An Attorney's Guide to Understanding Business Valuation Standards

Reputations and public perception are often associated with performance and adherence to rules that govern an activity.  Lance Armstrong, once the darling of cycling, is expected to lose more than $50 million dollars of future sponsorships and endorsements as a result of his admissions to violating his sport’s standards.  Many also believe that his well-documented doping activities will leave him stripped of a once untarnished professional reputation.  Armstrong is not alone; there have been many other examples of people purposely violating their professions’ standards in an attempt to gain an upper-hand.

Valuation analysts are held to certain standards established by their credentialing organizations.  Ultimately, these standards are intended to secure the credibility and quality to their work-product.  Working with a credentialed business valuation analyst that adheres to these standards is important to both attorneys and their clients. 

In our current whitepaper, "An Attorney's Guide To Understanding Business Valuation Standards," Mark S. Gottlieb outlines the organizations and premises of their professional standards.  Attorneys need to be familiar with these standards so that they can illustrate the credibility of their expert, or better understand the possible deficiencies of opposing professional opinions.

To obtain a free copy of this helpful whitepaper click here.

An Attorney's Guide to the Recent I.R.S. Changes Regarding Innocent Spouse Relief

ATTENTION MATRIMONIAL & FAMILY LAW ATTORNEYS

If you are representing clients in divorce proceedings, innocent spouse relief can help you to protect your clients from liability for underpayment or nonpayment of taxes caused by their spouse's dishonesty. Innocent spouse relief provides an important source of relief from tax debt, but until recently, there were significant limitations on when innocent spouse tax relief could be claimed.  The IRS recently lifted some of these limitations and the changes that were made can help you to make sure your client doesn't become unfairly burdened with his or her spouse's tax debts.

On July 25, 2011 the IRS issued Notice  2011-70, which made a significant change to the requirements for those seeking innocent spouse relief under (IRC Section 6015(f). IRS Commissioner Douglas Shulman indicated that the change was made because "when people are in tough circumstances, we [The IRS] need to be willing to work with them." Taxpayer Advocate Nina Olson has indicated that the change was a "a welcome occasion where everybody has emerged a winner."

The changes made by the IRS are simple - they extended the eligibility period for those seeking equitable relief, lifting the previously enforced two-year limit.

Mark S. Gottlieb recently wrote a white paper entitled, An Attorney’s Guide to the Recent IRS Changes Regarding Innocent Spouse Relief.  This is a must read for all matrimonial and family law practitioners.

This white paper is part of a 3 part special issue for all matrimonial practitioners.

Part 1 - An Attorney's Guide to Divorce-Related Tax Issues.

Part 2 - An Attorney's Guide to the Recent I.R.S. Changes Regarding Innocent Spouse Relief.

Part 3 - An Initial Document Request for Valuation & Litigation Services.

To obtain a free copy of this Special Report click here.

Using Business Valuation Experts to Your Best Advantage in Divorce

In 2010 we saw a number of high profile celebrity divorces and break ups occupying the tabloids and evening news. Tiger Woods and Elin Nordegren’s divorce was just the beginning. As the year closed we saw Sandra Bullock’s marriage crash and burn. Even Hollywood’s starlets like Elizabeth Hurley, Eva Longoria and Scarlett Johansson couldn’t avoid the hazards of matrimonial failure. In some instances these divorces may have ended inauspiciously due to a prenuptial agreement or the ability of the parties to cut ties financially without disrupting their lifestyle.

For attorneys representing clients in a divorce the breakdown of this economic partnership may require a forensic accountant and business valuation expert. But how does the matrimonial practitioner use this resource to better serve their client? Here are four things to consider, along with cases that illustrate the issues.

Always Use a Qualified Business Valuation Expert.

In Brooks v. Brooks, the husband owned minority interests in his family’s limited liability companies (LLCs), which held commercial property. At trial, the wife presented the companies’ financial statements and a real estate expert, who appraised the LLC’s underlying property at $61 million. Notably, the expert testified that his appraisal was only the first step in a fair market valuation (FMV), which required assessing the companies’ outstanding debt and closely held stock.

At the close of the wife’s case, the husband decided not to call his BV expert, saying there was “no valuation testimony” to rebut. Instead, he presented only the operative buy-sell agreements plus his tax returns, which essentially showed a book value of $400,000 for his LLC interests.

The court asked the wife if she wanted to call the husband’s expert to testify regarding the LLCs, including the effect of non-marketability and minority shares, but she declined. Thus the court was faced with the buy-sell and book values, on one side, and the broad real estate appraisals and financials on the other.

Finding the former “simply would not do justice,” the court took the appraised value of each property and multiplied it by the husband’s share in the LLC, less the mortgage debt on each property plus the value of cash-on-hand.

The husband appealed, claiming the trial court improperly equated the FMV of the properties with that of his LLC interests, thereby ignoring three “critical” features: lack of marketability, lack of control, and the effect of the restrictive buy-sells. The wife argued that since he’d neglected to present valuation evidence at trial, he couldn’t complain about its omission—but the appellate court disagreed.

The husband had “vigorously objected” to the wife’s real estate appraisals at trial, and her own expert conceded a lack of expertise to value the husband’s interests. The wife also rejected the chance to call the husband’s BV expert. At the same time, the trial court failed “to follow some reasonable path” in ascertaining FMV, which required assessing the marketability and minority aspects of the husband’s interests as well as any contractual restrictions, and the appellate court remanded the case for a new trial on valuation.

Use Your Expert to Facilitate Proper Discovery and Disclosure

In Hissa v. Hissa, the husband’s expert valued his orthopedic practice at approximately $320,000. By contrast, the wife’s expert valued it at $650,000, based in part on a comparison to industry averages. Both experts relied on the applicable FMV standard, and both agreed that accounts receivable (AR) were an important element. However, the husband failed to provide the wife’s expert with the same information concerning AR that he’d given his own expert, forcing the wife’s expert to estimate their value. The husband also provided flawed tax and financial information to both experts, and a result, the trial court found his evidence less convincing than the wife’s, and adopted her expert’s value.

The husband appealed, alleging the trial court erred by crediting the wife’s expert over his own. But, “the [trial] court determined that [the husband’s] failure to be forthcoming about his business expenses led it to discredit the information he provided his own expert,” the appellate court found, “particularly given his expert’s valuation of the medical practice at nearly one-half of what [the wife’s expert] determined the value to be,” and it affirmed the latter’s value.

