S Corporations is complex - not only are the methods difficult to understand, they are often inappropriately applied. However, we now have two cases which conclude that the method used in Gross v. Commissioner (no tax affecting is necessary) is not appropriate. Secondly, using all three approaches to value, rather than just the income approach provides a more accurate picture of an entity. It helps the courts recognize the enhanced or non-enhanced S Corp value and confirms that the larger income stream (the result of not paying taxes at the corporate level) should not be considered in the same light as the bottom line number in Figure 1. Finally, fair value standards (if they exist) vary from state to state and do not address the issue of fairness in the context of divorce. Keep in mind that methodologies appropriate to other valuation situations may not work in the divorce setting.
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