As we begin the second decade of the 21st Century, Americans are inundated daily with media coverage focused on important issues such as government-sponsored bailouts of banks and massive corporations, high unemployment rates and increased competition in a shrinking world economy. Given this backdrop, many people may not even realize that our country’s economy ultimately remains dependent on "the little guy." Small businesses employ nearly 50% of the nation’s private sector work force and generate 50% of the non-farm, private real gross domestic product.1
Unfortunately, another very real statistic is the high divorce rate in the United States. While the annual divorce rate declined slightly from 2000 to 2007, it is estimated 3.6 out of every 1,000 marriages dissolved in 2007.2 Most practicing attorneys have encountered situations involving a client where divorce became a factor in the attorney’s representation.
This article identifies significant areas in which an individual’s ownership of a small business impacts upon the ultimate determination of issues to be resolved in a divorce action. For attorneys who practice in business law and represent small business owners, familiarity with these issues will enhance the attorney’s ability to properly counsel his or her client when the potential for divorce becomes apparent.
The Small Business as Marital Property Subject to Equitable Distribution
Under the Illinois Marriage and Dissolution of Marriage Act ("IMDMA") "marital property" is all property acquired by either spouse subsequent to marriage, except for certain specified situations where property may be found to be "non-marital property."3 In an action seeking dissolution of marriage, the court is charged with the responsibility of dividing all marital property, without regard to marital misconduct, in just proportions considering all relevant factors.4 Courts interpreting the IMDMA have uniformly held that the business interest of a spouse acquired subsequent to marriage constitutes "marital property" subject to equitable distribution upon dissolution of marriage.5
Thus, in the absence of a dispute over whether a business interest is properly characterized as marital or non-marital or evidence indicating that an enforceable premarital or postnuptial agreement is controlling, the issue of including a business interest as part of the marital estate is not typically contested. However, the methodology to properly value such an interest in connection with the court’s duties to equitably distribute the martial estate under the IMDMA is a more complex and variable matter. In this regard, not only must a determination of value be made as to the business interest, but the parties and the court must also address how the interest is to be awarded and the impact such an award ultimately has on distributing the remainder of the marital estate
Addressing a Party’s Business Interest in a Dissolution Action
A majority of cases in which a business interest is to be distributed in a dissolution of marriage action entail a spouse who is either the sole owner of a business or is part owner along with one or more third parties. Situations where both spouses maintain an ownership interest in the same business raise entirely different issues for a court to address as to the ultimate disposition of the asset and are not within the scope of this article.
Generally, courts will avoid awarding an ownership interest outright to a party whose spouse holds title to the business. This is in furtherance of a public policy under the IMDMA encouraging the severance of economic ties between individuals who become ex-spouses at the conclusion of the action.6 As a result, unless the parties agree or circumstances require that a court-ordered sale of the business interest be undertaken, ultimately the business interest will be awarded to only one spouse. This places the utmost importance upon proper valuation of the business interest, as well as all other marital property, so as to ensure that the distribution of the property is equitable and in accordance with the statutory provisions of the IMDMA.
As a practical matter and financial resources permitting, the parties will need to rely on expert witnesses in order to produce a comprehensive valuation of a spouse’s business interest.
There is no single method of business valuation that can be universally adapted for purposes of a dissolution action. Indeed, the undertaking is as much an art as it is a science.7 Both parties to a dissolution action have the burden of presenting the court with sufficient evidence to determine a business interest’s value.8 This often places a court in the difficult position of evaluating competing valuations of a single business interest at trial, based upon what could be vastly different methodologies followed by the parties’ expert witnesses. Nonetheless, a trial court’s valuation that falls within the range testified to by expert witnesses will not be disturbed on appeal unless it is contrary to the manifest weight of the evidence.9
Methods Commonly Employed in the Valuation of Business Interests
The First District Appellate Court in Blackstone v. Blackstone provided an overview of factors that a trial court should consider in its role as fact-finder when presented with business valuation issues in a marriage dissolution action. While a privately held business may lack an established market value, and lack of marketability itself could be a factor adversely affecting a business’ value, nonetheless such businesses are capable of being assigned an ascertainable value in the context of a dissolution action.10 The court in Blackstone emphasized that the circumstances of each particular case will affect the manner in which the valuation is to be made; while methods such as "book value", i.e. assets minus liabilities, and potential fair market value of a business if sold are relevant, they seldom are appropriate to be considered standing alone.11
Two methods that have been commonly utilized in Illinois dissolution cases are the "future earnings" approach (also sometimes referred to as "capitalization of earnings" approach) and the "past earnings" approach. The "future earnings" approach focuses on projected future earnings of a business, discounted to a present value.12 By comparison, the "past earnings" approach is three-pronged in that it 1) calculates earnings for a business over a period of previous years (for example, the preceding 3 to 5 years), 2) applies a capitalization rate and 3) discounts in percentage form based on factors affecting the marketability of the business, the degree to which a business is connected to a particular individual or family and the like.