Use the Expert to Educate the Court

In re Marriage of Armour, the vast majority of the parties’ wealth was tied up in the husband’s 50,000 shares of stock in his employer, which were subject to the company’s right of redemption at a below market price. Like many jurisdictions, California family courts prefer an in-kind division of marital assets unless economic circumstances warrant another method.

Here, the wife’s valuation expert analyzed the consequences of an in-kind division: Assuming the husband retained his stock for a reasonable time until retirement, his 50% share would produce a present value of $36 to $40 million, but the wife’s share would net only $18 million at the forced redemption price.

Despite this evidence, the trial court ordered a simple in-kind division and the wife appealed. Based on the wife’s valuation evidence, the appellate court found this “disregarded economic realities” and ordered a division that ensured an equal result for both parties.

Use Your Expert to Rebut the Other Side

In Gupta v. Gupta, the husband owned three medical practices and an imaging center in rural Texas. At trial, his expert valued the practices at $359,000 and the imaging center at zero, due to its significant debt service and operating losses. By contrast, the wife’s expert valued all the businesses at $780,000, excluding goodwill and a marketability discount.

In addition, the wife’s expert submitted a separate report to rebut the husband’s expert, highlighting his errors regarding valuation of revenue, AR, equipment, depreciation, and his misuse of historical financial statements. As a result, the trial court accepted the wife’s expert value, and the husband appealed, claiming the wife’s expert failed to visit the practices, interview his staff, or view the equipment. She also misclassified his practice, comparing it to “specialty medical practices” rather than a “general physician office,” and failed to factor the debts and losses of the imaging center. His rebuttal was too late, however, and the appellate court upheld the wife’s expert evidence in full.

Conclusion.

The valuation of a business is often a difficult issue; but it is crucial for attorneys to understand the role of the business valuation expert in marital dissolution so that they can effectively counsel their clients in achieving their goals in asset distribution and financial support. To learn more how our business valuation and forensic accounting team can assist you please call our offices at 516-829-4936 (New York), 203-357-1500 (Connecticut), 973-226-4500 (New Jersey) or visit our website at www.msgcpa.com.

Valuing Small Businesses

Valuing the very small company can often be more challenging than valuing a large firm or corporation.  These types of valuations most commonly arise in the divorce cases, although they also are frequently present in shareholder litigation, partnership dissolutions, and similar litigation. Often, client budgetary restrictions are an overriding consideration. However, attorneys and valuation analysts can work together from the outset of an engagement to meet client budgets and provide credible valuation. Here are a few areas where communication and cooperation can be the most helpful.

Valuation Standards.  Just like attorneys, accredited valuation experts are bound by standards of professional conduct. However, none of those standards distinguish between a valuation for a small business (and perhaps small budget) and a larger business. Once engaged, valuation analysts often find themselves caught between performing a complete and credible valuation, complying with the applicable standard(s), and keeping the job within a client’s budget. In litigation settings, most valuation analysts expect to be cross-examined on whether they adhered to the proper standards. If not, a lack of client funds will be no defense, and the analyst’s credibility as well as the client’s case could suffer.

Managing Expectations. Proper client screening is just as important in the valuation as in the legal context. Valuation analysts can help retaining attorneys to inform the client why the appraisal is necessary, its potential costs and the benefits that will inure to the case. Clients—especially in the divorce setting—will often suffer from misplaced expectations or assumptions. These clients need to receive the proper information and guidance from their professionals as to the scope of the valuation engagement, its process and the problems it can solve—as well as those it can’t, including creating value in a business when in reality there may not be as much as the client anticipated or hoped. 

Discovery & Access to Records. Few things can drive up litigation costs and conflict faster than trying to compel another party to comply with applicable disclosure and discovery rules. At the same time, the other side may be genuinely frustrated by receiving an overly broad and generic discovery request. Valuation analysts can work with attorneys and the client from the outset of the case to narrow and tailor the scope of production, so that the experts will receive all of the documents they need—and none of what they don’t. Documenting clear, successive requests for production to the opposing party will also help in the event a motion to compel or an interim motion for fees becomes necessary.

Professional Protection. Communication and documentation are likewise critical to ensuring that both the attorneys and analysts meet the appropriate standards of care when valuing a very small business—with perhaps a small client budget to go with it. There are rarely any shortcuts in a valuation procedure that pay off in terms of case outcome or client satisfaction. By documenting every action and notifying each other whenever problems or roadblocks may arise, attorneys and the experts will help maintain their own credibility as well as their client and referral sources.

Case Study. Often, our initial due diligence reveal discrepancies concerning the integrity of the accounting records and tax returns presented. In these instances we often reconstruct one or more of the financial components to best determine the business’s financial capacity. Within our website we have presented two case studies that illustrate both common and the not so common approaches to these concerns.

To learn more about MSG’s business valuation, forensic accounting and litigation support services, please visit our web site www.msgcpa.com

The Joint Appraiser's Role in a Divorce Action

 

In these economically challenging times, parties are increasingly seeking ways to reduce the cost and conflict of divorce. Many attempt to streamline the process by retaining a joint expert/valuator to appraise the marital business and/or business interests. Indeed, there are numerous benefits. Consider, for instance, that without a joint appraisal, many non-business owning spouses or those without direct access to marital funds would not be able to afford any expert in the case.  

In addition to the added financial benefit of retaining a joint expert,

  • ·the evaluator is also likely to get better access to documents and other evidence than an expert who has been retained by one party or another, 
  • ·the evaluator can often take on the role of creative problem solver, coming up with financially efficient, resourceful solutions,
  • ·the parties and their attorneys frequently view the joint appraiser as more independent and objective, and can use the joint expert to expedite mediation and settlement.

Attorneys avoid any pitfalls by clearly explaining to their clients the differences between retaining a sole expert and a joint expert. This will help clients from feeling “betrayed” later on in the case—when, for example, the appraiser may spend more time with the business-owning spouse to obtain information and financial records; or when the appraiser’s opinions conflict with the owner’s perception of the business’ value. 

It is important for the legal practitioner to become acquainted not only with appraisers who have experience as joint experts, but also those who also have some mediation or alternative dispute resolution training, as they may prove to be the most efficient joint experts.

The emerging field of collaborative law in many jurisdictions also utilizes the joint expert process. Many mediators/arbitrators are taking advantage of the joint appraisers as well, to reduce the conflict and cost of divorce cases.

