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By: Joseph Aquino, CPA, CVA Director
There is a distinction between two types of goodwill depending upon the type of business enterprise: institutional goodwill and professional practice goodwill. Goodwill in a professional practice entity may be attributed to the practice itself and to the professional practitioner.
Goodwill continues to fuel debate in divorce cases that involve professionals, such as physicians and attorneys. In an Arizona case law, Walsh v. Walsh, the court of appeals reversed the family court’s ruling that limited a law firm partner’s goodwill to the amount he would receive under a stock redemption agreement.
Disagreement over goodwill
During the divorce proceedings between Cheryl and E. Jeffrey Walsh, the parties couldn’t come to terms about the value of Jeffrey’s intangible professional (or personal) goodwill. He claimed that his interest in the law firm should be $140,000, which was the stock redemption value pursuant to the firm’s stockholder’s agreement. Jeffrey’s expert testified that, while he had professional goodwill, the only realizable benefit from his employment as of the date of divorce was the $140,000 redemption value.
Cheryl’s expert applied a capitalization-of-earnings valuation approach and examined documents related to the husband’s tax returns, earnings sustainability, historical income performance, client loyalty, and reputation. Based on those factors, and giving very little weight to the stockholder’s agreement, the expert valued Jeffrey’s professional practice at about $1.3 million.
The family court agreed with Jeffrey’s expert and found that his interest in the firm (including goodwill) and the value of his law practice were limited to $140,000. Cheryl appealed, contending that the lower court shouldn’t have limited Jeffrey’s professional goodwill as an attorney to his stock redemption interest in his firm.
Appellate court sides with Cheryl
The appellate court explained that future earning capacity isn’t goodwill per se. On the other hand, goodwill may exist when future earning capacity has been enhanced because reputation leads to probable future patronage from potential and existing clients. Like other Arizona professionals, lawyers face evaluation of their professional goodwill as a community asset under the state’s divorce law.
To determine the existence and extent of goodwill, the court noted it may consider as “determinative factors” the practitioner’s age and health, past earning power, reputation in the community for judgment, skill and knowledge, and, finally, comparative professional success.
Added to this are terms of a lawyer’s partnership agreement that may also be considered when determining the value of goodwill in a divorce context, but only as a single factor. As noted by the appellate court, “Partnership agreements are designed to deal with particular aspects of the business, and simply do not address the considerations involved in valuation for a marital dissolution.”
The court of appeals faulted the family court for failing to consider Jeffrey’s professional goodwill beyond his stock redemption interest in the firm. The court also pointed out that it had previously rejected the lower court’s approach of requiring goodwill to be realizable (something that can be bought or sold on the open market).
The court acknowledged that, when goodwill has no immediate cash value, it must apply its own discretion and judgment in making a determination. The determination, of course, isn’t limited to corporate documents setting a shareholder’s interest in the company’s assets. Instead, the court can use expert testimony and the “determinative” factors to help guide its examination of enhanced future earning capacity.
The court of appeals concluded that the family court had conflated the firm’s net assets, which were subject to the stockholder’s agreement, along with Jeffrey’s own goodwill. It also decided that he possessed goodwill beyond the amount that the family court had designated.
However, the appellate court emphasized that its ruling should not be interpreted as equating future earning capacity with goodwill. While future earning capacity may be evidence of goodwill, the earning capacity isn’t itself a divisible community asset.
Sidebar: Professional goodwill: Community property or not?
The husband in Walsh v. Walsh (see main article) argued that professional goodwill is separate from “enterprise goodwill” and isn’t divisible marital property. The Arizona court of appeals acknowledged that some states do hold that professional goodwill may not constitute marital property. But, in Arizona, the court said that consideration of the “determinative” factors demonstrates that the state does consider qualities that are attributable to the individual when determining community property values.
The husband further argued that professional goodwill is already accounted for in spousal maintenance and realized through future earnings. The court disagreed, however, comparing the divisible component of professional goodwill with an interest in pension rights — value is generated (at least partly) during the marriage, and will be realized later. Courts must ensure that they don’t divide as community property future earnings that are based exclusively on post divorce efforts.
It is critical to understand your specific state’s position on whether professional goodwill constitutes martial property due to the fact that it could have a significant impact on stock redemption value in divorce proceedings.
If you have questions regarding professional goodwill, or any other litigation concerns please contact Freed Maxick CPAs litigation support team today.