Going through divorce is never easy. However, when a closely held business is involved, things get much more complicated. In such cases, many issues need to be addressed including, what is considered a business for property division purposes, when is a business valuation required, and the potential malpractice issues that can arise therein.
What is a Business and when must it be valued?
Defining “what is a business” for property distribution in divorce can become convoluted. Ownership interests in corporations and partnerships clearly qualify as an interest in a closely held business. A professional practice or sole proprietorship also clearly qualifies as an interest in a business. However, the lines become blurred when the party’s source of income is a franchise or agency agreement of some sort. Generally, if a party has a source of income from a franchise or agency agreement, the court will consider it a business, and a valuation of that business will be required for the purpose of property distribution.
There are four recognized business organizations for tax purposes; 1) Corporations, 2) Partnerships (General or Limited, 3) Limited Liability Companies (LLC), and 4) Sole Proprietorships. Corporations, most partnerships, and LLC’s must be registered with the Secretary of State, or similar agency by a different name, in the state in which the entity is organized. Most entities must also file a tax return separate from the tax returns of the owners. Sole proprietorships and general partnerships are not required to be registered. Sole proprietorships and single owner LLC’s are not required to file a separate tax return for the entity. Instead, the business activities are reported on the owner’s personal tax return on form 1040, schedule C.
Thus, the family lawyer can initially determine if the source of income is from a business by the entity type or tax treatment of the income.
Professional practices are generally considered businesses for property distribution. Professional practices include medical practices, dental practices, law practices, accountants, architects, financial consultants, IT consultants, and other consulting services. The practicing party does not necessarily have to be required to be licensed by a governing agency to be considered a professional.
Generally, the issue in the valuation of the professional practice is the value of “personal goodwill” vs. “entity goodwill”. Personal goodwill is the value of the professional practitioner’s contribution to the business. Entity goodwill is the value of the practice’s business absent the practitioner. The allocation of personal and entity goodwill varies among the states. Thus, the family lawyer must insure that the business valuator properly allocates goodwill in the valuation of the practice, if required by the state’s property division law.
An agency or franchise, based upon an agreement, may be deemed to be a business and a marital asset, even though the agent may not have transferable ownership rights in the agency or franchise. Case law in this area varies among the states. Following are a few examples:
In North Carolina, the North Carolina Court of Appeals held that a Nationwide Insurance agent, working as an independent contractor, had value as a business. The agent worked under an exclusive representation agreement with Nationwide and could not sell the business or any insurance policies in the business. The court held that even though the agent could not sell the business, “the agency still had value above and beyond a salary or the net worth of the agency’s fixed assets which could be sold.” Hamby v. Hamby, 547 S.E.2d 110 (N.C. App., 2001).
In contrast, the New Jersey Superior Court, Appellate Division held that an Allstate Insurance agent, working under an agent compensation agreement, did not have goodwill value as a business. The agent operated as an exclusive Allstate agent under the name of the Ersel Seiler Agency. The agent received a commission from Allstate. The agent did not own the fixed assets and could not sell the business or any policies in the business. The court held that the agent was an employee of Allstate and any goodwill value was the property of Allstate. Seiler v. Seiler, 706 A.2d 249 (N.J. Super. A.D., 1998).
In Washington, the Court of Appeals of Washington held that a State Farm Insurance agent, working under a State Farm agency agreement, did not have goodwill value as a business. The agency was incorporated and operated as an exclusive State Farm agent under the name of the Zeigler Insurance Agency, Inc. The agency received a commission from State Farm. The agent did not own the fixed assets and could not sell the business or any policies in the business. The court held that the agency had no goodwill value and any goodwill value was the property of State Farm. In re Marriage of Zeigler, 849 P.2d 695, (Wash. App. Div. 3, 1993).
In West Virginia, the West Virginia Supreme Court of Appeals held that a real estate development management company, working as an independent contractor under contract for one large developer, did not have goodwill value as a business. The company operated exclusively for a large real estate development company, did not have employees, and maintained one office location. The company received a fee at the completion of each development project equal to a percent of the profit earned by the project. However, the court held that management contracts in place at the date of separation were marital property and the value of those contracts was subject to division. Wilson v. Wilson
When must I have the business valued?
The general rule among the states is that all marital property must be valued for the purpose of property division. If neither party offers evidence of the value of marital property to the court, the court may assign a zero value to the property. Further, restrictions or buy agreements for the sale of a business interest are not reliable appraisals of the business’s value. This has happened many times in property division cases. The following are a few examples:
In North Carolina, the North Carolina Court of Appeals held that the husband’s business was not subject to distribution under the Equitable Distribution Act of North Carolina where neither party had presented creditable evidence of the value of the business. Grasty v. Grasty, 482 S.E.2d 752 (N.C. App., 1997). The appeals court held that the trial court did not err by rejecting the wife’s expert’s testimony as to the value of the husband’s business as “wholly incredible and without reasonable basis.” Id. The husband did not present any evidence as to the value of the business. Further, the court held that the trial court did not err by not appointing an expert to value the husband’s business. Finally, the court held that because the trial court properly refused to assign a value to the husband’s business, the husband’s interest in the business was not subject to distribution under the Equitable Distribution Act of North Carolina. Thus, the court held that the trial court therefore erred in distributing the business to the husband in the equitable distribution proceeding.
