In divorce cases, one of the more difficult assets to divide in property division is an ownership interest in a closely held business. A professional business valuation should be obtained to value the subject company for equitable division purposes. A business valuation report can be lengthy and confusing. One section of a business valuation report that is extremely important, and frequently confusing to family lawyers and judges, is Normalizing Adjustments. This article will define and explain the Normalizing Adjustments found in a business valuation report.

Normalizing Adjustments

Normalization adjustments are required to adjust the historical financial statements of the business, so the statements are representative of a normal condition of the subject company as of the business valuation date. Normalizing adjustments are also applied to eliminate various one-time charges and other abnormalities. Normalizing adjustments deserve much attention in a divorce property division case because these adjustments can greatly affect the value of the subject company. Following are the most common normalizing adjustments made by business valuators:

Officer Compensation

Owners of small, closely held businesses take money out of the business in a variety of ways, generally to minimize taxes. The form of the business entity will have a large effect on this issue.

For example, a business organized as a corporation under chapter C may deduct the salary and employee taxes paid to shareholders, but may not deduct dividends paid to shareholders. Further, dividends are taxed to the shareholder as income. The corporation and the shareholder are both taxed for the dividend resulting in double taxation. Thus, owners of closely held C corporations generally bucket-out money through the payment of salaries, bonuses, and benefits.

Alternatively, a business organized as an S-corporation, LLC, or partnership passes through all income to the members who are liable for income taxes. Salaries and bonuses are subject to employment taxes, but income distributions are not subject to employment taxes. Thus, members may pay themselves a minimal, or no salary to avoid employment taxes and bucket-out money through distributions.

The business valuator will generally adjust the owners’ and officers’ salaries to market rates to normalize the financial statements. I prefer to look at the situation as if I were buying the subject company and I ask “what would I have to pay employees to replace the owners and officers”? The US Bureau of Labor Statistics and other benchmarking databases maintain current and historical compensation statistics by occupation and region, which is useful in adjusting compensation to market rates.

In divorce property division cases, the attorney or judge must be alert to the danger of “double-dipping.” Double-dipping occurs where spousal support is based on the business owner’s actual income, but property division is based on the value of the subject company after the owner’s salary has been normalized. For example, a business owner pays himself a salary of $400,000 per year. The business valuator determines that the appropriate salary for the position is $250,000 per year and normalizes the business’s financial statements by adding back $150,000 to the income of the business. This will increase the value of the business for property division purposes and increase the amount awarded to the dependent spouse. The double dip occurs if spousal support is awarded based on the business owner’s income of $400,000, of which $150,000 was added back to the value of the business and distributed to the dependent spouse in the property division award. The result is that the dependent spouse receives an inflated amount of combined spousal support and property division. Whether the issue of double-dipping is a factor in a spousal support and property division case depends on the particular state law.

In Georgia, the Supreme Court of Georgia held in Miller that “with the separate bases for the alimony award and the property division clearly acknowledged before the court…, we find no double dipping here.” Miller v. Miller (Ga., 2010).

Depreciation

Depreciation is an income deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.[i] The Internal Revenue Code allows various forms of accelerated depreciation that permits a business to deduct the cost of an asset over a period that is shorter than the useful life of the asset. This can result in the financial statements reflecting varying depreciation expenses in certain years that may understate or overstate the actual income of the subject company.

The depreciation of assets may also be calculated under Generally Accepted Accounting Principles (GAAP).[ii] Under GAAP, the assets are generally depreciated using the straight-line method of depreciation which allows an annual deduction equal to the cost of the asset divided by the useful life of the asset.

A business valuation report, whether a “Conclusion of Value” or “Calculation of Value,” that is prepared from the business’s tax returns, or financial statements prepared on a “tax basis”, should normalize depreciation expense on the income statement and accumulated depreciation on the balance sheet by converting the depreciation from “Tax to GAAP.” By converting the “Tax” depreciation to “GAAP” depreciation, the financial statements are normalized to be representative of a normal condition of the subject company as of the business valuation date. Failure to normalize depreciation can result in an inaccurate value of the subject company.

