DCF (plus tax-affecting) is more appropriate for partnership valuation than cap/earnings approach, says post-Bernier court

Back in 2007, the Bernier decision by the Supreme Judicial Court of Massachusetts was among the first to analyze the “bedeviling” issue of tax-affecting the income stream of a closely held corporation in divorce. (See BVWire #60-2)  Recently—the same panel delivered an expedited opinion concerning the present value a husband’s interest in a highly lucrative hedge fund partnership. Three aspects promise to spark as much interest and debate as Bernier:

  • First, the trial court correctly included the present value of the partnership interest in the marital estate, when the asset produced a consistent income stream with annual cash distributions (in some years, return on capital and equity topped $20 million).
  • At the same time, the trial court erred by using the direct capitalization of income method to value the partnership (from which the husband would eventually retire), when a discounted cash flow (DCF) analysis “more accurately reduces a finite period of future cash-flow to present valuation,” the court held, citing Valuing a Business, 5th ed., by Shannon Pratt and Alina Niculita (available at BVResources).
  • The trial court also erred by tax-affecting the partnership at a combined capital gains tax rate without providing its specific reasons, the court held. (Note: At trial, the husband’s expert applied a 40% combined income tax rate to post-retirement income only; the wife’s expert tax-affected pre-retirement income at 31.5% and post-retirement at 38.5%.)
Accordingly, the Mass. Supreme Court rejected the trial court’s $80.1 million present valuation of the partnership interest and sent the case back for a valuation “consistent with this opinion.” Read the complete digest of Adams v. Adams, 2011 WL 1385570 (Mass.)(April 14, 2011) in the July 2011 BVUpdate, the court’s opinion will be posted soon at BVLaw.