Understanding Equitable Distribution

As the definition of marital property continues to expand and embrace more and more esoteric forms of property, equitable distribution cases become increasingly complex. Consequently, the tendency for matrimonial lawyers is to rely on the valuation expert and to blindly accept and utilize the bottom line numbers contained in their reports. The pitfall is that, whether in the context of settlement negotiations or litigation, in order to properly prosecute or defend the client's case, the matrimonial practitioner cannot wholly rely on the expert. The attorney must be able to understand on his or her own the analytical components and premises of the valuation methodology.

One frequently used valuation methodology, often seen in the context of valuing a professional partnership interest, is the capitalization of excess earnings method. In this approach, the amount of the titled spouse's earnings in excess of reasonable compensation - the so-called goodwill in the entity - is multiplied by a capitalization rate in order to arrive at the value of the interest in the partnership.

The following is a breakdown of the excess earnings valuation methodology into digestible pieces.

Step One: Partner's Income

The first step is to calculate the 5-year straight average as well as the 5-year weighted average of the partner's share of income from Schedules K-1 annexed to the tax returns, going back from and including the year in which the divorce action is commenced.

For example, date of commencement: 10/2/02

a. 2002                       $1,350,000

b. 2001                       $1,230,000

c. 2000                        $1,175,000

d. 1999                        $1,250,000

e. 1998                        $1,105,000

Straight 5-year avg. = $1,222,000

Weighed 5-year avg. = $1,253,333

Step Two: Share of the Accounts Receivable (A/R) and Work-in-Progress (WIP)

The second step involves the following sub-parts:

• Using the firm's audited financial statement, add together the billed and unbilled fees and disbursements receivables.
• Subtract out any estimated reserves of uncollectables to get the net billed and unbilled receivables.
• Multiply by partner's share of capital (overall percentage of equity in the firm).
• Subtract partner's tax rate.
• Arrive at partner's share of A/R and WIP.

Billed fees (A/R)                  $50,000,000

Unbilled fees (WIP)             $70,000,000

Billed disbursements           $3,000,000

Unbilled disbursements       $7,000,000

Total billed and unbilled

  fees and disbursements    $130,000,000

Less: estimated reserves   ($20,000,000)

Net A/R and WIP                 $110,000,000

Net partner's share

  of capital                           0.66666%

Partner's share of Net A/R and WIP

                                           $733,333

Less: Taxes (45%)             ($330,000)

Partner's Net share of Net A/R and

  WIP                                   $403,333

Step Three: Capital Account

For each of 5 years on the Schedule K-1 there is a number for capital at the beginning of the year, capital contributed during the year, the partnership income or loss (money being earned or lost), money withdrawn (ie, distributed or paid out) and capital ending balance. The capital ending balance in the most current year is used in the excess earnings valuation. Here, let's assume the capital account ending balance for the most current year is $375,000.

Step Four: Net Tangible Assets

Now you can arrive at a figure for Net Tangible Assets:

Add: Partner's Share

  of Net A/R and WIP                   $403,333

To this, add:

Partner's Capital Account Balance

                                                    $375,000

Partner's Share of Net

  Tangible Assets                         $778,333

Step Five: Return on Net Tangible Assets

In Step Five, you need to determine the return on the Net Tangible Assets. The rate of return usually ranges between 7.5% and 10%. This rate of return is one of the subjective variables in the valuation.

Net Tangible Assets                    $778,333

Multiply by: Reasonable

  Rate of Return                           x 8%

Reasonable Return on Net

  Tangible Assets                        $62,267

Step Six: Excess Earnings Analysis

The 5-year weighted average K-1 income is reduced by the partner's “reasonable compensation.” Reasonable compensation is another subjective variable. The concept is intended to capture what an individual with similar credentials to this partner could earn in the marketplace. Extensive research is conducted and surveys (such as those done by Altman, Weil, Pensa) of law firm compensation are employed. The experts look at this partner's education, compensation throughout various geographic regions, areas of specialization, and type of law firm. They may also look at non-partners at the firm itself for this measure. For mid- to large-sized firms, reasonable compensation numbers commonly range from $300,000 to $400,000, but have been seen as high as $600,000 at firms with extremely high compensation levels.

