Forensic Perspectives : New York Business Valuation, Litigation Support & Accounting Forensics in Connecticut, New Jersey & Long Island NY

I often tell of my first experience as an expert witness in a matrimonial matter. At that time there was not a plethora of literature that addressed the search for omitted income or hidden assets. Much of what we now call forensic accounting was performed intuitively by those of us with strong auditing backgrounds.

The “money spouse” was in a family business. Income, sales, and payroll tax returns were all filed on time and appeared to be complete and accurate. The problem appeared when the reported income (net of income taxes) was compared to the ordinary living expenses on the “non-money spouse’s” Certified Net Worth Statement.

As you probably guessed, the expenses greatly exceeded the funds earned and available to pay these expenses. Now that the red flag has been raised, two obvious questions emerged; (1) Were the expenses listed on the net worth statement actually paid or merely the non-money spouse’s wish list?; and (2) Were there other sources of funds such as increase in loans and/or credit card debt, distributions from other entities, receipt of gifts, etc. to account for this difference.

Truth be told, you don’t necessarily need to be an auditor or forensic accountant to smell a thief. However, to catch the culprit red handed you need the skills of a gumshoe. This article is designed to provide attorneys with a road map to identify those possible treasures found within tax returns.

Business tax returns report the assets, liabilities, equity, revenues, and expenses of an entity. The balance sheet primarily lists the historical cost of what the entity owns (assets) and its obligations (liabilities). Assets are those items that have economic value or which are used in the ordinary course of business. These are also commonly referred to as the business’s resources. Examples of assets are cash, inventory, fixed assets, and real estate. Liabilities represent amounts owed. Examples of liabilities are amounts due to vendors and suppliers, mortgage/loan obligations and other debts.

When analyzing the balance sheet of a business one should verify that these assets and liabilities are truly business related and not personal. Examples of personal assets hidden within the confines of a business commonly include automobiles, real estate, investments and other tangible assets. A good start in this analysis is to request a detailed fixed asset schedule and then identify what assets are actually being used in the normal course of business. Don’t forget to look for other assets identified within the balance sheet. Potentially, any excess assets identified may be personal.

Liabilities should also be considered. Recorded and paid debts should be verified to insure that they relate to the business. The payment of obligations can be easily traced to its source. If payments are being made, then an asset or benefit should exist. You may even identify debt payments where an asset is not apparent or recorded.

The income and expense sections of tax returns are also rich sources of information. However, the devil is in the detail. There are two common ways to identify personal expenses. First, compare expense categories year by year. Spikes and valleys within the same category commonly detect personal spending. Second, obtain grouping schedules and transaction listings for deductions taken. Identifying vendors, suppliers, and other payees often highlights those that may not be business related. The Treasury calls these non-deductible expenses, the forensic accounting community frequently refers to them as discretionary items. Expense categories that commonly contain such items are travel, meals, entertainment, automobile, and miscellaneous.

Further analysis can also identify hidden assets, such as real property. A review of the utility and real estate tax payments may uncover property not otherwise known. But these items may not necessarily be found only within the expense detail of tax returns. Amounts paid on behalf of the business owner may be recorded as a dividend distribution, loan payment or even salary. In these instances, the true nature of the disbursement can be easily disguised.

Personal income tax returns can also serve as an investigative tool. A review of itemized deductions can be very informative. For instance, a deduction for investment management fees can lead to the discovery of an undisclosed investment portfolio. Since such fees are commonly based upon the principal value of the portfolio, this amount may be reasonably estimated. And don’t forget about the miscellaneous deduction for the safe deposit box rental. Unfortunately, you won’t know what assets are kept there until you open the box.

A review of the pass-through entities on Schedule E, Supplemental Income and Loss, can also be informative. Schedule E lists the income and losses attributed to ownership interests from business entities. Bank and brokerage accounts appear on Schedule B, Interest and Dividend Income. What may be the most important observation in analyzing Schedules E and B are the change in their components from year to year. The change in bank, brokerage, and investment accounts may be an indication of money being moved.

Another item to note is the change in interest and dividend income. This may reflect a change in returns on investment or the alteration of principal investment. You may also want to trace the proceeds for the sale of stocks and investments. These transactions are itemized on Schedule D, Capital Gains and Losses on Form 1040.