In Ohio, the Ohio Court of Appeals, Fifth District, held that the trial court did not err by not setting a value on the husband’s business. It found that the wife “made no effort” to have an expert value the business or submit a report for trial. Greene v. Greene, 2001 Ohio 1675 (Ohio App. 2001).
In Mississippi, the Mississippi Court of Appeals held that the trial court did not err when it did not include any value of the husband’s automobile body shop in the equitable distribution. The husband operated the business as a sole proprietorship and the business had no tangible assets. The court found that in the absence of any valuation evidence beyond the business’s tax returns, the trial court appropriately characterized the business’s only asset as goodwill, which should not be considered for equitable distribution of a sole proprietorship in Mississippi. Fogarty v. Fogarty, 922 So.2d 836 (Miss. App., 2006).
In Illinois, the Appellate Court of Illinois, Second Division, was not sympathetic to the parties where the parties relied on the sale restrictions in the operating agreement of an LLC to value the business for equitable distribution. The court held in Schlichting v. Schlichting the following:
Valuation of marital property is a question of fact, not to be disturbed if in the range of competent evidence presented at trial. Moll, 232 Ill. App. 3d at 752. It is the parties’ burden to present valuation evidence. Id. An appellate court will not remand for an evidentiary hearing on value when a party had ample opportunity to present valuation evidence and failed to do so.
Schlichting v. Schlichting, 2014 IL App (2d) 140158 (Ill. App., 2014) citing In re Marriage of Moll, 597 N.E.2d 1230, (Ill. App. 2 Dist., 1992).
Legal malpractice occurs when an attorney intentionally or negligently mishandles a case and causes injury to a client. Statistics indicate that family lawyer malpractice is a significant problem in the United States and that the number of family law legal malpractice claims brought each year is increasing faster than the growth of the legal industry.
Clients bring legal malpractice claims when they feel that they have been harmed in some way by their attorney’s representation. To succeed in a legal malpractice claim, a client must prove four distinct elements. First, a client must show that an attorney-client relationship existed between the two parties. An attorney-client relationship typically arises when an attorney gives or promises to give legal advice to any person. Second, a client must prove that the attorney acted negligently, or with the intent to harm the client. Attorney negligence is defined as the failure to exercise the care, skill and diligence commonly possessed by a member of the legal profession. Third, the plaintiff must show that the attorney’s actions were the cause of the plaintiff’s injury. Finally, the plaintiff must convince the court that without the attorney’s improper behavior, the plaintiff would have been successful in the underlying case. The final element is often the most difficult to prove. If the injury may have occurred, despite the attorney’s actions, no cause of action for legal malpractice will be admitted. In order to preserve a claim for legal malpractice, a client must file a complaint within the statute of limitations period. The length of the statute of limitations for legal malpractice claims varies among states. Failure to file a claim within the limitations period bars the plaintiff from pursuing legal action against the attorney.
The family lawyer representing a client in a property division case has a duty to the client to reasonably attempt to value all marital property. Failure to advise the client that a business, which is all or partially marital property, should be valued is a breach of this duty. The client may decline to have a professional valuation of the business conducted, due to costs or other reasons. However, the family lawyer that overlooks this important asset subjects herself to a potential malpractice claim.
The Model Rules of Professional Conduct state “a lawyer shall provide competent representation to a client. Competent representation requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation.” Model Rules of Prof’l Conduct R. 1.1 (2013). Further, the rules state “a lawyer shall act with reasonable diligence and promptness in representing a client.” Model Rules of Prof’l Conduct R. 13. (2013).
A client with a legal malpractice claim may also report the attorney to the state disciplinary board. Each state has a licensing board (generally known as the “state bar”) which is responsible for regulating the ethical behavior of all attorneys within that particular state. While the client is unlikely to recover damages, potential disciplinary sanctions include disbarment or the payment of fines to the state bar association for improper handling of a valuation issue.
The family law judge and practitioner should have a basic understanding of the valuation of a closely held business for property division. The preliminary issues in dealing with a closely held business that is part of the marital estate are: 1) defining “what is a business”; 2) recognizing when a business must be valued; and 3) understanding the malpractice issues a family lawyer may face for failure to identify the business to the client and to explain the necessity to have the business valued. If it is determined that an interest in a closely held business is part of the marital estate, the family law practitioner should advise the client of the importance to obtain the services of a professional business valuator to appraise the value of the interest. Otherwise, an “unequitable” division of the property may result.