Once the K-1 income is reduced by the reasonable compensation, you arrive at the “gross” excess earnings. Next, you offset taxes at the partner's tax rate, and then you subtract the return on the net tangible assets (calculated in Step Five), to arrive at:

After-Tax Excess Earnings

5-yr Weighted Average K-1 Income

                                             $1,253,333

Less: Reasonable Compensation

                                              $(400,000)

Excess Earnings Before Return on Net 

Tangible Assets                   $853,333

Less Taxes (45%)                ($384,000)

After-Tax Excess Earnings   $469,333

Less: Return on Net

  Tangible Assets                 $(62,207)

After-Tax Excess

  Earnings                            $407,066

Step Seven: Indicated Value

The partner's interest is composed of both his or her share of the net tangible assets (ie, A/R, WIP, and capital account) and goodwill. Therefore, there remains the derivation of goodwill from the after-tax excess earnings number by the use of a “multiple” or “capitalization rate,” another subjective variable. Often in a professional practice, an expert will use a multiple of 1.5 if the excess earnings are pre-tax, and 3.0 if the excess earnings are after-tax. Then, the final “indicated value” of the partner's interest is achieved by adding together the partner's share of the net tangible assets and the goodwill (ie, the after-tax excess earnings times the multiple).

Partner's share of Net Tangible

  Assets:                              $778,333

After-Tax Excess

  Earnings:                           $407,066

x Multiple 3.0

  Goodwill                             $1,221,198

Indicated Value:                  $1,999,531

Conclusion

The excess earnings method is by no means dispositive of value, but it is widely accepted, and, therefore, it is essential for the matrimonial lawyer to understand and master it.

As the definition of marital property continues to expand and embrace more and more esoteric forms of property, equitable distribution cases become increasingly complex. Consequently, the tendency for matrimonial lawyers is to rely on the valuation expert and to blindly accept and utilize the bottom line numbers contained in their reports. The pitfall is that, whether in the context of settlement negotiations or litigation, in order to properly prosecute or defend the client's case, the matrimonial practitioner cannot wholly rely on the expert. The attorney must be able to understand on his or her own the analytical components and premises of the valuation methodology.

One frequently used valuation methodology, often seen in the context of valuing a professional partnership interest, is the capitalization of excess earnings method. In this approach, the amount of the titled spouse's earnings in excess of reasonable compensation - the so-called goodwill in the entity - is multiplied by a capitalization rate in order to arrive at the value of the interest in the partnership.

The following is a breakdown of the excess earnings valuation methodology into digestible pieces.

Step One: Partner's Income

The first step is to calculate the 5-year straight average as well as the 5-year weighted average of the partner's share of income from Schedules K-1 annexed to the tax returns, going back from and including the year in which the divorce action is commenced.

For example, date of commencement: 10/2/02

a. 2002                       $1,350,000

b. 2001                       $1,230,000

c. 2000                        $1,175,000

d. 1999                        $1,250,000

e. 1998                        $1,105,000

Straight 5-year avg. = $1,222,000

Weighed 5-year avg. = $1,253,333

Step Two: Share of the Accounts Receivable (A/R) and Work-in-Progress (WIP)

The second step involves the following sub-parts:

• Using the firm's audited financial statement, add together the billed and unbilled fees and disbursements receivables.
• Subtract out any estimated reserves of uncollectables to get the net billed and unbilled receivables.
• Multiply by partner's share of capital (overall percentage of equity in the firm).
• Subtract partner's tax rate.
• Arrive at partner's share of A/R and WIP.