The joint appraiser is particularly suited to smaller cases that concern sole proprietorships or family-owned businesses, when two experts would most likely reach similar conclusions of value. Parties in the smaller cases will not often have the funds to hire specialists or consultants—and conversely, where the parties do have such funds, a joint expert may not work to their advantage.

Once the parties have decided to take this route, it is important to work toward creating a framework for the engagement by taking steps to:

  • Define the scope of the engagement and determine whether the expert will provide ancillary services, such as forensic investigation, income determination, and accounting for separate property.
  • Establish a protocol for communications between the expert and counsel and the expert and the parties.
  • Establish a protocol for communications between the expert and the court.
  • Establish a protocol for communications between the expert and any consultant, specialist, or rebuttal expert that the parties may hire.
  • Establish a timeline and procedure for the document production process, especially who will provide the documents and what they will provide.
  • Provide a methodology to enforce the cooperation of the parties and a means of recourse for the expert if requested information is not forthcoming.
  • Discuss and define the applicable standard of value.
  • Institute a procedure for providing draft reports and receiving comments from attorneys and the parties.
  • Determine the format of the final work product and whether the expert will provide a summary or detailed report
  • Establish a procedure to compensate the expert, including the amount of a retainer, and his/her recourse for delinquent payments.

There are, of course, common problems in divorce cases. Just because the parties have retained a joint expert does not immune the process, or the appraiser, from the same challenges that can frustrate any divorce proceeding.  Investing the effort to establish a framework for the engagement can reduce these frustrations. In addition, if the attorneys and both spouses support the retention of a joint appraiser, they will have more confidence in the process. 

For more information on business valuation in matrimonial matters, please visit our website www.msgcpa.com. In addition, please visit our podcast library at www.msgcpa.com/podcasts/ for a variety of broadcasts specific to financial matters in a matrimonial setting.

 

Valuation Issues in the Bankruptcy Process

When it comes to business bankruptcies, the numbers seem to loom larger with every year. From 2005 through 2008, annual business bankruptcies increased by over 200%. In the years 2009 and 2010, business bankruptcies were more than double for the years 2006 and 2007.

We have seen bankruptcy filings from businesses with long histories such as the 163-year-old Tribune Company, or, more recently, younger companies as Blockbuster, whose goal is to cut its debts from $900 million to $100 million, and Circuit City, which seems to be finding a second life online of late. No matter what the size of the company or its reputation, however, valuation plays a key role in the bankruptcy process; and, inevitably, valuation issues will arise.

These issues pervade throughout the entire bankruptcy process--and impact each of the stakeholders along the way. While it is the attorney’s job to reach legal conclusions as part of the valuation, fairness or solvency analyses, the valuation analyst may serve debtors, creditors and legal counsel as either a consulting expert or a testifying expert. Whether a valuation expert uses one or all three of the accepted methodologies—the income approach, the sales or company comparison approach, or the cost approach--they are influenced by data and assumptions used under the formulas.

A company typically elects to file for bankruptcy under Chapter 7 of the Code when continued business operations cannot be supported by the income the company is generating. If a company does elect to file a Chapter 7 bankruptcy petition, a trustee is appointed and the debtor then discontinues its operations and all assets are liquidated on an orderly basis. The proceeds are subsequently distributed to the claimholders and creditors in order of priority.

Valuation issues can range from asset/collateral matters, to disputes as to the true value of a business as a whole entity, to fairness issues related to the valuation of securities and cash flow streams being proposed to settle the claims of various stakeholders. What are some of the most common valuation issues in bankruptcy? A few that come to mind are:

  • Distressed companies will often defer necessary expenditures that cause a reorganized company to catch up to retain a competitive position.
  • If a recent downturn was caused by a low point in a “cyclical” industry, attorneys and valuation experts need to carefully consider the timing and magnitude of an uptick.
  • Working capital deficits are common as accounts payable days lengthen;
  • Restructuring professional fees can impact significantly on a company’s cash flows;
  • When there is operational restructuring, severance and costs of closing a business’ locations need to be carefully considered.

Working in tandem, counsel and the valuation analyst should be aware of the nuances in market transaction method valuation. For instance, to the extent that financial distress in an industry has been caused by “inflated acquisition multiples,” then great caution should be employed in relying upon such market data.

In addition, it is very important for the analyst to adjust debt to market value in calculating numerator of multiples; to consider that the stock values of distressed companies may not be meaningful; and to utilize “debt-free” market multiples to mitigate the impact different capital structures can have on valuation.

It isthe expert’s responsibility to determine the current value of a business’s collateral, as well as determining the extent to which the collateral has recently declined in value or will likely decline in value in the future. In addressing the valuation issues in this regard, a going concern premise of value is typically assumed, unless the subject company is not expected to reorganize. Depending on the facts and circumstances of each situation, all traditional valuation methods should be considered.

In an economic downturn where even venerable, financially sound businesses can approach insolvency, it is important for valuation experts to capably assist attorneys—especially those with a broad range of legal expertise-- in resolving challenging valuation issues, and successfully meeting clients’ objectives in the bankruptcy process.

For more information about MSG’s business valuation, forensic accounting and litigation support services, please visit our web site www.msgcpa.com.

8 Minefields Attorneys Should Avoid Before Presenting Your Valuation Report to the Court

 

Attorneys know that a credible valuation analysis requires a substantial number of hours by an analyst with a high level of expertise. When reviewing an expert valuation report, it is critical to identify the most common errors that can cause a court to discredit or even disregard a report.

The following checklist serves as a quick guide for attorneys to avoid the most obvious deficiencies:

  1. Is the standard of value followed?  Has the analyst carefully disclosed and defined the applicable standard of value?  Has the standard of value been followed consistently throughout? 
  1. Are all three valuation methods considered?  These include the income, market, and asset approaches.
  1. Is the internal analysis consistent?  For example: 
    1. Did the analyst match pricing multiples or capitalization rates to the wrong economic income measure? 
    2. Are current intangible asset operational data matched to different time periods, without appropriate adjustment? 
    3. Did the analyst “normalize” financial statements without also normalizing the corresponding data for selected comparable companies? 
    4. Was a “highest and best use” analysis performed? 
    5. Was an “actual use” analysis also performed? 
    6. Did the analyst make extraordinary, subjective, or speculative assumptions? 
  1. Is there sufficient support for selected variables?  Any analyst should document the data used, the procedures performed, and the valuation conclusions reached.  There should also be sufficient tracing from the data in the quantitative analysis to the intangible asset in the owner/operator financial statement. 
  1. Do the numbers add up?  Mathematical errors are more common than anyone cares to admit; check all numerical calculations for accuracy, and make sure rounding conventions are consistent. 
  1. Does the analyst rely too heavily on ‘rules of thumb’?  These serve only as a “sanity check,” not as a basis from which to derive substantial intangible asset valuations. 
  1. Is there sufficient data and research?  The analyst should have conducted all relevant research, clearly threading the data into the quantitative analysis and valuation conclusions. 
  1. Is there adequate due diligence?  The analyst should have reviewed all relevant contracts and corporate documentation, including internal financial statements and external marketing statements.  Sales, licenses, contingent liabilities, and litigation should have also been considered. 