The paths on which business and individual income tax returns take you may be limitless. Although this process may be an expensive task, more times than not it provides an insight to a couple’s finances that may otherwise go undetected. Hopefully, this blog will make you aware of the potential issues you may encounter and how you may want to address these matters with your client.

I will be lecturing on this topic, “Finding Hidden Treasures In Tax Returns” at the upcoming annual conference sponsored by the Association of Divorce Financial Planners (CDFA) this fall.  Please visit their website for registration information.

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Since our last blog was published, the New York State Assembly gave final passage on July 1st to no-fault divorce, clearing the way for New York State to allowing couples to end their marriages quickly when one spouse believes the union is over. The new measure, which requires one spouse to swear under oath that the relationship has broken down irretrievably for at least six months, is the final piece of a legislative package enacting the most sweeping changes to the state’s divorce laws in 40 years. This final legislative approval comes after what one member of the Assembly called “an awfully long and hard battle.” The bills now await Governor Paterson’s signature.

No-fault divorce has long been opposed by the Catholic Church, with the view that the legislation would make divorce easier; feminists argued that no-fault did not address the concerns of poorer women. The National Organization for Women of New York State has found itself on the same side of the issue as the Church, although the New York City chapter of NOW supports the legislation.

Marcia Pappas, president of the New York State chapter of NOW, has written recently, “No-fault can take away the bargaining leverage of the non-moneyed spouse—and that is usually the woman….In fairness, any partner to a marriage should be provided with notice that the other partner wants a divorce and given an opportunity to negotiate the terms for the divorce. Often, there is fault with ‘divorce on demand,’ not only can the more moneyed spouse begin hiding assets (which happens even under our current laws), but this spouse can proceed quickly with legal actions before the other spouse, with limited means, even has the time to find and hire an attorney.”

Until 2004, the Women’s Bar Association has also objected to no-fault divorce. But as Annette G. Hasapidis, co-chairwoman of the association’s legislation committee has said, “We came to the realization that forcing one party to either admit or be found at fault in the deterioration of a marriage provides no economic or other advantage to either party. And more importantly, it harms the children of the marriage.” The concern of advocates for women that there would be difficulty receiving appropriate alimony or child support was considered unsupportable by the Women’s Bar Association.

Both supporters and opponents have concerns regarding the creation of a formula that computes alimony. This mechanism, however, is intended to alleviate the conflict and legal jockeying commonly associated with the determination of spousal maintenance.

The Honorable Sondra Miller, currently Chief Counsel of the White Plains law firm McCarthy Fingar, has been advocating for an amendment to allow no-fault divorce for many years. Recently, we had the opportunity to interview Judge Miller for our podcast on this historic legislation. Some of the key questions she thoughtfully addresses include: Why is no-fault divorce still a hot-button issue for politically liberal groups, religious groups and even among certain members of the legal community? Why has it been such an uphill battle for New York legislators to simplify New York State's divorce laws? Is it possible to measure the impact on children without no-fault divorce?

Please visit our Web site www.msgcpa.com to hear our edifying podcast interview with the Honorable Sondra Miller.

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Forty years ago, no-fault divorce was a controversial topic. Among the arguments made against it was that the full-time homemaker would lose leverage if unilateral divorce became a reality. But the American household has changed considerably over the years: more and more, two-parent earner households are the norm, and the working mom/stay-at-home dad model has become commonplace. Since 1969, when Gov. Reagan signed the nation’s first no-fault divorce law, the country has gradually fallen into place with no-fault divorce legislation—except for New York State.

But that seems about to change. On Tuesday, June 15, the State Senate’s Democratic Majority passed a legislative package that seeks to finally end New York’s status as the remaining state without no-fault divorce. The No-Fault Divorce bill restructures New York State’s matrimonial law to streamline the process and improve the outcome of divorce for New Yorkers. The bill, approved 32-29, would allow no-fault divorce after a marriage has “irretrievably” broken down for six months or more and after all financial and custody issues are resolved. The legislative package must still pass the State Assembly, which is considering two bills that would adopt some version of no-fault divorce.

Senator Ruth Hassell-Thompson, a Democrat from Westchester and the Bronx who was chief Senate sponsor of the bill, said after the vote, “What I’m hoping is that because the Assembly now has a partner in the Senate, that will give impetus to help the Assembly move along.”

