Business Goodwill in Divorce Settlements: A Primer
If you and/or your spouse own a business, the valuation may include business goodwill. Here are the courts’ definitions of business goodwill, the types of goodwill those courts generally recognize, and which types can be considered marital property subject to division on divorce.
By Margaret Simpson, Family Lawyer
Divorce is seldom a pleasant or uncomplicated matter, and inherent stresses are amplified when the division of marital property includes a business owned by one of the spouses. Further complicating matters are variations from jurisdiction to jurisdiction of the definition of business goodwill, types of business goodwill, and approaches to business goodwill in divorce matters – all of which can make goodwill valuation challenging when dividing marital assets.
When the value of a marital business is in dispute, it is helpful to have an understanding of the relevant courts’ definitions of business goodwill, the types those courts generally recognize, and the primary approaches to determining which types can be considered marital property and thus equitably divided. An experienced family law attorney can help couples navigate the complexities and nuances of goodwill from jurisdiction to jurisdiction.
Defining, Determining, and Valuing Business Goodwill
Definition of Business Goodwill
It’s important to first understand how the states define business goodwill. It is uniformly recognized that goodwill is a type of property and constitutes a valuable asset of the business of which it is a part. From there, the definitions vary. Pennsylvania statute describes goodwill generally as “the favor which the management of a business has won from the public, and probability that old customers will continue their patronage.” Georgia family law defines it as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” And in Indiana, goodwill is “the value of a business or practice that exceeds the combined value of the net assets used in the business.”
Types of Goodwill
There are essentially two types of goodwill recognized by courts in divorce litigation: enterprise goodwill (also called commercial or professional goodwill), and personal goodwill (also called individual goodwill).
Enterprise or commercial goodwill is transferred whenever the enterprise to which it is attached is bought and sold as an ongoing concern. Individual or personal goodwill is not transferable when the enterprise is bought and sold and instead resides primarily in the personal reputation of the owner.
3 Approaches to Business Goodwill in Divorce
Whether enterprise and/or personal goodwill in a professional practice may be characterized as marital property and thus equitably divided varies by state. Three different approaches have developed:
1. All goodwill is marital property.
Many courts make no distinction between personal and enterprise goodwill. These jurisdictions have taken the position that both personal and enterprise goodwill in a professional practice constitute marital property.
The California Court of Appeals summarized the underlying rationale for this position in Golden v. Golden:
“In a divorce case, the goodwill of the husband’s professional practice as a sole practitioner should be taken into consideration in determining the award to the wife. In a matrimonial matter, the practice of the sole practitioner husband will continue, with the same intangible value as it had during the marriage. Under the principles of community property law, the wife, by virtue of her position of wife, made to that value the same contribution as does a wife to any of the husband’s earnings and accumulations during marriage. She is as much entitled to be recompensed for that contribution as if it were represented by the increased value of stock in a family business.”
2. No goodwill is marital property.
A minority of jurisdictions have taken the stance that neither personal nor enterprise goodwill in a professional practice constitutes marital property, and neither should be used in determining the fair market value of a business for equitably dividing it in divorce cases.
The justification for this view is summarized by a Mississippi court:
“It becomes increasingly difficult for experts to place a value on goodwill because it is such a nebulous term subject to change on a moment’s notice due to many various factors which may suddenly occur, i.e., a lawsuit filed against the individual or the death and/or serious illness of the individual concerned preventing that person from continuing to participate in the business. It is also difficult to attribute the goodwill of the individual personally to the business. The difficulty is resolved however when we recognize that goodwill is simply not property; thus it cannot be deemed a divisible marital asset in a divorce action.”
3. Only enterprise goodwill is marital property.
The majority of states, however, differentiate between enterprise goodwill and personal goodwill. Courts in these states take the position that enterprise goodwill is marital property, but personal goodwill is not.
An Indiana case summarizes this approach:
“Enterprise goodwill is an asset of the business and accordingly is property that is divisible in a dissolution to the extent that it inheres in the business, independent of any single individual’s personal efforts and will outlast any person’s involvement in the business. It is not necessarily marketable in the sense that there is a ready and easily priced market for it, but it is in general transferrable to others and has a value to others.
In contrast, the goodwill that depends on the continued presence of a particular individual is a personal asset, and any value that attaches to a business as a result of this ‘personal goodwill’ represents nothing more than the future earning capacity of the individual and is not divisible.”
