When business assets are involved in financial disclosure, there may be much more going on than meets the eye
As we all know, form E requires divorcing parties to make disclosures about their financial status. This includes details of income and expenditure and their general financial position.
Financial disclosure in divorce
For a shareholder in an owner-managed business, this can require details of business assets (section 2.11) and directors’ loan account (DLA) balances, which can be a financial asset or liability, as well as any associated tax liabilities.
Disclosure and assessment of such details is not straightforward as there is often significant interaction between different parts of the form. For example:
- Drawing a higher salary will make a company appear to be less profitable. If not adjusted for, will suggest a lower business valuation.
- An overdrawn DLA is a non-trading company asset and will increase the business value and increase personal liabilities.
- Properties owned personally yet used rent-free by the individual’s business will make a company appear more profitable and, if not adjusted for, will suggest a higher business valuation.
- Shareholders in a more valuable business will have a higher potential CGT bill on the assumed disposal of their shares.
In this article we discuss some of the issues we typically encounter when reviewing form E disclosures from an accounting perspective, with a particular focus on issues relating to business valuation.
The business is only an income-producing vehicle
When reviewing the form E of an individual who is an employee of a company or a ‘one man band’, it is relatively straightforward to substantiate any income disclosed.
However, it is harder when an individual is the owner of all or part of a business through which they receive their income.
In such circumstances, it is common for an individual to consider that the business is solely relevant as a source of income and not attribute within their form E any value to the shares they hold. Sometimes the business has never been considered as an asset with a separately identifiable value by the parties themselves. Sometimes a party to the divorce is trying to suppress the value of their assets.
It is common for a shareholder in an owner-managed business to state that the value of the business lies in what they draw out of it. This is based on the assumption that, without them, the business would have no future and therefore no market value. Assuming the business is profitable, this is a very unlikely situation for a number of reasons:
- Most profitable businesses have net assets, which will have value.
- Succession planning enables value to be transferred from one owner to another.
- Most profitable businesses do have value.
If a business has positive net assets it has value. The minimum value that can be ascribed to a business is generally considered to be the total market value of assets, less total liabilities due. For many businesses this is likely to be the value of net assets shown on the balance sheet. In simple terms, if the company was wound up it is an amount equivalent to the value of net assets that would be received. Sometimes a business is worth more or less than the net assets reported in the balance sheet, as discussed below.
Succession planning makes good business sense
It is uncommon for any individual to be irreplaceable, even in a small owner-managed business. Reliance on one or a small number of individuals will have an impact on the value of the business, but this does not mean that it is worthless.
Take, for example, a one-man plumbing business (we’ll call it Joe’s Plumbing). It could be argued that the business was worthless without Joe but — and this is an example from real life — Mike, the new owner, continued to win business trading as Joe’s Plumbing. Existing customers in need of a plumber phoned Joe’s Plumbing, spoke to Mike (who explained that Joe was no longer with the business) and asked him to come and fix the problem. Joe may have been a great plumber, but he was not irreplaceable.
Whilst there may be significant reliance on one person, in the event of a trade sale it is typical for the parties to enter into earn-out arrangements. Such arrangements act to tie in the owner-manager for a period of between one and three years after sale in order for key customer or supplier relationships to be transferred. The price payable for the business will ultimately depend on its profitability during the earn-out period.
Another example from the authors’ recent experience involved the sale of a business reliant on retaining key relationships established by the owners. In order to achieve this, part of the consideration was deferred over three years to ensure that the sellers remained connected to the business. A further part of the consideration was calculated on an earn-out basis to motivate the sellers to transfer and maintain client relationships.
So what is the value?
Even when a value has been attributed to a shareholding within form E it should be approached with a certain level of skepticism. There are a number of reasons for this, but it is important to note that the net asset position of a business shown in a set of accounts (and referred to above) will frequently be lower than the actual value of a business.
There are a number of different ways to value a business but the most typical approaches are:
- The earnings basis — determining the future profitability based on a multiple of a maintainable earnings figure.
- The asset basis — considering the total market value of assets less total payable liabilities.
Whichever approach is used to disclose a value in a form E, there are a number of important considerations. It’s important to look beyond the simple figures set out in the form E or even the accounts.
Assets may be undervalued, by being included at a historical or depreciated cost that doesn’t reflect the true market value. The most common undervalued assets are land and buildings. If purchased many years ago the value shown in the accounts could be significantly out of date. It is important to obtain an up-to-date valuation, preferably from a chartered surveyor or other suitable expert.