Attorneys should always be prepared to have their expert's report withstand the scrutiny of cross-examination and criticism. This checklist is intended to help you prepare for those potential vulnerabilities.

For more information about MSG's business valuation, forensic accounting, and litigation support services, please visit our Web site at www.msgcpa.com.

 

Fraud in the Workplace

 

The popular media have devoted countless hours to storylines that portray fraud in the workplace as an important plot device. From the early TV series Perry Mason and Arrest and Trial to the ubiquitous “ripped from the headlines” stories of the Law and Order franchise, as well as new series on cable such as White Collar, we’ve never lost our fascination for stories that involve fraud and how the perpetrator is finally caught. What compels the senior level manager, the low level employee or the longtime middle manager to ultimately risk everything, convinced that their crimes will go undetected? The characters in  popular fiction, as in the real world, are frequently motivated by financial need caused by avarice, gambling debts, business reversals, poor investments or trying to maintain a lifestyle well beyond their means. Now it seems that almost every day in the business media there are new reports on workplace fraud in all its forms. The frequency of such reports now seem to be outpacing the tv episodes that draw from the “true stories,” and underscoring that truth is stranger than fiction.

In a time of massive Ponzi schemes and burgeoning white-collar crime, one can understand why fraud is not uncommon in the business world. In fact, employee fraud costs businesses billions of dollars each year. Employee fraud is an ongoing, widespread and varied problem, one that comes in all sizes for all kinds of companies. It can significantly impact a company’s productivity and profitability. The reasons for fraud are not always obvious to the business owner or even their attorneys. However, what is obvious is that it is often overlooked, ignored, and even undetected.

The current statistics for fraud in the workplace are staggering (source: ACFE Report to the Nations):

·         The typical organization loses 5% of revenue due to occupational fraud;

·         The median loss per case was $160,000, and it took an average of 18 months for it to be uncovered;

·         Fraud is much more likely to be detected by tips, than by any other means;

·         Smaller companies are disproportionately victimized by fraud, as they usually lack a sufficient level of checks and balances;

·         Fraud is more likely to be committed by a single individual, without a prior history of fraud, who often raises a red flag because they are living beyond their means and are experiencing financial difficulties.

To better understand why these statistics are so alarming one should be familiar with the three categories of fraud; Management Fraud, Employee Fraud, and External Fraud.

Management Fraud often involves a senior management’s intentional misrepresentation of financial statements, theft or improper use of company resources. Employee Fraud involves a non-senior employee theft or improper use of company resources. Lastly, External Fraud is the theft or improper use of resources by people who are neither management, nor employees of the firm.

Indications of fraud generally fall into a few categories: Accounting Anomalies, Internal Control Symptoms, Analytical Symptoms, Lifestyle Symptoms and Behavioral Symptoms. The prevalent warning signs of fraud may include accounting record discrepancies, unusual transactions, and conflicting or missing evidential/supporting documentation. If a business has not been producing the profits it anticipated, it might be advisable to conduct a fraud audit sooner rather than later. One can draw a direct connection between unexpectedly lower revenues (or business losses) and possible patterns of fraud.

It is very important to maintain strict confidentiality regarding such matters. Some common mistakes businesses make is failing to retain counsel when fraud is uncovered or suspected, and/or not engaging the services of independent fraud investigators or a forensic team. If criminal or civil charges are pursued, an independent forensic accounting firm may be necessary.

Employee fraud is common, but not as inconsequential as the common cold. To help protect their clients, attorneys should be more cognizant of the various types of employee fraud.

To read about “The Fraud Triangle” and learn more about the forensic accounting services MSG provides, please visit our Web site at www.msgcpa.com.

 

Cliff Lee's Earnings Capacity Is At Its Peak. Would He Be Able to Keep It All If He Divorced In New York?

 

December is an exciting month for sports fans, particularly New York sports fans. The area’s football teams are both bidding for playoff berths; basketball and hockey fans are settling in with mixed feelings about their team’s early performance; and major league baseball’s “hot stove” league is a buzz with the potential of free agent signings.

This year’s biggest baseball free agent star is pitcher Cliff Lee. And to no surprise the New York Yankees are among the few teams bidding for his affection. The AngelsRangers, and Yankees have all reportedly “pitched” Cliff Lee and have offered him a king’s ransom to play for their team. 

Each of the three teams courting Mr. Lee has something different to offer. California has beautiful weather; Texas has no state income tax; and New York has an opportunity to earn millions of dollars above a baseball contract in endorsements and sponsorships. There is little doubt that in addition to his agent, family, and friends Mr. Lee is getting plenty of advice from a variety of marketing, legal, and tax professionals.

Even though I have not been asked, I thought I would give my two cents to Mr. Lee’s quandary. Cliff, stay away from New York. It could be your financial ruin.

Assume Cliff Lee signs with the Yankees for seven years at $25 million per year and contracts for an additional $5 million per year for marketing. It doesn’t take a forensic accountant to compute that during the next seven years he will earn $210 million.   But suppose Lee, A-Rod, and Jeter go out one night to celebrate a big win over their arch rivals, the Boston Red Sox. We all know that Alex Rodriguez and Derek Jeter are magnets for beautiful women. And just suppose Cliff Lee decides shortly thereafter that he would be happier living as a bachelor in New York City. Unlike any other state in the union, New York State provides equitable distribution for the enhanced earnings capacity acquired during marriage; a concept that the future ex-Mrs. Lee will shortly learn.

The enhanced earnings capacity (commonly referred to as EEC) is computed as the present value of the enhancement in earnings over an expected work life. In Lee’s case, this expectancy would extend over the next seven years of his new contract and may proceed for many years thereafter, if he should be fortunate enough to become a coach, commentator, or television analyst after his playing days are over.