The Georgia Supreme Court case Miller v. Miller reinforced the majority view that enterprise goodwill is marital property that should be included in the valuation of a professional practice.
However, the court’s ruling was narrow and did not explicitly adopt the second component of the majority view: that individual goodwill does not constitute marital property. Rather, the court noted that the trial court, in accepting the testimony of the wife’s expert, had excluded individual goodwill from its valuation of the husband’s medical practice. The Supreme Court upheld the trial court’s valuation of the husband’s business based on the assumption that individual goodwill does not constitute marital property in Georgia.
This holding leaves open the possibility that, under other facts and circumstances, individual goodwill could be considered marital property in Georgia and therefore included in the valuation of a business.
Again, the interpretations of what defines goodwill are highly nuanced, often based on case history and structure, and can and will vary from jurisdiction to jurisdiction.
Valuation of Business Goodwill
Although the definition of goodwill can be interpreted differently, most courts see the necessity of valuing that goodwill. The Miller v. Miller court recognized that there is no precise formula for determining the value of goodwill, but held that “even though it is difficult, it must be undertaken in each divorce matter where applicable. Goodwill may be measured by any legitimate method of evaluation that measures its present value by taking into account some past result, so long as the evidence legitimately establishes value.”
5 Types of Goodwill Valuation
The next logical step is to understand the types of goodwill valuation. Here are five common methods for valuing business goodwill.
1. Straight capitalization.
Under the straight capitalization accounting method, the practitioner’s average net profits are determined, and this figure is capitalized at a definite rate – for example, 20 percent. This result is considered to be the total value of the business, including both tangible and intangible assets. To determine the value of goodwill, the book value of the business’s assets is subtracted from the total value figure.
2. Net asset value.
The second accounting formula is the capitalization of excess earnings method. Under the pure capitalization of excess earnings, the goodwill net asset value is determined by calculating the average net income, subtracting the average annual salary of an employee practitioner with like experience, and multiplying that remaining amount by a fixed capitalization rate.
3. Capitalized excess earnings.
The IRS variation of capitalized excess earnings method takes the average net income of the business for the last five years and subtracts a reasonable rate of return based on the business’s average net tangible assets. A comparable net salary is subtracted from this, and the remaining amount is capitalized at a definite rate. The resulting amount is goodwill.
4. Market value.
The fourth method, the market value approach, sets a value on professional goodwill by establishing what fair price would be obtained in the current open market if the practice were to be sold. This method requires that a comparable professional practice has been recently sold, is in the process of being sold, or is the subject of a recent offer to purchase. Otherwise, the professional spouse may manipulate the value.
5. Buy/sell agreement.
In this fifth valuation method, goodwill is valued based on a recent actual sale, or an unexercised existing option or contractual formula set forth in a partnership or corporate agreement. Since many factors other than fair market value may have influenced the terms of the agreement, courts relying on this method should take those factors and the arm’s length nature of the transaction into account.
Additionally, the North Carolina Court of Appeals noted that “among the factors which may affect the value of goodwill and which therefore are relevant in valuing it are the age, health, and professional reputation of the practitioner, the nature of the practice, the length of time the practice has been in existence, its past profits, its comparative professional success, and the value of its other assets.”
In South Carolina, “another factor at play is the clear intent not to include future earnings as part of an equitable division award and also order an award of alimony based on those same earnings – in essence, to prevent the inequity of a double recovery.”
Finally, the court in Georgia’s Miller case held that “a determination of goodwill is a question of fact and not of law,” and “where it appears that the trial court reasonably approximated the net value of the practice and its goodwill, if any, based on competent evidence and on a sound valuation method or methods, the valuation will not be disturbed.”
Valuing Business Goodwill for Divorce Settlements Can Be Challenging
It is clear from this examination that business goodwill presents unique challenges when dividing marital assets. The situation becomes even more complex when the business in question operates in multiple states. Clear, informed counsel from an attorney experienced in the nuances and jurisdictional variations of family law can help accurately define and determine business goodwill and its value for couples seeking a divorce.
Margaret Simpson is an associate at Boyd Collar Nolen Tuggle & Roddenbery in Atlanta, Georgia. Her practice focuses on matters including divorce, alimony, asset division, child custody, and child support. She has handled numerous cases before the Georgia Court of Appeals and the Supreme Court of Georgia. www.bcntrlaw.com