There are multiple methods for valuation beyond the approaches referenced in this article. Many of these methods are variations of the book value, hypothetical fair market sale, "future earnings" or "past earnings" approaches. Ultimately, however, valuation of a business for purposes of a dissolution action may well be based on a seminal revenue ruling of the Internal Revenue Service from 1959 that was originally intended for applications outside the divorce context.
The stated purpose of IRS Revenue Ruling 59-60 is to outline generally the approach, methods and factors to be considered in valuing a closely held corporation’s shares for estate tax and gift tax purposes.13 However, this Revenue Ruling has been particularly useful for providing guidance to individuals and entities in many contexts, from negotiated buy-sell agreements to court proceedings as varied as dissenting shareholder actions under the Illinois Business Corporation Act14 to actions under the IMDMA.15 Revenue Ruling 59-60 recognizes the inherent imprecision of business valuations and the multitude of factors affecting a business from time to time, including economic "booms" and "depressions", and suggests a non-exclusive set of fundamental factors that should be followed in all instances. Illinois courts have thus assessed fair market value of businesses by reference to the relevant factors set forth in Revenue Ruling 59-60:
(a) The nature of the business and the history of the enterprise from its inception;
(b) The economic outlook in general and the condition and outlook of the specific industry in particular;
(c) The book value of the stock and the financial condition of the business;
(d) The earning capacity of the company;
(e) The dividend-paying capacity;
(f) Whether or not the enterprise has goodwill or other intangible value;
(g) Sales of the stock and the size of the block of stock to be valued;
(h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.16
Goodwill: What Is It, And Where Does It Belong In A Dissolution Action?
Goodwill may be defined as "the value of a business or practice that exceeds the combined value of the physical assets."17 Goodwill is an intangible asset whose placement on the books of a business as an asset for accounting purposes is unquestioned in both the private and public business sectors. However, its placement within the contours of a dissolution action under the IMDMA has been debated and the subject of several Illinois Supreme Court cases.
Initially, the Illinois Supreme Court analyzed the division within the appellate courts in earlier cases as to whether goodwill should be included in the valuation of a business interest in In re Marriage of Zells.18 The respondent in Zells owned a law practice that constituted marital property subject to equitable distribution in connection with the parties’ dissolution of marriage. In reaching its holding that the goodwill of the husband’s law practice is not to be considered a divisible marital asset, the Court adopted language from an earlier Third District Appellate Court case regarding the goodwill value of a doctor’s medical practice:
"Although many businesses possess this intangible known as good will, the concept is unique in professional business. The concept of professional good will is the sole asset of the professional. If good will is that aspect of a business which maintains the clientele, then the good will in a professional business is the skill, the expertise, and the reputation of the professional. It is these qualities which would keep patients returning to a doctor and which would make those patients refer others to him. The bottom line is that this is reflected in the doctor’s income-generating ability."19
After reasoning that goodwill of a professional business is responsible for the party’s future production of income, the Court then concluded that counting goodwill both as part of the value of an asset and in the determination of maintenance and child support awards would be duplicative and improper.20
Subsequently, the Illinois Supreme Court addressed the same issue in the context of a business interest fundamentally different than a professional practice, i.e. ownership of an automobile dealership. The court in In re Marriage of Talty21 rejected the wife’s argument that the holding in Zells was limited to situations involving a spouse’s ownership of a professional business interest. Instead, the Court held that a trial court’s responsibility to equitably divide marital property pursuant to the IMDMA requires consideration of the extent to which a non-professional business interest depends upon the owner’s personal efforts in a manner consistent with the analysis undertaken of a professional’s business.22 In so doing, the Court distinguished between "personal goodwill", that goodwill which is directly attributable to the personal efforts of the individual owner, and "enterprise goodwill", that goodwill which inheres in the business and exists independently of the owner’s personal efforts.23
Particularly striking in the Court’s decision in Talty was the extension of the concept of excluding personal goodwill in valuing a business interest even when the potential for improper double counting did not exist. Unlike the situation in Zells, where the husband had a maintenance obligation to the wife, the parties in Talty had children who were already emancipated and additionally the wife had waived any claim to maintenance.
The Illinois Supreme Court resolved any lingering uncertainty following Zells and Talty as to the proper treatment of personal goodwill in dissolution actions in the case of In re Marriage of Schneider.24 In Schneider the Court reversed the appellate court’s decision to include personal goodwill in the valuation of the husband’s dental practice for purposes of property distribution in the underlying dissolution action. The Court unequivocally held that, regardless of whether child support and/or maintenance awards are made, personal goodwill will never be considered an asset of a business for purposes of dividing marital property since it is already the subject of the court’s consideration of a party’s future income producing potential under the factors set forth in Section 503(d) of the IMDMA.25
An individual’s business interest, to the extent it qualifies as marital property, will be a significant aspect to any dissolution of marriage proceeding in Illinois. No matter the method by which a valuation is performed, at a minimum a thorough examination of the financial records of the business and an evaluation of its future prospects will be necessary. The value of the business interest itself will impact directly upon the property distribution to be made in the dissolution action. To the extent the business has any personal goodwill, it will not be considered a martial asset; however, personal goodwill as a barometer for future income producing potential directly impacts upon the proportionate share of marital property assigned to each spouse and can in applicable cases impact upon child support and maintenance.