The approach to calculating the enhanced earnings capacity in New York State was established in 1985 as a result of a New York Appellate Court’s decision in O’Brien v. O’Brien. This concept was later reaffirmed in 1995 in the New York Court’s decision in McSparron v. McSparron; as well as many other cases that followed. The methodology employed to this calculationspecific to Cliff Lee can be broken down into five steps:

  1. Determine Cliff Lee’s earnings capacity at the commencement of the hypothetical divorce action, resulting from signing with the NY Yankees. This is referred to as Top-Line Earnings.
  2. Determine Cliff Lee’s earnings capacity if he had not become a baseball phenom and continued the career path chosen at the time of marriage. This is referred to as Base-Line Earnings.
  3. Compute the after-tax earnings of the Top-Line and Base-Line amounts by applying federal, state and local income tax rates, as well as the social security and medicare tax.
  4. The difference between the net after-tax earnings of each earnings base is the net enhanced earnings capacity attributable to his record setting contract.
  5. Compute the present value of the net enhanced earnings capacity over his NY Yankee contract.

For illustrative purposes, let’s assume that Cliff Lee had a bachelor’s degree at the time of marriage. Let’s further assume that a white male with a bachelor’s degree, living in New York City at Mr. Lee’s current age would earn $125,000 per year. This is the amount considered as a proxy for Base-Line earnings.

The following table illustrates the after-tax earnings of both the Top-line and Base-Line amounts; as well as the annual net enhanced earnings capacity.

                                                 Top-Line Earnings
Base-Line Earnings
Pre-Tax Earnings 30,000,000 125,000
(-) Fica/Medicare -441,622 -8,434
(-) Federal Income Taxes -9,256,731 -24,333
(-) State/City Income Taxes -3,784,335 -12,019
Net After Tax Earnings
16,517,312
80,214
Net Enhanced Earnings Capacity   16,437,098

A present value discount rate is designed to reflect the value of money in a relatively risk free investment. Economists, financial analysts and accountants generally agree that the real rate of interest is between 2% and 4%. The courts have historically accepted 3% as the present value factor applied in this computation; but in recent cases have considered rates between 5% and 10%. The present value discount rate is very important. As the present value discount factor increases, the total enhanced earnings computation decreases.

Based upon these computations, the enhanced earnings capacity attributed to Cliff Lee’s potential seven year contract with the NY Yankees is $102 Million (Rounded). The following table illustrates this computation.

Year                       
Net Enhanced Earnings Capacity Present Value Discount Factor @ 3% Net Present Value
1 16,437,098 0.97087 15,958,348
2 16,437,098 0.94260 15,493,541
3 16,437,098 0.91514 15,042,273
4 16,437,098 0.88849 14,604,149
5 16,437,098 0.86261 14,178,785
6 16,437,098 0.83748 13,765,811
7 16,437,098 0.81309 13,364,865
    Total
102,407,772

Since New York is an equitable distribution State, a portion of this amount would belong to his soon to be ex-wife. In some instances the courts have awarded as much as a 50% share and in others as little as 10%.

As you can imagine, there are a variety of things Cliff Lee has to consider when deciding which mound to call home next year. Will he flourish in the California sun; the familiarity of Texas home cooking; or the cement jungle of New York City. Only time will tell. But what we do know is this – getting divorced in New York State after signing a record setting free agent contract could be more painful than losing in the World Series to the San Francisco Giants.

For more information about the computation and application of the enhanced earnings capacity calculation, including our Enhanced Earnings Capacity Questionnaire, please visit our website.

 

An Attorney's Guide To Divorce-Related Tax Issues

There may be no glory in being a family law attorney these days, especially when it comes to dealing with the often challenging economic consequences in a divorce action.

Clients may initially contact you with one issue related to their potential divorce, but often these concerns can quickly manifest as emotions and pressures begin to develop.

Perhaps the questions attorneys resist the most or feel least comfortable in answering pertain to divorce-related tax matters. Many individuals, including those contemplating divorce, will be reaching out to you for answers to a variety of tax-related divorce questions. So, this may be the best time to revisit some of the questions you may be faced with.

Here are ten divorce-related tax issues that all matrimonial and family law attorneys should know.

1.       Taxability of Assets Distributed Incident to Divorce

In many instances one of the most disputed issues in a divorce is the distribution of the marital assets. This is commonly referred to as “equitable distribution” or “ED”. Under the Internal Revenue Code (IRC) Section 1041 (a), no gain or loss is recognized on the transfer (acquisition or distribution) incident to divorce provided such transfer occurs within one year after the divorce or related to the ending of the marriage. 

The ending of the marriage is defined pursuant to a divorce or separation agreement and occurs within six years after the date on which the marriage ended. 

Practice Tip: Often, one of the most significant marital assets is the marital residence and/or a business. The values of these assets should be appraised by an independent credentialed valuation expert in the early stages of the divorce proceeding.

2.       Tax Deductibility of Professional Fees

Legal and other professional fees related to getting a divorce are generally not tax deductible. These non-deductible costs include expenses related in arriving at financial settlements and retaining income-producing property. However, some legal and accounting expenses can be deducted as a miscellaneous itemized deduction, subject to the 2% limitation (and also as a preference for alternative minimum tax purposes). Here is a short list of some of these exceptions:

  • Fees related to tax advice related to a divorce,
  • Fees to determine or collect alimony,
  • Fees to determine estate tax consequences of property settlements, and
  •  Appraisal and actuary fees to determine tax liabilities or to assist in obtaining alimony

Practice Tip: When your client retains an accounting/tax professional ask them to prepare their invoices with specific descriptions so that the tax deductible portion of their charges can be easily determined.

3.       Alimony v. Child Support

In simple terms, alimony is taxable to the recipient and deductible by the payer. To qualify as alimony under IRC Section 71(b) the payments must meet the following requirements:

  • Payments are required under a written divorce or separation agreement,
  • The payment cannot be designated as “not alimony”,
  • Spouses may not be members of the same household,
  •  Payments may not be treated as child support,
  •  Payments must cease upon death of recipient, and
  •  The parties cannot file a joint tax return

Child Support is never taxable, and there are a few other common payments that do not qualify as alimony, such as:

  • Non-cash transfers,
  • Payments for use of property, and
  • Payments to keep up the payer’s property

In addition, an often neglected issue pertains to the short-fall of child support obligations. When an individual is obligated to pay (both) alimony and child support, payments are first applied to satisfy child support obligations and then to alimony. In other words, child support obligations must be fully satisfied before any amount of alimony is considered deductible.