Under current law, New York couples who want to divorce must fault their spouse on specific grounds, such as adultery or cruel and inhuman treatment. Otherwise, couples must legally separate for a year before being allowed to file for divorce. Proponents of no-fault divorce say a great deal of time and expense—often beyond the means of a spouse—is wasted on legal fees, making a difficult situation considerably worse. The New York Senate legislation—S3890—would permit spouses unilaterally to initiate divorce proceedings in which the court rather than the parties will resolve issues such as property division, alimony, child support and custody.

There have been many concerted efforts over the years to change New York State’s divorce laws, but to no avail. In 2006, for example, a panel appointed by Judith S. Kaye, then New York State’s chief judge, urged a major overhaul of New York’s divorce and child custody rules—including allowing, at long last, no-fault divorce. But opponents, including the National Organization of Women, the Catholic Church and, until 2004, the Women’s Bar Association of the State of New York, objected to change in the law because, among other reasons, it would raise New York State’s divorce rate and hurt women financially.

Perhaps now, after decades of opposition, and the passage of the legislative package by a slim margin, divorcing spouses in New York State will finally be able to avoid the costly litigation and seemingly endless custody battles that have become all so common when a marriage irrevocably ends.

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On Wednesday, June 9, 2010, John Jay College, the New York State Council on Divorce Mediation, and the Family & Divorce Mediation Counsel of Greater New York sponsored a panel discussion on the Proposed Maintenance Guidelines. The panel was comprised of three attorneys, Steven Abel, Esq., Alton L. Abramowitz, Esq., Emily Ruben, Esq. and forensic accountant and business valuation expert, Mark S. Gottlieb, CPA. The program was moderated by Rod Wells, CFP.

While the panel and the audience primarily agreed the intent of the proposed legislation has merit - there was some concern whether the proposed legislation addresses the need of a mechanism to calculate maintenance awards.

Emily Ruben, Esq. (Attorney-in Charge of the Brooklyn Neighborhood Office of The Legal Aid Society) pointed out that many couples going through a divorce do not have substantial assets to divide and that their greatest asset of the marriage is frequently the income of the more-monied spouse.   That being said, moderate and low-income spouses usually cannot afford the often costly litigation required to establish a right to maintenance.

Considering the unpredictable and inconsistent climate of maintenance awards, the less-monied spouse will usually settle, albeit under some pressure, to avoid costly litigation.

The New York legislative houses are each considering possible legislation to establish guidelines for post-marital income sharing not dissimilar to the Child Support Standards Act. By establishing guidelines for both the amount of maintenance to be awarded and the duration of the award, post-marital guidelines would provide the consistency and predictability for spousal support that the Child Support Standards Act has provided for child support.

So we are prompted to ask: Is this Bill a long-awaited solution? Is it indeed the new approach consistent with Chief Judge Judith Kaye’s call for a “cultural revolution” to reduce drastically the time and costs—both financial and emotional—of matrimonial cases?

Senator Hassell-Thompson, who introduced the Bill in the Senate, has said, “Neither spouse should feel financially compelled into accepting potentially detrimental or unfair settlements. Post-marital income guidelines will simplify the basis on which a predictable and equitable settlement between two divorcing spouses may be reached.”

According to Senator Liz Krueger, “As it is, divorce is a very emotional and painful process, the State should not be making it more difficult through antiquated laws and a lack of guidance to our courts. As legislators, if we can help people during this difficult time by improving the process and making it easier for them to get on with their lives, then we need to explore these options.”

Many agree with these Senators’ views on setting guidelines. Currently, trial courts have broad discretion in deciding whether to award maintenance and in determining its duration and amount. It’s for this very reason that spousal maintenance often becomes one of the most contested issues in divorce proceedings.

“The real battleground for financial issues,” Catherine J. Douglas, Executive Director inMotion has said, “is maintenance (formerly called alimony), for which outcomes are troublingly unpredictable and inconsistent. A spouse who may well be entitled to substantial maintenance and who may badly need this income for basic economic security has two choices: engage in the ritualized battle that is litigation or abandon the claim for maintenance altogether.”

The goals of the proposed guidelines recognize that marriage as an economic partnership.  However, as Steven Abel, Esq. (founding member and President of the Board of Directors of the New York State Chapter of Association of Family and Conciliation Courts) stated, “the devil is in the details.”

