Divorce for Accountants, Doctors, and Lawyers

Valuing a professional practice

Characterizing and valuing an ownership interest in a professional practice can be a complicated and fact-intensive endeavor. California law generally requires the court to value an interest in a professional practice at fair market value (FMV) at the time of trial unless the parties can agree on a different arrangement. (See Fam. Code, § 2552.) FMV is the price a willing buyer and seller would pay without compulsion. (See E. Division of Community Estate Upon Dissolution, Legal Separation or Nullity, Cal. Prac. Guide Family L. Ch. 8-E.)  

In valuing a professional practice, the court typically looks to the value of “fixed assets” (e.g., any real estate, furniture, office equipment, cash, etc. owned by the professional practice), “other assets,” (e.g., accounts receivable, work-in-progress, and costs advanced by the professional), “professional goodwill,” and liabilities. (See  In re Marriage of Lopez (1974) 38 Cal.App.3d 93, 110.)

The valuation of professional goodwill is often a highly contested issue in cases involving a professional practice. Professional goodwill may be valued and apportioned between the community and the professional’s separate estate. There is no single rule or formula for valuing and dividing professional goodwill. (See  In re Marriage of Lopez (1974) 38 Cal.App.3d 93, 109.) However, some courts have found the “excess earnings” method to be a valid method for valuing professional goodwill. “Broadly put, the excess earnings approach is predicated on a comparison of the earnings of the professional in question with that of a peer whose performance is ‘average.’” (See  In re Marriage of McTiernan & Dubrow (2005) 133 Cal.App.4th 1090, 1095.)  

To value an interest in a professional practice, the court must follow the valuation guidelines set forth by the IRS in Revenue Ruling 59-60. (See, e.g.,  In re Marriage of Hewitson (1983) 142 Cal.App.3d 874, 888.)

Under Revenue Ruling 59-60 there isn’t just one way to value a professional practice. Instead, the valuation may consider a series of factors to determine FMV, including, among other things:

• Historical earnings and financial condition
• The economic outlook for the industry in which the business operates
• Book value
• Goodwill and other intangible value
• Recent transactions for the business’ shares
• Recent transactions for shares in comparable businesses

(See Rev. Rul. 59-60.)

Approaches to valuing a professional practice may include the income approach (e.g., discounted cash flow or capitalization of earnings), the market approach (looking to past transactions for shares in the same or comparable entities), or the asset approach. Determining which approach is best is often highly fact-dependent and requires the expert testimony from a business valuation specialist.  

Having a knowledgeable and experienced attorney who can effectively present the judge with business valuation evidence (which can be dense and jargon-heavy) is extremely important.

Equitable apportionment of a professional practice interest

If an interest in a professional practice is acquired before the date of marriage, it is considered the separate property of the spouse who acquired it. (See Fam. Code, § 770.) However, if a separate property interest increases in value during marriage, the community may acquire an equitable interest in the appreciation. This is referred to as  Pereira/ Van Camp equitable apportionment, named after two important cases on the subject. (See  Pereira v. Pereira (1909) 156 Cal. 1;  Van Camp v. Van Camp (1921) 53 Cal.App. 17.)

If it is determined that a spouse’s labor primarily caused the business to appreciate in value during marriage, then the court may employ the  Pereira approach. Under the  Pereira approach, the court may divide the appreciation by awarding the operating a return on the value of the professional practice at the date of marriage at a “well secured” rate as their separate property, with the balance of the appreciation apportioned to the community. (See  Pereira v. Pereira, supra, 156 Cal. at p. 7.)  Pereira apportionment is generally favorable to the community.

However, if the judge finds that factors other than a spouse’s marital labor primarily caused the professional practice to appreciate (e.g., market forces or the labor of others within the professional practice), then the court may use the  Van Camp approach. Under the  Van Camp approach, the community is apportioned the reasonable value of the operation spouse’s services, while the operating spouse is allocated the value of the balance of the appreciation in the professional practice’s value during marriage. (See  Van Camp v. Van Camp, supra, 53 Cal.App. 24-25.)  Van Camp apportionment is usually favorable to the professional practitioner.

The court has wide discretion to apportion appreciation in a professional practice equitably and is not limited to either the  Pereira or  Van Camp approach. (See  Beam v. Bank of America (1971) 6 Cal.3d 12.) Having a knowledgeable attorney who can persuasively apply the facts to the law and present a compelling apportionment case to the court is important.

Buy/sell agreements

If the professional practice has a buy-sell agreement, it may specify how interests are to be divided in the event of a divorce. Common buy-sell provisions may restrict how the practitioner’s interest is divided upon divorce. They may also require either the business and/or the titled interest holder to buy out the non-employee spouse’s interest in the professional practice. In such cases, a business valuation may be necessary.

Retirement accounts

A professional’s defined contribution plans like 401(k)s and defined benefit plans (pensions) may need to be specially divided by what’s called a qualified domestic relations order (QDRO). For other types of defined contribution plans like IRAs, a QDRO may not be necessary.