Column: Discussion on salable goodwill continues

Soshnick

Alerding

By R. James Alerding and Andrew Z. Soshnick

On July 29, 2010, the Wisconsin Court of Appeals issued a decision that upheld the inclusion of salable professional (personal) goodwill in a marital estate in Wisconsin. In McReath v. McReath, 729 N.W.2d 89 (Wis. Ct. App. 2010), the husband (Tim) had an orthodontic practice, and admitted that he could sell his practice for just over $1 million. Nonetheless, Tim argued that most of that amount was attributable to non-divisible professional goodwill. The Court of Appeals disagreed and ruled that professional goodwill was includable in the marital estate to the extent that it is salable. The Court of Appeals emphasized that there was no rule in Wisconsin that specifically excluded salable goodwill from marital estates. The Wisconsin Supreme Court affirmed the McReath Court of Appeals decision and focused on interesting aspects of the difficult question of valuing personal goodwill. (“Professional” goodwill is understood to include “personal” goodwill.)

The Wisconsin statute does not specifically exclude professional goodwill. – Both Wisconsin appellate courts made clear that the Wisconsin statute did not exclude professional goodwill from marital estates. It would be surprising if any state statute specifically excludes professional goodwill from marital estates; Indiana’s Dissolution of Marriage Act certainly does not. In fact, most state statutes do not even address the issue of professional goodwill. As a result of this dearth of legislative guidance, the exclusion of professional goodwill from marital estates generally emanates from court decisions. Those court decisions have often focused on the issue of “future earnings.” Some states statutorily exclude as a marital asset in the marital estate the “future earnings” of either spouse. The theory that professional goodwill essentially represented future earnings has been espoused by a number of courts. The Indiana Supreme Court, in Yoon v. Yoon for example, “explained that because personal goodwill depends on the continued presence of the particular professional, it ‘represents nothing more than the future earning capacity of the individual.’”

So the clear inference is that, since there is not a statutory exception for the exclusion of professional goodwill from marital estates, courts must articulate a sound basis for excluding some or all professional goodwill. Usually that reason is because it is a part of future earnings. The McReath court now offers another reason for exclusion – “pure” professional goodwill is not salable and salable goodwill, whether personal or enterprise, is includable in a marital estate.

The McReath court chose “not to require circuit courts to draw a distinction between personal and enterprise goodwill when dividing a marital estate that includes professional goodwill.” This is a curious but soundly reasoned conclusion. As a practical matter, there is a distinction between “pure” personal goodwill, transferrable personal goodwill (or simply “transferable goodwill” because it is not truly personal if it is transferable), and entity or enterprise goodwill. This second class, or “transferrable personal goodwill,” is what is at issue in the McReath case. The Supreme Court implies the conclusion that transferrable goodwill will include enterprise as well as transferrable personal goodwill, thus eliminating the need to specifically identify enterprise goodwill when deciding the portion of total goodwill includable in the marital estate.

And why shouldn’t salable professional goodwill regardless of characterization be includable in a marital estate? Many states espouse that the standard of value is fair market value. Salable personal goodwill is, by definition, includable in the fair market value of the entity being valued. Therefore in theory at least, determining the FMV of an entity would by definition include both the entity goodwill and the salable personal goodwill. The Wisconsin Court of Appeals and Wisconsin Supreme Court clearly agree with this statement. If FMV is the standard of value, there is no reason to conclude other than salable professional goodwill of any nature is to be included in a marital estate. However, as has been seen time and again, states will declare that the standard of value is FMV and then proceed to make an exception for a particular item. Why don’t they just call it “FMV Except”?

The Wisconsin Supreme Court concluded that although the best indicator of (goodwill) would be an actual purchase price, it would not proscribe or preclude the use of mathematical computations to determine the value of goodwill. – The McReath court further said that the employment of such mathematical formulas appeared to be widespread. While this comment might seem trivial, it is potentially valuable to the work of valuation analysts. There has often been criticism from some in the legal community over the use of formulas instead of actual transactions in determining not only the goodwill portion of the value of an interest in a business, but also the overall value of a business interest. Of course, most of the criticism is misintended to advance a case-specific agenda. The fact is: Only the market approach of the three accepted approaches to value would satisfy the standard of either an actual transaction or a value derived from transactions or guidelines. Valuation analysts know that often in the valuation of smaller businesses the income approach or the cost approach is utilized in determining the value of a business interest – including the goodwill value. This framework appears to be the “mathematical formulas” referred to by the court. While, this conclusion seems obvious to valuation analysts, it nevertheless will be helpful going forward to have the obvious stated as clearly as it is by the McReath court.

So where does this decision leave us. First, while it is, of course, relevant to cite when it is useful to your position, McReath only has precedential value in Wisconsin. Notwithstanding that fact, various states seem to cite each other frequently in arriving at their own decisions. That precedent may serve as useful persuasive authority. Secondly, McReath clearly confirms that FMV includes value that can be transferred from a seller to a buyer. Again, valuation analysts have known that fact even though some professionals have parsed it out when valuing goodwill to be excluded in a marital estate.

The Indiana Supreme Court in Yoon clearly implied that salable goodwill is includable in the marital estate when it said that, “The goal in dissolution, however, is not to value the business (including the professional) for a buyer. Rather, it is to identify the portion of the value that is attributable to the business without the professional’s continuing participation.” Obviously, salable goodwill, by definition, stays with the business and does not remain with the professional. Therefore, there should be further discussions and opinions in Indiana related to salable goodwill, regardless of characterization being part of a marital estate, thanks to the Wisconsin Supreme Court’s advancement of the art of valuation in a positive direction.•

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R. James Alerding CPA/ABV/CFF, ASA, CVA (Clifton Gunderson, LLP) is a partner with the Valuation and Forensic Services national practice. Drew Soshnick is chairman of Baker & Daniels’ family law group. The opinions expressed are the authors’.