It is the duty of both parties to a dissolution action to present sufficient evidence from which a court may make determinations as to these important issues. So long as the parties present information about the business that a court needs in order to follow the mandate of the IMDMA and the case law that has developed over time, the overriding objective of an equitable distribution of the marital estate can be achieved.
1 See The Small Business Economy: A Report to the President, U.S. Small Business Administration (SBA) Office of Advocacy (2009 ed.)
2 See National Marriage and Divorce Rate Trends (2000-2007), Division of Vital Statistics, National Center for Health Statistics
3 750 ILCS 5/503(a.)
4 750 ILCS 5/503(d) (listing twelve non-exclusive factors courts consider in making an equitable distribution of marital property)
5 In re Marriage of Schneider, 343 Ill.App.3d 628, 634, 798 N.E.2d 1242, 1247 (2nd Dist. 2003), quoting In re Marriage of Stone, 155 Ill.App.3d 62, 72, 507 N.E.2d 900, 906(4th Dist. 1987)
6 See, e.g., In re Marriage of Isaacs, 260 Ill.App.3d 423, 431, 632 N.E.2d 228, 234 (1st Dist. 1994); see also In re Marriage of Banach, 140 Ill.App.3d 327, 331, 489 N.E.2d 363, 366 (2nd Dist. 1986) In re Marriage of Jones, 187 Ill.App.3d 206, 231, 543 N.E.2d 119, 136 (1st Dist. 1989)
7 In re Blackstone v. Blackstone, 288 Ill.App.3d 905, 913, 681 N.E.2d 72, 78 (1st Dist. 1997)
8 Id., 288 Ill.App.3d at 910, 681 N.E.2d at 76.
9 See In re Marriage of Olson, 223 Ill.App.3d 636, 646, 585 N.E.2d 1082, 1089 (2nd Dist. 1992); In re Marriage of Brooks, 138 Ill.App.3d 252, 260, 486 N.E.2d 267, 272 (1st Dist. 1985)
10 In re Blackstone v. Blackstone, 288 Ill.App.3d at 918, 681 N.E.2d at 78 (1st Dist. 1997)
11 Id., also citing In re Marriage of Reib, 114 Ill.App.3d 993, 449 N.E.2d 919 (1st Dist. 1983) and Beerly v. Department of Treasury, 768 F.2d 942 (7th Cir. 1985)
12 Illinois appellate courts have differed in their views on the appropriateness of the "future earnings" approach. Compare Marriage of Cutler, 334 Ill.App.3d 731, 778 N.E.2d 762 (5th Dist. 2002with In re Marriage of Olson, 223 Ill.App.3d 636, 646, 585 N.E.2d 1082, 1089 (2nd Dist. 1992)
13 See Rev Rul 59-60 at §1
14 805 ILCS 5/1.01 et.seq.
15 See, e.g., In re Marriage of Puls, 268 Ill.App.3d 882, 645 N.E.2d 525 (1st Dist. 1994); In re Marriage of Rossi, 113 Ill.App.3d 55, 60, 446 N.E.2d 1198, 1202 (1st Dist. 1983)
16 See, e.g., Taxy v. Worden, 181 Ill.App.3d 97, 101, 536 N.E.2d 901, 904 (1st Dist. 1989)
17 In re Marriage of White, 151 Ill.App.3d 778, 780, 502 N.E.2d 1084, 1086 (1986), quoting 2 Valuation and Distribution of Marital Property, sec. 23.04(M.Bender ed. 1984)
18 In re Marriage of Zells, 143 Ill.2d 251, 254-55, 572 N.E.2d 944, 946 (1991)
19 Id., 143. Ill.2d at 255-256, 572 N.E.2d at 946, quoting In re Marriage of Courtright, 155 Ill.App.3d 55, 58, 507 N.E.2d 891, 894 (3rd Dist. 1987)
20 Id., 143 Ill.2d at 256, 572 N.E.2d at 946.
21 In re Marriage of Talty, 166 Ill.2d 232, 652 N.E.2d 330 (1995)
22 Id., 166 Ill.2d at 238-239, 652 N.E.2d at 333-334.
23 Id., 166 Ill.2d at 239, 652 N.E.2d at 334.
24 In re Marriage of Schneider, 214 Ill.2d 152, 824 N.E.2d 177 (2005)
25 Id., 214 Ill.2d at 165-166, 824 N.E.2d at 185-186.
Daniel P. Fitzgerald is a solo practitioner and owner of The Fitzgerald Law Firm, P.C. in Lisle, Illinois. Mr. Fitzgerald concentrates his practice primarily in family law, business law, civil litigation and residential/commercial real estate contracts. He is an active member of the DuPage County Bar Association, Illinois State Bar Association and Lisle Area Chamber of Commerce. Mr. Fitzgerald received his B.M. in both Music and Economics from DePauw University in 1996 and his J.D., cum laude from Loyola University-Chicago School of Law in 1999.