Understanding the mathematics of the double dip in California divorce (Part III of III)

As previously discussed, the value of a business is determined by capitalizing the income the business generates. Typically, the business interest's value is awarded to the owning spouse and an equal offset of assets is awarded to the non-owning spouse. Using the same income stream to calculate the business value and award spousal support constitutes a "double dip." The same income stream is used once to calculate an equal offset of property and used again to award spousal support.

A double dip is frequently associated with an adjustment made by the business valuer for the owning spouse's salary. In smaller companies, an owning spouse may control the amount she/he receives as salary. The salary paid to her/him many times is arbitrarily set irrespective of the market rate for salaries of similarly situated employees. This distorts the true economic earning capacity of the business. In other words, if an owner/employee sets her/his salary too high, the business profits will be lowered and the value of the business will correspondingly be lower. The opposite is also true. If an owner/employee sets her/his salary too low, the business profits will be higher and the value of the business will correspondingly be higher.

Business valuers separate the reasonable salary of the owner as an employee, from the profits an owner receives by virtue of her/his ownership rights. This process of setting the salary to a reasonable compensation rate or market rate is referred to as salary "normalization."

Above, the company profit before owner compensation is $1,400,000. In the first column the owner's salary is unadjusted at $800,000 (line 2). This produces a profit of $600,000 (line 3). Multiplied by a valuation multiple of 6-times-profit produces a business value of $3,600,000 (line 5).

In the second column, the business valuer adjusted owner compensation to a reasonable market rate of $400,000 (line 2). The salary adjustment is based on an independently derived reasonable compensation rate that more closely reflects what a third party would require to be paid relative to the position offered and the size of the company. In this example, the excess compensation paid of $400,000 represents business profits which were paid as salary compensation. Accordingly, these business profits are added back to the company's profits to ascertain the true economic earning capacity of the business for valuation purposes. Adding back these business profits by reducing the salary paid to a reasonable rate, increases the profitability from $600,000 to $1,000,000 (line 6). Using the same valuation multiple (line 4) produces a business value of $6,000,000 (line 5). By normalizing the owner's salary to a market rate, the value of the underlying business increased from $3,600,000 to $6,000,000 (line 5). This change in value is the result of increasing the company profits by decreasing the owner's salary to a reasonable rate. This results in a corresponding award of property to the non-owning spouse of $6,000,000 rather than $3,600,000. The capitalization of $400,000 of business profits changed the property award by $2,400,000 -- from $3,600,000 to $6,000,000.

A double dip occurs when the adjusted $400,000 of salary is used for valuation purposes and the unadjusted $800,000 of unadjusted salary is used for spousal support purposes. The result is an inflated award of property and spousal support. To avoid a double dip in this example, an award of the lower business value of $3,600,000 corresponds with a spousal award based on $800,000 of salary and a higher business value of $6,000,000 corresponds with a spousal award based on $400,000 of salary. 