To achieve a fairer version of what is now called maintenance, a formula will be used to arrive at a presumed award amount, and a second formula will be used to determine how long this amount will be paid. Judges can vary the formula results when the amounts seem unfair for specific cases.

The amount of the post-marital award will depend on the incomes of the divorcing spouses. In practice, their post-award incomes will range from a 30%-70% split of combined income (when one spouse has no pre-award income) to a 40%-60% split of combined income (when pre-award incomes are closer to equal). The divorcing parties can present reasons for deviating from the guidelines.

Post-marital income payments would be tax-deductible to the payor and taxable to the payee. As a result, the after-tax income for spouses making payments under the post-marital income guidelines will actually be higher than the 60%-70% of combined income and lower than the 30%-40% of combined income for spouses receiving payments.

Judges can vary the required time period for payments if deemed necessary. Suffice to say, the longer the marriage of the divorcing couple, the longer the post-marital payments will last.

Not all divorcing couples, however, will use the proposed guidelines. Couples with combined assets over $1,000,000 will have their cases resolved differently since marital assets are likely to include much more than the future ability of the former spouses to earn income—including significant property that will subject to equitable distribution.

The guidelines would help those who do not have the means to pay for lengthy, expensive divorces. Under the existing law, it is so difficult to make a claim for maintenance that the majority of lower-earning spouses from low and middle income families simply give up claims for maintenance.

One of the more controversial aspects of the current New York law is the assumption that all a spouse requires after a marriage, no matter how long its duration, is a brief period of “rehabilitative” maintenance. But even a short time out of the labor market has repercussions. And for older individuals who have not been employed for years at a time face rather bleak prospects in the labor market.

Still, there are those distinguished members of the legal community who feel that the proposed changes are problematic. In a series of articles for the New York Family Law Monthly, Alton L. Abramowitz, Esq. (partner in the law firm Mayerson Stutman Abramowitz, LLP) has written that, among other things, the proposal does not constitute a comprehensive approach to reforming the current equitable distribution law; rather it alters one aspect of the law without considering the overall effect on each party.

Mr. Abramowitz also says that it is readily apparent that this is not a proposal for support of a spouse following a divorce, but is disguised “wealth distribution” or, even worse, “compensation” for having been married.

So is the possible legislation to establish guidelines for post marital income sharing a long overdue “just due,” especially for those many litigants who have no real choice. Or, in Mr. Abramowitz’s words, would the legislation create “mischief of untold proportions” by tinkering with discrete portions of the financial aspects of our divorce laws—without making adjustments to the other aspects of those laws—so as to allow a court to piece together all of the parts in an equitable fashion?

After each attorney on the panel provided their comments on the proposed bill, Mark S. Gottlieb, CPA provided a calculation template he designed to compute the maintenance award as prescribed in the existing bill. This exercise, as well as the comments from the members of the panel, made this program both informative and practical.

We will continue to keep a watchful eye on the progress of this bill, as well as comments offered by its supporters and critics.

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In recent years, we have seen an increasing number of cases dealing with palimony filed in the New Jersey courts. Palimony has long been based on the law of contracts, where an oral promise can be enforced if a party relies and acts on it to their detriment. But a new law came into being during the last days of the Corzine Administration, requiring that in order for a palimony agreement to be enforceable, it must now be in writing and be executed with the independent advice of legal counsel.

Recently, forensic accounting expert, Mark S. Gottlieb,  met with Stephanie Hagan, a Family Law attorney and Partner in the firm Donohue, Hagan, Klein, Newsome and O'Donnell PC, to discuss the enactment of the Statute and its effect on couples. Both of these professionals have extensive experience in matrimonial and family law matters.

Although early palimony decisions found that cohabitation was a necessary element in a palimony action, this concept was eventually overruled by the New Jersey Supreme Court in 2008 when the Court ruled in Devaney v. Esperance .  In this case cohabitation was no longer a required factor. The Court found that a marital-type relationship is essential to any palimony claim; however, cohabitation is not essential to a determination of a marital-type relationship.  In many instances married couples may be separated by employment, military, or educational opportunities. Hence, not all married couples live together on a full-time basis.

