How Income is Determined in Divorce When One Party Owns a Business: Reasonable Compensation 101

On February 3, 2020, Pecos Law Group published a blog regarding how business valuations are conducted in a divorce when a party owns a business or part of a business. As discussed, one of the approaches used to value a business is the “income approach,” which involves the future income stream of a business.
Often, when one spouse owns a business, their income is higher than the other spouse’s. If the lower-earning spouse is receiving a community portion of a business that was calculated using income stream, an issue arises when the court determines alimony. Additionally, Nevada law has established that “goodwill,” or, more simply put, a business’s reputation, is an asset subject to community property division. Should a business owner’s actual income be factored into both the business value and an alimony calculation?
One approach that is sometimes used is the idea of reasonable compensation. The idea behind this is that instead of using the business owner’s actual income for alimony purposes, the business valuation expert will calculate the business owner’s “reasonable compensation,” or the owner’s earning capacity and what they might expect to make, or what the business might expect to pay, a similar employee. The argument in favor of reasonable compensation is that it avoids “double dipping” of the value of the business based on income stream and goodwill and the use of the owner’s entire income (which is already factored into the business’s income stream) for alimony purposes.
The idea of “double dipping” is the idea that dividing an income-producing asset and also using the income produced by that asset to determine alimony results, essentially, in the spouse receiving that income paying the other spouse for it twice. Often, this is avoided in things like pension and retirement accounts. If, for example, a retirement account is split 50-50 between two spouses at the time of a divorce, when one spouse begins receiving those retirement benefits, they should not be considered as income for alimony purposes because the other spouse already received his or her half of the benefits.
The Nevada Supreme Court has not yet issued case law either instituting or rejecting double-dipping in cases involving a business owner. Other states differentiate between “professional goodwill,” or the future earning capacity of the business owner, and “enterprise goodwill,” which includes things like whether the business is in a good location and has a good reputation.
The case law out of Nevada, however, has not differentiated between “professional goodwill” and “enterprise goodwill,” but discusses only goodwill generally. Other states have determined that it is improper to consider goodwill as both an asset for community property division and income for alimony.
In New York, for example, double-dipping has been prohibited. In Sodaro v. Sodaro, 286 A.D.2d 434, 435-36, 729 N.Y.S.2d 731, 732 (2001), the court adopted an “excess earnings method” in valuing a party’s psychiatric practice. This involved calculating an average of the amount by which the psychiatrist’s adjusted income from the practice exceeded what would be his reasonable compensation. The trial court converted a certain amount of the psychiatrist’s future income into an asset, subject to property division, but used his entire income, including those excess earnings for alimony. The appellate court found this was improper, stating, “[o]nce a court converts a specific stream of income into an asset, that income may no longer be calculated into the [alimony] formula and payout.” Id. at 436.
Similarly, the Supreme Court of Illinois has stated that goodwill is not a marital asset because it is reflected in the spouse’s income capacity. In Illinois, goodwill value is reflected only in alimony awards and “[a]ny additional consideration of goodwill value is duplicative and improper.” In re Marriage of Zells, 572 N.E.2d 944, 946 (Ill. 1991).
In Indiana, goodwill is also not divisible as an asset because it represents “a surrogate for the owner’s future earning capacity and is not divisible.” Yoon v. Yoon, 711 N.E.2d 1265, 1267 (Ind. 1999). The Supreme Court of Utah has stated that the “fruits” of a business owner’s degree and reputation are already “shared by” the other spouse “in the form of alimony” and that dividing the value of a business owner’s reputation would constitute improper “double counting.” Sorensen v. Sorensen, 839 P.2d 774, 776, 183 Utah Adv. Rep. 13 (1992).
Currently, there are four different positions states take regarding reasonable compensation and double-dipping. First, there are states that count enterprise goodwill as part of the community estate, but not personal goodwill. These states include Alaska, Arkansas, Connecticut, Delaware, Florida, Hawaii, Illinois, Indiana, Maryland, Massachusetts, Minnesota, Missouri, Nebraska, New Hampshire, Oklahoma, Oregon, Pennsylvania, Rhode Island, Texas, Utah, Virginia, Wisconsin, and Wyoming.
Next, there are states that count all goodwill, both enterprise and personal, as community property. As stated, Nevada is one of these states, along with Arizona, California, Colorado, Kentucky, Michigan, Montana, Nevada, New Jersey, New Mexico, New York, North Carolina, North Dakota, and Washington.
In other states, no goodwill is considered community property, and a business valuation expert will need to determine the business owner’s actual compensation, as well as the business’s tangible assets. These states include Kansas, Louisiana, Mississippi, South Carolina, and Tennessee. Finally, some states – Alabama, Georgia, Idaho, Iowa, Maine, Ohio, South Dakota, and Vermont – remain undecided.
While Nevada recognizes that goodwill is a community asset, there is currently no published case law dictating that double-dipping is or is not allowable. This has led to inconsistent decisions from the courts, and differing arguments by attorneys. When arguing against double-dipping, there is an argument to be made that goodwill already incorporates future income and that considering a business owner’s total income for alimony purposes results in an unconscionable windfall to the other spouse.
If you own a business or your spouse owns a business and you are going through a divorce or contemplating one, it is clear that, at least in Nevada, determining the value of that business so it can be divided in a divorce is not as simple as simply adding up receivables and tangible assets and subtracting liabilities. It is important, in those cases, to retain an attorney experienced in complex divorce litigation.