Rent

Owners of small, closely held businesses sometimes set up arrangements where the property occupied by the subject company, or certain equipment used by the subject company, is leased from the owner or a related entity. A business owner may use this arrangement to bucket-out cash from the subject company as an expense, or to boost earnings of the subject company by reducing rent expense.

A business valuation report should normalize rent expense to related parties by adjusting the rent expense to the market rate for similar properties or equipment. By adjusting the rent to market rates, the financial statements are normalized to be representative of a normal condition of the subject company as of the business valuation date. Failure to normalize rent expense can result in an inaccurate value of the subject company.

Shareholder Discretionary Spending

Owners of small, closely held businesses may direct the subject company to purchase and/or maintain certain assets that are for the quasi-personal use and benefit of the owner. These expenditures are referred to as owner or shareholder discretionary expenditures. The most common examples are luxury automobiles, private aircraft, boats, and vacation properties.

A business valuation report should normalize shareholder discretionary expenditures by eliminating these expenditures as expenses on the financial statements. This will increase the earnings and the value of the subject company. By adjusting the shareholder discretionary expenditures, the financial statements are normalized to be representative of a normal condition of the subject company as of the business valuation date. Failure to normalize discretionary expenditures can result in an inaccurate value of the subject company.

Pension and Retirement Contributions

Owners of small, closely held businesses may set up pension or retirement plans for the benefit of the owners only. These plans are generally not tax deductible and are a form of an owner’s discretionary spending.

A business valuation report should normalize these owner benefits by eliminating these expenditures as expenses on the financial statements. This will increase the earnings and the value of the subject company. By adjusting these owner benefits, the financial statements are normalized to be representative of a normal condition of the subject company as of the business valuation date. Failure to normalize discretionary expenditures can result in an inaccurate value of the subject company.

Meals and Entertainment Expense

Most small, closely held businesses incur expenses for business meals and entertainment. The Internal Revenue Code allows only 50 percent of these expenses to be deducted for tax purposes.[iii] Thus, if the business valuation is being prepared from the tax returns, or financial statements prepared on a “tax basis” of the subject company, the meals and entertainment expense will be 50 percent of the actual expenses incurred.

A business valuation report should normalize the meals and entertainment expense from the tax returns by increasing the expense for the 50 percent that is disallowed on the tax returns. On the other hand, if the meals and entertainment expense is inflated by the business owner’s personal expenditures, then the business valuation report should normalize the meals and entertainment expense by eliminating these expenditures as expenses on the financial statements. Failure to normalize meals and entertainment expense can result in an inaccurate value of the subject company.

One-time Charges and Other Abnormalities

One-time charges and abnormalities include income and expenses that are outside the subject company’s normal course of business. Examples of one-time charges and abnormalities include the following: 1) the sale of an asset, 2) a one-time contract for a service or product that the subject company normally does not provide, 3) a gain or loss on investments, 4) a lawsuit settlement, 5) employee embezzlement or theft, 6) uninsured losses, 7) regulatory fines and compliance costs, and 8) etc. … you get the idea. A business valuation report should normalize these one-time charges and abnormalities by eliminating these incomes and expenses on the financial statements. Failure to normalize one-time charges and abnormalities can result in an inaccurate value of the subject company.

Conclusion

The family law judge and practitioner should have a basic understanding of the valuation of a closely held business for property division. 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. A business valuation report can be lengthy and confusing. One section of a business valuation report that is extremely important, and frequently confusing to family lawyers and judges is Normalizing Adjustments. Normalizing adjustments deserve much attention in a divorce property division case because these adjustments can greatly affect the value of the subject company. Thus, an understanding of Normalizing Adjustments is important to prevent an “unequitable” division of property.

[i] IRS Small Businesses & Self Employed, A Brief Overview of Depreciation, 2017, http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/A-Brief-Overview-of-Depreciation.

[ii] Federal Accounting Standards Board, FASAB Handbook of Federal Accounting Standards and Other Pronouncements, as Amended, June 30, 2016.

[iii] I.R.C. § 274 (2014).

Dwight A. Ensley, JD, MBA, BBA, CVA

This article was published in the Spring 2017 edition of “The Family Law Review” by the Family Law section of the Georgia State Bar Association.https://sbog.informz.net/sbog/data/images/FLR_Spring2017.pdf