Close-Up on Goodwill in Divorce Cases
When divorcing spouses own a private business interest, it complicates the settlement process. A spouse who’s active in the business may want to continue participating in day-to-day operations after the divorce is settled. So, it might not be an option to sell the business and split the proceeds. Instead, the business interest must be valued and included — either entirely or partially, depending on state law and legal precedent — in the marital estate.
Once a value has been assigned to the business interest, the parties need to work out an equitable distribution of the remaining marital estate. Often, that’s easier said than done. Fortunately, a business valuation professional can help the parties sort through the issues.
Two Components of Business Value
The value of a business can be broken down into two pieces. First up are tangible (or hard) assets, which include such items as cash, receivables, and equipment. These items are typically recorded on a company’s balance sheet. The difference between the combined market values of tangible assets and liabilities (such as payables and bank debt) is called net tangible value.
The second component is intangible value. Most intangible assets aren’t reported on financial statements because they’re generated internally. Moreover, any book values of intangible assets that are reported on the balance sheet are typically from a former purchase. Sometimes estimates used to allocate the purchase price to intangibles vary from the assets’ current fair market values, especially if the purchase occurred many years ago.
In general, intangible value equals the difference between the business’s fair market value and its net tangible value. Often, divorce courts lump all intangible value into a catchall phrase called “goodwill.” Sometimes, goodwill may include other identifiable intangible assets, such as patents, customer lists, brands, leases, and proprietary software.
Divvying up Goodwill
How goodwill is treated in a divorce depends on case facts, state law and relevant legal precedent. Some judges may look to other jurisdictions for guidance. State laws and legal precedent vary, but courts generally have three choices when dividing goodwill:
- Exclude all goodwill from the marital estate. Here, the expert separates business value into tangible and intangible components, and only the former is included in the marital estate.
- Include all business value in the marital estate. The business valuation expert makes no distinction between personal (or professional) and enterprise (or business) goodwill.
- Differentiate between enterprise and personal goodwill. Personal goodwill is specifically excluded from the marital estate, but enterprise goodwill is included.
A handful of states have yet to take sides on this issue, and others have made inconsistent rulings on goodwill. Although goodwill is generally associated with professional practices, some states have ruled that other types of businesses — including retailers, manufacturers and construction contractors — also may possess goodwill.
Enterprise vs. Personal Goodwill
In more than half the states, goodwill is broken into two pieces: enterprise and personal goodwill. The former is linked to the business itself. Companies with established brand names, accessible locations, and an assembled workforce likely possess enterprise goodwill.
Conversely, personal goodwill is inextricably linked to the business owner and can’t easily be transferred to a buyer. Personal goodwill is a function of an owner’s reputation, skills, and personal efforts. It’s also important to consider the age, health and retirement plans of shareholders. Personal goodwill is limited if shareholders are expected to participate in operations only for a short remaining time.
The logic behind excluding personal goodwill from the marital estate is that it represents a spouse’s future earning capacity. Some courts have determined that it’s unfair to credit a spouse who’s not active in the business for a company’s personal goodwill and also award maintenance payments based on the former spouse’s future earnings.
There’s little consensus across the United States on how courts should divvy up intangibles for divorce purposes. A clear understanding of relevant legal precedent and the theory underlying goodwill allocations can help divorcing spouses achieve equity. Contact a business valuation professional for more information.