According to Ms. Hagan, there is no doubt that the L'Esperance decision was the catalyst for the Legislature in passing the new law. Effective January 2010, the law requires all "promises" of support to be made in writing. As a result, many people who have entered into a long-term committed relationships without being married may find themselves in financial jeopardy.  Ms. Hagan emphasizes this issue for those of modest means. Without recourse, many individuals, regardless of financial capacity, may find themselves vulnerable when living with someone without a written agreement..

These written agreements are still considered "contracts" between two parties and can be held invalid for any number of reasons--including being "unconscionable" or "void" as against public policy. The legislation also says the written promise will not be binding unless it was made with independent legal advice for both parties.

To learn more about the new palimony law in New Jersey, please listen to Mark S. Gottlieb's  podcast with Stephanie Hagan.

We welcome your thoughts and comments on this issue.

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Over on New Jersey Family Legal Blog, I saw a post that editor Eric Solotoff, a family law attorney at Fox Rothschild wrote that struck my interest.

Upon reading the post, Madoff Mess Hits Divorce Court, I knew I had to sit down with Eric for a podcast, to discuss what all this means in respect to forensic accounting.

For context, Justice Saralee Evans in Manhattan recently decided on a case regarding a divorcing spouse who attempted to revise his agreement with his wife.

First, some background for our readers who may not be that familiar with the case:

After thirty years of marriage, a husband and his ex-wife spent nearly two years debating the value of their home in Scarsdale, The husband's law partnership, and their Manhattan apartment. The two agreed on at least one thing: an account they opened during their marriage with Bernard Madoff Investment Securities LLC was worth $5.4 million.

As part of a 2006 equitable distribution agreement, the husband claimed he paid his wife some $2.7 million, which represented what he thought was his ex-wife's fair share of their investments with Madoff. But after Madoff's arrest in December 2008, the husband attempted to redo the agreement, claiming it was based on a "material, mutual mistake" and resulted in a windfall for his ex-wife.

After the husband learned that he and his wife had "been tricked by a sophisticated fraudster," he sought to reform the divorce agreement. The husband claimed the agreement did not accomplish the parties' goal of ensuring that each would keep approximately half of the marital assets.

The husband alleged that because the Madoff account turned out to be valueless, the spirit of the agreement was broken. But according to Justice Evans, there was no evidence that defendant was unjustly enriched.

Justice Evans last December held that while the husband's decision to hold on to the Madoff account may have been "improvident," that did not give the Court an equitable basis to set the agreement aside. In dismissing the suit, Justice Evans wrote, "There is no evidence that defendant was unjustly enriched. In 2006, at the time of their agreement, each of the parties received the benefit of his or her bargain."

Justice Evans rejected the husband's argument that the mutual releases of both parties signed as part of their divorce agreement were based on a mutual mistake. The husband had liquidated part of his Madoff investment to fund his wife's equitable entitlement. So in 2006, and several years after, that the husband maintained this investment, the account could have been redeemed for cash, presumably in excess of its 2004 value. The wife's attorneys said Justice Evans' ruling underscored the importance of ensuring that both sides in a divorce agreement waive future claims against each other.

The lesson of this case is that clients and their divorce attorneys should be very careful in fashioning settlement agreements. Even when significant mistakes are made at the time the agreements are entered into, it's very difficult to set them aside--even in such extreme circumstances as being a victim of a historic scam.

To learn more about this decision please listen to our podcast with Eric.

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Since the Federal Rule of Civil Procedure 26 was last amended in 1993, it has required parties to submit expert reports for all testifying experts. Those amendments have been interpreted by some courts to allow discovery of all draft expert witness reports and all communications between counsel and testifying expert witnesses. In the view of many litigators, the experience under those changes revealed significant practical problems.

Allowing such broad discovery significantly expanded expert discovery; it also irrevocably led attorneys and experts to take counteractive measures. However the steps taken to avoid creating discoverable drafts or communications has predictably resulted in inefficient and costly litigation. According to Charles S. Fax in Litigation News, Rule 26, “has bedeviled lawyers in dealings with expert witnesses. However, proposed amendments promise to resolve the difficulties caused by the present rule.”

These proposed amendments, the first major revision in nearly two decades, are to take effect in December of this year. No longer would Rule 26 allow full discovery of draft expert reports and require broad disclosure of any communications between an expert and trial counsel. Instead, those communications would come under the protection of the work-product doctrine. The amendments specifically extend work-product protections to drafts of both expert reports and expert party disclosures under Rule 26, and to attorney-expert communications.