Some assets may be overvalued, for example debts that are very unlikely to be received, or internally generated software. Amounts owed from related parties will frequently remain on the balance sheet (and appear as assets that could be realised if the business was wound up) but the related party may not, in fact, be good for the money. Internally generated software is unlikely to have a value on the open market.
Balances owed to or from a divorcing party should also be considered.
An amount owed to a party by a company will decrease the business value but represent a personal asset; therefore a corresponding adjustment to the personal assets within the form E may be required. If money is owed to the business the opposite would be the case — the business value would be higher but the individual should also report a liability in respect of the debt due. Whilst these entries are simply opposites on the form E and could therefore be overlooked, it is important to note that the impact on the business valuation will also have an impact on any CGT due on the ultimate sale or transfer of shares. There are no tax implications of the repayment of business loans.
The value of a profitable business will often exceed the value of its net assets. An earnings-based valuation assesses value with reference to future expected profitability, rather than just what assets the business has now. It is usually necessary to consider past profitability, as this gives an indication of future earnings, although it is also important to try to obtain any forecasts and budgets that may be available. The assessment of future profitability requires a questioning approach tailored to the circumstances of the individual business. Trade may be affected either in the past or in the future by a host of internal or external factors, such as regulatory changes, the loss of key personnel, disputes with suppliers, winning significant new contracts, changes in technology, or the local or national economy.
It is therefore important to ensure that the most up-to-date financial and commercial information is obtained.
Any valuation prepared solely on the basis of the statutory accounts cannot hope to be accurate, since those accounts will most likely be out of date at the point at which the parties are trying to resolve the value of the company and will not contain the important information about factors affecting the business going forward.
Take a closer look
Sometimes one party to a divorce will have concerns about the manipulation of financial results in order to paint a less favourable impression of the business and its value.
Engaging an expert with sufficient relevant experience should mean that the right questions are asked to establish the true position.
Having valued a business using an earnings-based approach, it is still necessary to consider the assets of the business and assess whether any may be surplus to requirements.
Typical surplus assets include excessive cash or properties that are not core to the operation of the business. The value of these surplus assets should be added onto the earnings-based valuation on the basis that the assets could be sold to generate funds without impacting the trade of the business.
It is important to note that property owned by a business will almost always be a surplus asset. A business could sell and lease back property to realise capital with a relatively small impact on its earnings potential. This could be the case even where the property is considered to be integral to the nature of the business, for example a restaurant or private school. Given generally high property prices, this can have a significant impact on business valuation and is often overlooked.
If the earnings basis provides a higher value, this should be used if it is intended for the business to carry on trading. The excess of the earnings basis of valuation over the asset basis represents goodwill associated with the business.
It all affects the tax position
Once the value of a business has been determined, it is often necessary to consider the tax consequences of either a disposal or transfer of shares. Without consideration of the tax position, matrimonial assets could be overstated and one party may be at a disadvantage due to unexpected tax liabilities. There are an even greater number of considerations here, which are beyond the scope of this article, but some of the typical tax issues that are rarely dealt with in full in form E are:
- Shareholder directors pressured to resign before share disposals are made may lose entitlement to entrepreneurs’ relief and CGT at the lower rate of 10%.
- Write off of loans due from shareholders may mean income tax is due by the individual on a deemed dividend distribution equal to the amount of the loan write off.
- Properties owned by the business yet used personally rent-free may mean unpaid Class la NICs by the company and unpaid income tax on the benefit received by the individual.
Whilst not relevant to form E, it is worth mentioning the tax implications of deferred consideration on settlement. Accountants are rarely involved at the time of agreeing a settlement but deferred consideration can increase the tax rate significantly if the settlement agreement is not structured in a tax efficient way.
For example, a transfer of shares worth £2m from a husband to a wife attracting entrepreneurs’ relief would result in CGT of £200k being paid. If the shares are purchased out of post-tax income by the husband and entrepreneurs’ relief is lost by the wife, the total income and capital taxes paid by the couple would be £1.4m.
When reviewing form E it is important to bear in mind that most profitable businesses have a value and that the value often may not be apparent from the form E or even the company’s accounts. Further investigation of all the circumstances surrounding the business is likely to be required, sometimes at a forensic level. It is also important to consider the completeness of the form E in relation to financial assets and liabilities, and the interplay between the various sections.
Finally, detailed consideration should be given to the tax implications at every stage of the matter. Sometimes the tax bill is significantly greater than the fees paid to professional advisers during divorce.