Practice Tip: When structuring alimony agreements one should be conscious of the possible applicable alimony recapture rules. If there is a decrease or termination of alimony during the first three calendar years, recapture rules apply if the alimony in the second or third calendar year is $15,000 less than in the prior year. The recapture provision may be initiated by one or more of the following:

  • Failure to make timely payments,
  • Change in divorce or separation agreement,
  • Reduction in spouse support needs, and
  • Reduction in payers ability to provide support

4.       Sale of Personal Residence

If you live in your “Principal Residence” for any two of the last five years you are eligible for a capital gain exclusion upon the sale of the home. This exclusion is $250,000 for a single taxpayer and $500,000 for a married couple. Because of the significant difference in tax treatment, the tax consequences related to the sale of the marital home should be considered early on in the divorce settlement negotiations.

Practice Tip: If the sale of the marital residence is contemplated, consider the transaction prior to the termination of the marriage in order to take advantage the higher exclusion amount in order to secure more proceeds from the sale.

5.       Filing Status

An individual’s marital status is determined as of the last day of the calendar year – December 31st. Married individuals can file jointly or married filing separate. When the parties file jointly each is jointly liable for the tax obligation, regardless of what a divorce instrument may say. 

The married filing separate status is the highest tax rate. When spouses file separate returns they both must utilize the standard or itemized deductions. The first one to file establishes the requirements for the other to follow. When married individuals file their tax returns separately we often find other critical issues being considered. 

If an individual is divorced as of December 31st, even if married and living together with their ex-spouse sometime during the year, they must file as a single taxpayer or head of household for that year.

For those that are still married at the end of the year but were legally separated on December 31st or have not lived with their spouse for the last six months of the year – they may be able to file as head of household. This filing status is attractive because the tax rates are significantly less than for those filing as married filing separate. 

To file head of household a number of requirements must be met:

  • The individual must have paid more than half of the cost of keeping a home for a child or other qualifying person,
  •  This individual is entitled to claim the qualifying person as a tax exemption, and
  •   The qualifying person must have lived in the individual’s home for more than half the year

Practice Tip: Income Tax projections utilizing different scenarios are an often neglected but valuable planning tool. This exercise should be performed for years before and after the termination of the marriage.

6.       Children/Dependents Personal Exemptions

Generally, the custodial parent is entitled to the dependency exemption as long as the parents (individually or together) provide at least one-half of the dependents support. However, there are two exceptions to this general rule:

  •  When the custodial parent relinquishes the rights to the exemption, or
  •   When a multiple support agreement is established

Practice Tip: Dependent exemptions often vary by agreement. When preparing these arrangements make sure you consider the age of the child/dependent and the taxable income of each parent.

7.       Deductibility of Mortgage Interest & Real Estate Taxes

When a couples’ principal residence is jointly owned and the mortgage interest and real estate taxes are paid from a joint account there is a presumption that these payments are attributed to each party on a 50/50 basis. 

However, when a home is jointly owned and these payments are paid directly by the non-occupant spouse, half of the mortgage interest and real estate taxes is deductible to the paying spouse as an itemized deduction and the remainder qualifies as alimony. The occupying spouse must report these amounts as income (alimony) but is able to deduct the interest and taxes as an itemized deduction.

If the home is owned only by the occupying spouse but the non-occupying spouse is still obligated on the mortgage, the non-occupying spouse can only deduct the mortgage interest if a minor child of the marriage resides in the home. The non-occupying spouse cannot deduct any of the real estate taxes, since he or she has no ownership in the property.

Alternatively, if the non-occupying spouse solely owns the house and pays the mortgage interest and real estate taxes then those amounts can be deducted in their entirety as an itemized deduction. The occupying spouse would not have to report these amounts as alimony.

Practice Tip: Don’t assume that the marital residence is jointly owned by each the husband and wife. Inquire as to who owns the property and who is obligated on the primary and secondary mortgages.

8.       IRA’s and Retirement Plans

A Qualified Domestic Relations Order (QDRO) is a useful tool to designate a portion of a qualified retirement plan to the other spouse. This vehicle allows the distribution of the marital asset without damaging the integrity of the plan or the creation of a taxable event. Benefits are taxed when distributions are made, not when the QDRO is established. QDRO’s do not apply to Individual Retirement Accounts (IRA’s); however, IRA’s transferred pursuant to a divorce or separation agreement is not a taxable event.

Practice Tip: The use of a QDRO is an accessible tool to facilitate the equitable distribution of assets when there are limited liquid assets.

9.       Stock Option & Deferred Compensation Plans

The transfer of an interest in a non-statutory stock option or a non-qualified deferred compensation plan incident to a divorce is not a taxable event. However, income is reported when the former spouse exercises the stock options or when the deferred compensation is paid (or made available).

Practice Tip: Stock option & deferred compensation plans can be identified within employment contracts and/or annual wage reporting statements. Obtain the periodic statements (monthly, quarterly, annual, etc.) for your file.

10.   Innocent Spouse Relief

There are currently three sections of Internal Revenue Code that provide relief from tax liability to spouses:

  • Innocent Spouse (IRC Section 6015 (b)),
  • Separation of Liability (IRC Section 6015 (c)), and
  • Equitable Relief (IRC Section 6015 (f))
  • When applicable, the courts have considered the following factors to determine their applicability:
  • Knowledge,
  • Economic hardship,
  • Benefit,
  • Compliance with tax laws,
  • Tax liability attributed to non-requesting spouse,
  • Marital status, and
  • Spousal abuse

Practice Tip: If you plan to invoke the innocent spouse rule prepare your argument by addressing as many of the above factors discussed above. IRS Form 8857, Request for Innocent Spouse Relief, is filed separately, not with the couples’ individual income tax returns.

We hope this brief summary is of value to you and your practice. Your questions or comments regarding this information are always welcome.  

For additional timely information to assist your family law and matrimonial law practice please feel free to visit our website www.msgcpa@msgcpa.com, or call our offices.

New York State's New Legislation Impacts The Financial Concerns of Family Law

 

The summer of 2010 may be remembered by many Family Law practitioners as the “Historic Summer of Legislation” that will forever change how matrimonial law is practiced in New York State. There have been five major changes of legislation; new laws that many in the legal community have strong views about.  These changes include significant financial implications.