With the prohibition of discovery about who said what to whom—a matter of no interest to jurors—depositions would now be allowed to focus on the expert’s analysis of the case. What will still be allowed, however, would be full discovery of the expert’s opinions and of the facts or data used to support them.

Plaintiff and defense lawyers agree on the need to apply work-product protection to expert draft reports, and that the revisions are an important step towards reducing the cost and contentiousness of litigation. Interrogating an expert about his or her conversations with counsel and prior report drafts is regarded by many as an utter waste of time. No longer would attorneys and experts feel compelled to avoid written communications; and well-funded litigants would no longer hire two sets of experts—one to consult in case development and the other to testify.

Congress has until December 1, 2010 to override the change, and if that does not happen, it becomes law on that day.

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As most forensic accountants and business valuators know, post-acquisition disputes between an acquirer and target company are on the rise. These conflicts can be disruptive, time-consuming and expensive. To help in successfully resolving a dispute, the post-acquisition advisor needs to be extremely well versed in accounting, business valuation, economics, finance and litigation. In times when bank failures and bankruptcies are not uncommon, resolving post-acquisition disputes can be a formidable challenge.

The most common disputes involve post-closing adjustments for working capital or net assets, indemnity or fraud claims, and earnout disputes. In a dispute involving both working capital and indemnity claims, for example, working capital claims are typically measured on a dollar-for-dollar basis while indemnity claims can be measured dollar for dollar, over a finite period or into perpetuity.

The measurement of damages into future periods is predicated on assessing whether the misstatement will affect future periods; the buyer’s expectations were based on future performance; the business was significantly devalued after the acquisition; and the misstatement would have been “material” to a “willing buyer.”

Potential disputes in mergers and acquisition transactions can often be just as complex as the deals themselves. It is the acquirer that instigates a dispute on the grounds that it’s unable to complete the deal because of financial shortfalls, although there are exceptions.

In a 2009 roundtable discussion published in Financier Worldwide, one participant commented:

“The economic downturn has significantly increased the number of commercial disputes, and it has changed the nature of dispute resolution. Where once parties could resolve their differences through negotiation because they sought to preserve an ongoing business relationship, they are now realizing that there is not a next transaction on the horizon, so that litigation and arbitration, as opposed to mediation or reconciliation, become more likely.”

Throughout history we have seen that challenging economic times inevitably lead to a significant rise in conflicts between organizations. In attempting to resolve post-acquisition disputes, even the financial expert comes to terms with the fact that there is a finite amount of ways to resolve it, and each approach has its benefits and downsides.

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I recently sat down and did a podcast with Leonard Florescue, a family law attorney at Blank Rome LLP, who advises clients primarily in complex matrimonial matters. We discussed the role parenting plans play in the divorce process.

Among the most important aspects of family law are custody and parenting plan issues. The family law practitioner is expected to take great care to work with his or her clients to create a viable parenting plan, which is an agreement between parents, who are either divorcing or who have never married.

In the simplest terms, a parenting plan establishes who will spend time with the children and when and under what circumstances. The parenting plan also determines who makes the major decisions about education, medical care and other important issues.

A good parenting plan is necessary in promoting harmony and alleviating stressful situations for both parents and children. There can be serious repercussions when parents have either a poorly though-out parenting plan or no plan at all.

In an organizational or government hierarchy, there's a single person or group with the most power and authority, and each subsequent level represents a lesser authority. Parents must create a "hierarchy" of their own.

Time sharing is often a very stressful topic for parents. When outlining shared parenting schedules, parents must try their best to avoid potential areas of stress.

It's also advisable for parents to create a formula for the events they are anticipating for the first years of the parenting plan's existence.

I know parental death is a subject a lot of parents don't want to consider, but we're all mortal, and one or both parents may die during children's minority. By incorporating clauses in a parenting plan that address times of tragedy in a family as the passing of a parent, conflicts over relatives spending time with the children can be pre-empted.

When the parents, for whatever reasons, can't agree to a mutually agreed parenting schedule, the final arbiter in this situation is the Court.

To learn more about parenting plans, please listen to our podcast with Leonard.

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