minority-discount-divorce-240px-499058488Schickner v. Schickner, 2015 Ariz. App. LEXIS 48 (April 16, 2015)

In the context of divorce, may a court apply a minority discount when valuing a minority interest in a business to determine the nonowner spouse’s fair share? This was the primary issue the Arizona appeals court addressed in ruling on the wife’s claim that the trial court undervalued two jointly owned business interests.

Interest in two professional practices. The husband was an ophthalmologist who, during the marriage, acquired a 50% community interest in an eye clinic and a 20% interest in a surgery center in which he performed eye operations. Arizona is one of nine community property states.

At trial, the valuations of the two interests for purposes of equitable distribution of the property became the flash point. Both parties retained seasoned business appraisers to support their positions.

In all, for each of the two business interests, four valuations were in play.

  1. Fifty percent interest in eye clinic. The husband’s first appraiser applied discounts for lack of control and for lack of marketability and valued the 50% interest in the eye clinic at $475,000.

The husband’s second appraiser valued the interest by: (a) applying minority interest and lack of marketability discounts to arrive at a value of $620,000; and (b) applying no such discounts to achieve a value of $830,000.

In contrast, the wife’s expert valued the entire business at over $3.2 million and from the total value concluded the community’s 50% interest was worth $1.6 million.

  1. Twenty percent interest in surgery center. Again, the husband’s first appraiser applied both minority share and lack of marketability discounts to conclude the community’s 20% interest in the surgery center was worth $580,000.

The wife’s second appraiser determined the interest was worth $490,000 when discounted for lack of control and lack of marketability and was worth $540,000 without discounts.

In contrast, the wife’s expert determined the surgery center as a whole was worth just under $5.3 million, which he concluded translated into $1.05 million for the community’s interest. (The court’s opinion does not include a detailed discussion of the appraisers’ valuation methodologies.)

At trial, the husband attacked the valuations of the wife’s expert, claiming the expert used too high a capitalization rate and for both businesses failed to account for lack of marketability and lack of control. The wife challenged the valuations from the husband’s experts, arguing his appraisers addressed the issue from the standpoint of the husband’s selling to a third party when there was no intent to do so. She also maintained that both discounts were only relevant factors if an outside buyer was buying into the practice but not where the present owner was “buying out” the co-owner, as was the case here. Further, the wife claimed the valuations were based on the use of “inflated rents” and excessive salaries to family members.

Valuator as ‘Zen master.’ The trial court said the husband’s first appraiser used a “Zen master” approach to valuation (no further explanation available) that it found “disconcerting.” It then went on to say that since this expert’s calculations aligned with those of the husband’s second appraiser, the first appraiser was credible.

At the same time, the trial court disapproved of certain “foundations” informing the calculations of the wife’s expert. For one, the court objected to the use of the 11% capitalization rate. A rate this high typically applies to a large publicly traded company, not to small businesses like the ones at issue, the court said. Further it pointed out that the expert did not value the specific interest of the community in each of the entities but instead determined the total value of the respective entity. Once he had ascertained that value, he divided it based on the share the community owned. But, said the trial court, a “minority interest has less value than the total interest of a company on a per-share basis.” Since the community did not own a controlling interest in either entity, this distinction was meaningful, the court said.

The trial court concluded that: (1) the fair market value of the 50% interest in the eye clinic was worth $602,000; and (2) the 20% interest in the surgery center was worth $536,000. Accordingly, it ordered the husband to pay the wife $569,000 for her half of the community’s interests in both businesses.

Facts don’t support discount. The wife appealed the trial court’s decision to the state’s Court of Appeals, contending that the lower court improperly applied a minority share discount that resulted in undervaluation. Use of this discount in a divorce setting violated Arizona law, she claimed.

The appeals court found the wife relied on the wrong case to support her position. Specifically, she cited a dissenting shareholder case that centered on the applicable statutory provisions requiring a “fair value buy-out.” But a marital dissolution proceeding is subject to an equitable division principle, thus a different standard, the appeals court pointed out.

It went on to say that no Arizona case prohibited the use of a minority interest discount in a marital dissolution case. It went on to say: “Consistent with the majority of other jurisdictions that have addressed the issue, we decline to adopt such a bright-line rule here.”

Rather, the appeals court said whether or not to apply a minority discount in the divorce context was a case-by-case determination requiring the trial court to “consider factors such as the minority shareholder’s degree of control, lack of marketability, and the likelihood of a sale of the minority interest in the foreseeable future.”

When applying these considerations to the facts of the case, the appeals court found the trial court’s valuation as to the eye clinic did not hold up. For one, the husband held the same interest in the business—50%—as the only other member of this limited liability company. The husband also had considerable power over financial decisions, including determining how much of his compensation he wanted to take in the form of salary and how much by way of distributions. Other than an inability to change the terms of rent, the record showed few limitations on the husband’s joint control of the business, the appeals court observed. What’s more, he did not indicate that he had any plans to sell his interest in the business. None of the justifications for a minority discount applied here, the appeals court concluded.

The appeals court also pointed out that the trial court’s valuation ($602,000) was not only substantially below the value the wife’s expert calculated ($1.6 million), but also below the fair value determination the husband’s second appraiser produced ($820,000). The trial court’s value even fell below that appraiser’s discounted value ($620,000). Therefore, the Court of Appeals remanded, ordering the trial court to revalue the interest in the eye clinic.

At the same time, the appeals court detected a rationale for applying a minority share discount to the valuation of the surgery clinic. The husband only owned 20% of the business, and there was no evidence in the record that his control “is not substantially limited by the holder of the 80% interest.” Consequently, the trial court did not abuse its discretion when it decided the fair market value of the community’s interest in the surgery center was $536,000, the appeals court said.

Distributions-related dispute. A second point of contention had to do with the husband’s compensation. In 2009 and 2010, the husband received “exactly the same” amount of compensation, $500,000, from the eye clinic. However, his CPA testified that, in 2010, the husband decided to change the form of payment from all salary to one-half salary and one-half distributions, ostensibly to avoid paying Medicare. In June 2010, the husband filed for divorce. The husband had an employment agreement with the eye clinic specifying a base salary for his medical services of $250,000.

The record did not show what the reasonable amount of compensation was for the husband’s “toil and labor” at the surgery center. Both businesses had operating agreements that specified that distributions of cash or other property to members were to be in proportion to their percentage interests.

After the husband had filed for divorce, the wife asked the trial court for a declaration that she was entitled to all the distributions from the two businesses issued prior to the court’s entering a final decree. The trial court declined to do so. It determined that the distributions represented salary or earned income and, therefore, were the husband’s separate property.

On appeal, the wife contended the trial court’s finding on this point was erroneous.

Under the applicable legal principles, “the community is generally ‘entitled to the profits and gains attributable to community assets,’” the appeals court explained. Further, “although property acquired by either spouse after service of a petition for dissolution of marriage is the separate property of the acquiring spouse, the service of a petition for dissolution does not alter the status of preexisting community property.” Here, the appeals court noted, the parties agreed that the husband’s $250,000 base salary was his separate property once he filed for divorce. At the same time, for him to be able to claim all of it as separate property meant proving in court that the remaining $250,000, which he received annually in the form of distributions over a three-year-period, was compensation for his toil and labor.

The appeals court concluded that the trial court had failed to “adequately consider Wife’s community interest in the two businesses.” Nor had it imposed the requisite burden of proof as to the distributions on the husband. Accordingly, the appeals court remanded, ordering the trial court to determine the reasonable amount of compensation as to each business and to credit any excess to the community “as profits derived from existing community assets and subject to equitable division.”