Billed fees (A/R)                  $50,000,000

Unbilled fees (WIP)             $70,000,000

Billed disbursements           $3,000,000

Unbilled disbursements       $7,000,000

Total billed and unbilled

  fees and disbursements    $130,000,000

Less: estimated reserves   ($20,000,000)

Net A/R and WIP                 $110,000,000

Net partner's share

  of capital                           0.66666%

Partner's share of Net A/R and WIP

                                           $733,333

Less: Taxes (45%)             ($330,000)

Partner's Net share of Net A/R and

  WIP                                   $403,333

Step Three: Capital Account

For each of 5 years on the Schedule K-1 there is a number for capital at the beginning of the year, capital contributed during the year, the partnership income or loss (money being earned or lost), money withdrawn (ie, distributed or paid out) and capital ending balance. The capital ending balance in the most current year is used in the excess earnings valuation. Here, let's assume the capital account ending balance for the most current year is $375,000.

Step Four: Net Tangible Assets

Now you can arrive at a figure for Net Tangible Assets:

Add: Partner's Share

  of Net A/R and WIP                   $403,333

To this, add:

Partner's Capital Account Balance

                                                    $375,000

Partner's Share of Net

  Tangible Assets                         $778,333

Step Five: Return on Net Tangible Assets

In Step Five, you need to determine the return on the Net Tangible Assets. The rate of return usually ranges between 7.5% and 10%. This rate of return is one of the subjective variables in the valuation.

Net Tangible Assets                    $778,333

Multiply by: Reasonable

  Rate of Return                           x 8%

Reasonable Return on Net

  Tangible Assets                        $62,267

Step Six: Excess Earnings Analysis

The 5-year weighted average K-1 income is reduced by the partner's “reasonable compensation.” Reasonable compensation is another subjective variable. The concept is intended to capture what an individual with similar credentials to this partner could earn in the marketplace. Extensive research is conducted and surveys (such as those done by Altman, Weil, Pensa) of law firm compensation are employed. The experts look at this partner's education, compensation throughout various geographic regions, areas of specialization, and type of law firm. They may also look at non-partners at the firm itself for this measure. For mid- to large-sized firms, reasonable compensation numbers commonly range from $300,000 to $400,000, but have been seen as high as $600,000 at firms with extremely high compensation levels.

Once the K-1 income is reduced by the reasonable compensation, you arrive at the “gross” excess earnings. Next, you offset taxes at the partner's tax rate, and then you subtract the return on the net tangible assets (calculated in Step Five), to arrive at:

After-Tax Excess Earnings

5-yr Weighted Average K-1 Income

                                             $1,253,333

Less: Reasonable Compensation

                                              $(400,000)

Excess Earnings Before Return on Net 

Tangible Assets                   $853,333

Less Taxes (45%)                ($384,000)

After-Tax Excess Earnings   $469,333

Less: Return on Net

  Tangible Assets                 $(62,207)

After-Tax Excess

  Earnings                            $407,066

Step Seven: Indicated Value

The partner's interest is composed of both his or her share of the net tangible assets (ie, A/R, WIP, and capital account) and goodwill. Therefore, there remains the derivation of goodwill from the after-tax excess earnings number by the use of a “multiple” or “capitalization rate,” another subjective variable. Often in a professional practice, an expert will use a multiple of 1.5 if the excess earnings are pre-tax, and 3.0 if the excess earnings are after-tax. Then, the final “indicated value” of the partner's interest is achieved by adding together the partner's share of the net tangible assets and the goodwill (ie, the after-tax excess earnings times the multiple).

Partner's share of Net Tangible

  Assets:                              $778,333

After-Tax Excess

  Earnings:                           $407,066

x Multiple 3.0

  Goodwill                             $1,221,198

Indicated Value:                  $1,999,531

Conclusion

The excess earnings method is by no means dispositive of value, but it is widely accepted, and, therefore, it is essential for the matrimonial lawyer to understand and master it.