These five major bills address the following:

  1. Significant changes effectuating child support modification (Bill # A8952); effective October 13, 2010,
  2. “No-Fault” Divorce (Bill # A3890); effective October 12, 2010,
  3.  The new Counsel Fee Bill that addresses payment of attorneys’ fees (Bill # A4532) on behalf of the less monied spouse; effective October 12, 2010,
  4. New procedures for setting awards of temporary maintenance while a divorce is pending (Bill # S08390); effective October 12, 2010, and
  5. Limiting the grounds by which orders of protection may be denied, or applications for such orders may be dismissed; effective August 13, 2010.

For those of you that have been following our blog throughout the summer, you are very much aware of how the legal community has been intensely interested in these and other changes. For instance, on our podcast Forensic Perspectives, we interviewed the Honorable Sondra Miller on the topic of No-Fault Divorce. In addition, I recently participated in a panel discussion with three prominent attorneys on New York State’s Current Legislation to Develop Maintenance/Alimony Guidelines. Additional information regarding these programs are available on our website.

According to Governor David Paterson, in addition to bringing New York’s divorce laws into the 21st Century, “These bills fix a broken process that produced extended and contentious litigation, poisoned feelings between the parties, and harmed the interests of those persons—too often women—who did not have sufficient financial wherewithal to protect their legal rights.”

So how is the divorce process now going to be different for Family Law practitioners?  

Let’s quickly look at some of these new provisions.

No-Fault Divorce

Before the “No-Fault” legislation was passed, couples at both ends of the economic spectrum often had to leap over hurdles addressing grounds. With the passing of the No-Fault Legislation, grounds are no longer an obstacle, if certain financial and custody issues have already been resolved. It should also be noted that the no-fault provisions are only applicable after a marriage has “irretrievably” broken down for six months or more.

Counsel Fees

The Counsel Fee Bill is intended to cure instances where the parties have significantly different economic resources. In situations where one party has significantly more assets and/or higher income, the less monied spouse will now have access to funds for attorney fees. It is often said that “all is fair in love and war”. This legislation is intended to even the playing field of the less monied spouse by providing resources for legal representation.  In the end, the court still must exercise its discretion. Many legal practitioners have welcomed this change, but are cautioned to understand that no one will be given carte blanche.

Temporary Maintenance Guidelines Bill

The Temporary Maintenance Guidelines bill will allow for a speedy resolution of the maintenance issues. It is intended to prevent the non-monied spouse from descending into poverty because they lack the resources to obtain a temporary maintenance order. The guideline amount of temporary maintenance is the sum derived by a formula set forth in the statute. The Court has the right to make a durational temporary maintenance award which ceases prior to the end of the case or death. If the Court finds this award unjust, as determined from this formula, it can be changed. 

Modification of Child Support

The Family Court Act (“FCA”) was amended to conform provisions governing the modification of child support orders to the Domestic Relations Law. This change would allow modification of an order of child support due to “substantial change in circumstances”.

In addition, unless parties specifically opt out, the court can modify a post October 13, 2010 order where three years have passed since the last order was entered, modified, or adjusted. Substantial change in circumstances is generally defined in a change in either party’s gross income by 15% or more. A reduction in income shall not be considered as a ground for modification unless it was involuntary and the party has made diligent attempts to secure employment.

Chapter 341 of the Laws of 2010

Various provisions of the Family Court Act and the Domestic Relations Law have been amended by Chapter 341 of the Laws; effective August 13, 2010. They provide that a court “shall not deny an order of protection solely on the basis that the acts or events alleged are not relatively contemporaneous with the date of the application.” The duration of any temporary order shall not by itself be a factor in determining the length of any final order. It applies to all orders of protection pending or entered on or after the effective date.

As you can see from this overview, these changes will significantly impact how you approach a matrimonial case. While this summary is not intended to provide a complete analysis of the changes, you can easily see the financial implications concerning your current and future case load. Many of the local Bar Associations are conducting CLE classes addressing these changes. We have been fortunate enough to have sponsored a number of them. For further information regarding these classes please contact your local Bar Association.

 

Determining Lost Profit v. Lost Business from the Financial Expert's Perspective

Until this past summer, the idea that YouTube might turn a substantial profit at long last may have been as improbable as Jon Stewart friending Glenn Beck on Facebook. But a federal judge’s recent ruling in YouTube’s favor in the 3-year-long copyright dispute with Viacom, the owner of such profitable brands as Paramount, Nickelodeon and Comedy Central, is a major victory in what some are calling a landmark copyright case.

The much-discussed suit revolved around Viacom’s allegations that YouTube only became the Internet’s most viewed video site by posting copyright-protected clips “stolen” from its shows. But in evoking a law that shields Internet services from claims of copyright infringement as long as the illegal content is removed,the Court noted that YouTube had removed about 100,000 videos the day after Viacom sent a mass takedown notice. If the Court in this case had agreed with Viacom, and ordered Google to pay the more than $ 1 billion in business damages the media conglomerate was seeking, the impact on YouTube’s future profitability could have been considerable.

For a media conglomerate such as Viacom, however, copyright infringement on a site that might attract well over a billion visitors a day, could translate into lost revenue from DVD sales and rentals, worldwide TV syndication, and paid online distribution of their content. When copyrighted content is readily available for free on YouTube, for example, the Court may take into account what profits, if any, would have been generated by Viacom if not for the alleged copyright infringement. But is this a case of lost profits or lost business for a media conglomerate--or perhaps both?

In considering whether a case merits a claim for either or both, one must examine the facts and circumstance early in the litigation process to analyze the appropriate theory of recovery. The final determination can directly affect the appropriate damage calculations as well as the identification of proper claimants to the litigation. In some instances, the courts have allowed both lost profits and the decrease of the market value of the subject business; however, on some occasions, the court has allowed one or the other.

Whether business damages are calculated by the financial expert as lost profits or lost business, the objective is to restore the plaintiff to the position it would have been --“but-for” the defendant’s actions that caused the damages. When calculating lost profits, damages are typically measured for a specific or limited period of time. In general, the loss is the difference between what the business would have produced during the loss period, minus what it actually did produce during this same time frame. All the business’s expenses are taken into consideration in both the “what would have happened” and “what did happen”scenarios.

