In California, a business or professional practice owned by one or both spouses should be valued to determine the community property interest which is then divided between the spouses upon a divorce.
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Business allocation begins by valuing the business to estimate the economic value of an owner’s interest in a business or professional organization. Evaluating a business or professional organization may be necessary during a divorce so that both parties fully understand the economic impact of the investment.
Business valuations are used by financial market participants to determine the price they are willing to pay or receive to affect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, a forensic accountant may be necessary as the joint expert doing the business valuation.
Business Allocation of the Community Interest
A business allocation may be needed to determines the value of separate property business and what portion is community property. During a marriage when one spouse owns a business that was started before marriage, the other spouse may be entitled to share in the community interest created by the increase in value. Courts may do a business allocation using the Pereira formula, the Van Camp formula, or a combination of the two formulas.
The potential business allocation is based upon statutory law that provides that while a party’s earnings during the marriage are community property, the earnings of a separate property asset are separate property. If a spouse contributes substantial effort (community property) to his business (separate property) the community must be reasonably compensated. If the business does not increase in value during the marriage, there is no value to allocate. Any allocation is in the form of a reimbursement, not in the form of an ownership interest in the business itself.
If the increase in value is due primarily to the efforts of the owner-spouse, California family law courts generally apply the Pereira formula for a business allocation. This formula gives the owner-spouse a reasonable rate of return on the value of the separate property business, as it existed on the date of marriage. The remainder of the increase in value is allocated to the community in the form of a reimbursement. This formula is often applied to personal service businesses, professional practices and businesses that increased in value as a result of the work, skill and talent of the operating-spouse.
Van Camp formula
If the compensation of the owner-spouse and distributions received by the community from the separate property business exceeded the value of the owner-spouse’s contributions to the business (reasonable compensation), then the community has been made whole and it has no right to reimbursement relative to the increase in value of the separate property business under the Van Camp formula.
This approach analyzes whether the community was reasonably and adequately compensated for the work, effort and skill contributed to his or her separate property business. If the compensation was not reasonable and adequate, the community may be awarded a sum equal to the amount of under-compensation. Additionally, the divorce court may consider any distributions made by the separate property business to the community during the marriage as either reducing the amount owed to the community for under-compensation or in the determination of whether the community was reasonably and adequately compensated for the work, skill and effort of the owner-spouse. In other words, a court may find that the owner-spouse’s compensation was a combination of his or her compensation and the distributions received by the community.
The Van Camp formula is often applied to capital intensive businesses. It may be applied where the increase in value was not due primarily to the work, skill and talent of the operating-spouse. The court will look to whether the increase in value was due, in part, to the industry, existing momentum, unique competitive advantages, patents, a monopoly, legislation, a world class management team or other market factors.
Business Valuation Methods
- Fair market value – a value of a business enterprise determined between a willing buyer and a willing seller both in full knowledge of all the relevant facts and neither compelled to conclude a transaction.
- Investment value – a value the company has to a particular investor. Note that the effect of synergy is included in valuation under the investment standard of value.
- Intrinsic value – the measure of business value that reflects the investor’s in-depth understanding of the company’s economic potential.
- Going Concern – value in continued use as an ongoing operating business enterprise.
- Assemblage of assets – value of assets in place but not used to conduct business operations.
- Orderly disposition – value of business assets in exchange, where the assets are to be disposed of individually and not used for business operations.
- Liquidation – value in exchange when business assets are to be disposed of in a forced liquidation.
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