Case law and statutes dictate what a plaintiff needs in order to demonstrate lost profits. It is the financial expert’s task to employ both a scientific and artistic interpretation of the facts and circumstances that will eventually tell a detailed, accurate story.

The approach to determine lost profits is multi-faceted and generally requires the following 6 steps:

  1. Calculate lost earnings by comparing profit history before and after a damaging event,
  2. Understand the subject company’s cost structure,
  3. Examine the calculated expenses for reasonableness,
  4. Determine causation (i.e. consider possible reasons for drop in sales),
  5. Examine how things such as economic conditions, marketplace demands and government regulations have impacted a sales loss,
  6. Present detailed information to support the assumed revenue, expense, and growth rates.

As an experienced practitioner, the steps of assessing lost profits can be simply stated; but more often than not, the process itself requires meticulous attention to detail and a sharp eye for any contradictory information. Often, one needs to step back to inquire about issues that arise during this endeavor.

Three that come to mind are as follows:

  1. What influence does an immature line of business affect the overall operations of the entity?
  2. How does a poor performing sector influence the results?
  3. How influential should projections and forecasts that materially differ from historical results be, and how should they be utilized?

The financial expert knows that the credibility relevant to projected income—and anticipated expenses—is absolutely critical in supporting a lost profits claim. The analyst works methodically from business plans, market surveys, income projections, and other evidence of projected revenues to estimate future receipts. One may use data from industry sources, comparable companies, market data or any other source that may help in predicting accompany’s financial results. It is imperative that the expert acquires in-depth knowledge of the subject company early in the process: its products, markets and competition, and the market forces to which it is subject.

In a case when an entire business is destroyed, the analyst’s task is still to determine the lost future cash flow. But in contrast to a lost profits case, the loss is now permanent. Just as in the lost profit calculation, the expert considers all of the subject company’s expenses in the “what would have  happened” vs. “what did happen” scenarios. The fair market value of the subjectcompany is determined based on the assumption that an earningsstream will continue into perpetuity.

So when the attorney considers whether a plaintiff may recover both lost profits and lost value, I can tell you of an important exception: when a business operates for a certain amount of time and then closes as a direct result of the defendant’s behavior, thereby incurring a period of lost profits followed by lost business. In this case, the courts have found no “double-counting” of the plaintiff’s allowable recovery.

Simply summarized, how does a lost profits case differ from a lost business case? Lost profits are usually measured over a specific time period (e.g. the estimated time it will take the plaintiff to restore “normal” profits).With lost business value, profits are projected into perpetuity. A lost profits analysis views a business from the perspective of a plaintiff; a business valuation views the business from the “hypothetical buyer’s” perspective.

Drawing from the analyst’s skills in finance, accounting and economics, the financial expert—reasonable and objective-- can distill complex data into an  understandable, accessible communication that can prove invaluable to the litigation team.

This past August, Viacom filed an appeal in the U.S. Circuit Court of Appeals for the Second Circuit in New York; any decision, however, is likely several years away. Did YouTube build its business, in part, at Viacom’s expense, thus depriving the media conglomerate of significant revenue? Could YouTube have done more to keep illegal content off its site with the help of copyright detection tools it later developed after its sale to Google? Will Jon Stewart ever have Glenn Beck on his show? And could a clip still find its way on YouTube? Stay tuned. 

Hiring a Forensic Expert Early in a Lost Profits Case Yields High Dividends

 

In a recent meeting with some of my colleagues in the legal community, the question came up: Why is the analysis of lost profits deferred until late in the litigation process? One colleague is of the opinion that often the financial issues associated with damages will sometimes take a back seat to liability issues because attorneys will frequently tend to focus on the legal procedures and on discovery procedures. But based on my 20+ years experience in forensic accounting, business valuation and expert testimony, early involvement by the financial expert is often crucial to an effective analysis in a lost profits case—and ensures that all aspects of the lost profits case are covered.

Forensic experts are typically involved in complex commercial litigation where economic damages or lost profits are at issue. They’re also involved when a case requires forensic accounting skills such as in a fraud or embezzlement case or the value of a business is at issue such as in a shareholder dispute or marital dissolution. The forensic expert may also be called upon to explain an accounting, tax or financial issue to the judge or jury.

Forensic experts often are also hired by attorneys to provide expert testimony as litigation support consultants. The expert witness can play a variety of roles in lost profits cases including performing damage calculations to coordinating complex research and analysis and creating case strategies. To do this, the forensic expert must select an approach in the pretrial planning phase that helps develop and integrate facts and legal theories presented later in trial testimony. Involving the forensic expert early on in the litigation process helps to ensure that all the financial issues are identified and related documents obtained.

As I’ve written, forensic experts are sometimes not designated by counsel until late in the lost profits case; often at that point, the discovery process is closed and data that would have been relevant and potentially helpful to the analysis was not obtained. To some attorneys, determining lost profits in a case may seem at times to be relatively straightforward; yet opposing forensic experts can come up with vastly different numbers.

The forensic—or financial—expert may assist legal counsel in identifying the particular financial issues related to the case. The expert may also assist legal counsel in creating discovery requests, preparing for depositions of financial witnesses, or helping with trial exhibits and settlement negotiations. The expert can also help the legal team make a determination of the possible range of recovery before incurring a substantial amount of fees pursuing a claim. Involving the forensic expert early on in the process helps to ensure that all the financial issues are identified and related documents obtained.

The expert must first have a comprehensive understanding of the operations and financial dynamics of the subject company, the markets in which the company operates, and the economics of the related industry. It’s the expert’s task to gather the relevant underlying evidence, apply the appropriate methodology, and exercise professional judgment. The goal of the expert in the lost profits case is to accurately calculate the most reasonable measurement of damages that also meets the legal standard of “reasonable certainty.”

It is also the forensic expert’s responsibility to recognize that financial records provided can be inaccurate, incomplete or misleading. Applying the appropriate tests will help the expert avoid relying on any faulty or flawed records. Suffice to say, the forensic expert whose opinions are well-supported by forensic evidence can be effective in serving the case and the client.

I believe that if attorneys truly want to advance their clients’ desires to resolve business disputes early on in the process, it is important to focus as early as possible on the key issues associated with damages claims. In business litigation cases, that means an early focus on lost profits claims, because it’s those claims that tend to drive whether the case is tried or settled.

 

 

Finding Hidden Treasures In Tax Returns

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.

 

The Honorable Sondra Miller's Take On No-Fault Divorce

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.